The qualified business income deduction – QBI deduction – is relatively new to the tax scene. It’s a powerful tool in reducing your tax liability, but calculating the deduction can be tricky.
Here’s a step-by-step guide on how to calculate your QBI deduction.
First, what’s the QBI deduction?
It’s a way for individual taxpayers to reduce their tax liability with qualified business income (QBI) they receive from partnerships, S corporations, and sole proprietorships.
Generally, taxpayers can deduct 20% of QBI, qualified cooperative dividends, qualified REIT dividends, and qualified publicly traded partnership (PTP) income.
How do I calculate my deduction?
Start by using your taxable income, NOT your adjusted gross income (AGI). Your taxable income is your gross income after you’ve subtracted your deductions and personal exemptions.
Remember to determine your QBI separately for each of your qualified businesses, then combine them all as a single amount on your tax return.
Now that we have the basics, let’s walk through calculating your deduction!
Step 1. Determine whether your income is related to a qualified trade or business
You must have ownership interest in a qualified trade or business to claim the QBI deduction. A qualified business is a partnership, S corporation, or sole proprietorship. They’re also known as pass-through entities.
However, some businesses might face a limited deduction. They’re called specified service trades or businesses or SSTBs.
SSTBs include businesses in the following industries: health, law, accounting, actuarial science, performing arts, consulting, athletics, investing and investment management, and trading. SSTBs also include any business with a principal asset of a reputation or skill of one or more of its employees or owners and businesses dealing in securities, partnership interests, or commodities.
If your business falls under any of these categories, there’s a chance you can’t claim this deduction. If you can claim it, your deduction amount might be limited.
Find out if you qualify, by reading ‘Do I Qualify for the QBI Deduction?‘
Step 2. Calculate the QBI for each business for the tax year and your net taxable income.
What counts as qualified business income?
QBI is the net amount of the business’ qualified items of income, gain, deduction, and loss. It doesn’t include investment-related items of income, gain, deduction, and loss.
These rules also apply to active and passive investments.
What’s not QBI?
- Amounts paid for services that are your reasonable compensation*
- Guaranteed payments to a taxpayer for services performed
- Amounts paid to a taxpayer that’s acting outside of his/her capacity as a partner for services
- Qualified REIT dividends
- Qualified cooperative dividends
- Income from foreign pass-through entities
- Qualified PTP income
Usually, you can deduct 20% of qualified REIT dividends, qualified cooperative dividends, and qualified PTP income, but you don’t include these items when calculating your QBI.
*Reasonable compensation is limited to the compensation of S corporation shareholders-employees. It doesn’t apply to partnerships.
Can I combine QBI sources?
Yes. In order to calculate your total QBI, you can combine multiple sources of income.
If you have two or more businesses, you can combine the QBI, W-2 wages, and basis of qualified property for each of them. Then, you apply the W-2 wage and qualified property limitations. You aren’t required to combine – or aggregate – your businesses, but it’s allowed.
If you do choose to aggregate, your businesses have to meet certain criteria and requirements. And, you would have to continue to aggregate in future years until circumstances change.
Now that you’ve calculated your QBI for each of your businesses, let’s move on to calculating your limitation. Unfortunately, you may not always get to claim a straightforward 20% deduction. It may be limited.
Calculating your limitation will help you decide if aggregating your businesses hurts or helps your total deduction amount.
Step 3. Apply the W-2 wages and qualified property limitation
You must calculate your limitation if:
- You have ownership interest in a qualified trade or business
- Your taxable income is more than $315,000 as a married filing jointly taxpayer or more than $157,500 as a single taxpayer
If your taxable income is less than these amounts, you don’t have to calculate the limitation. You can just take the straight 20% deduction.
Here’s how to apply the limitation.
First, know how much the company paid in W-2 wages and how much qualified property it has.
W-2 wages are total W-2 wages the company paid to employees that are subject to tax withholding, elective deferrals, and deferred compensation.
Qualified property is tangible property – personal or real – that’s subject to depreciation. Land isn’t qualified property.
Then, you’ll have to do some math.
Your QBI is limited to whichever of these options is the least:
- 20% of your QBI
- 50% of the company’s W-2 wages OR the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property. You can choose whichever of these two wage tests gives you a greater deduction.
Step 4. This is your total deduction amount
You’ve successfully calculated your deduction amount! If the net amount of your combined QBI during the tax year is a loss, you carry the loss forward into the next tax year.
Read ‘How Do Business Losses Affect My QBI Deduction?‘ to learn more.
Let’s walk through an example.
Mary is married. Her filing status is married filing jointly. She owns a manufacturing business that generates $100,000 of QBI.
Her taxable income is more than $415,000. The business paid $30,000 in wages and has $50,000 in qualified property.
Because Mary’s taxable income is more than $315,000, she can’t automatically claim the 20% deduction. She has to calculate her limitation. She performs both wage tests to find the greatest deduction.
Test 1: 50% of the company’s W-2 wages
50% x $30,000 = $15,000
Test 2: 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property
(25% x $30,000) + (2.5% x $50,000) = $8,750
Mary chooses the greater deduction, so her total QBI deduction amount is $15,000.
However, if her taxable income was less than $315,000, her QBI deduction could have been $20,000 (20% x $100,000).
If you need a visual guide on how to calculate the deduction and help you figure out if you qualify, check out ‘A Simple Flowchart of the QBI Deduction.‘
We know this deduction can quickly become complicated with eligibility rules, definitions, aggregation requirements, and applying the wage tests. The good news is, tax professionals can help you figure out if you can claim this deduction and calculate your total deduction amount. You don’t want to miss out on a 20% tax deduction.
If you want to understand how this deduction will impact your tax return, contact us. We can run tax projections to estimate your deduction amount and tax bill. And, we can discuss how this deduction factors into your overall tax strategy so you can maximize your savings.
Originally published 10/17/18. Updated 10/2/19.
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