The qualified business income deduction – QBI deduction – is new to the tax scene. It’s a powerful tool in reducing your tax liability, but calculating the deduction can be tricky.
Here are the basics of this deduction based on the IRS’ August 2018 guidance and how to calculate it.
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?
First, you use your taxable income, NOT your adjusted gross income (AGI).
Remember! Your QBI is determined separately for each of your qualified businesses, but combined as a single amount on your individual tax return.
Let’s walk through the calculation.
1. Determine whether your income is related to a qualified trade or business.
In order to claim the QBI deduction, you must have ownership interest in a qualified trade or business.
Specified service trades or businesses, such as accounting, health, law, performing arts, consulting, and actuarial science, may be unable to claim this deduction.
We’ll cover that in an upcoming blog post.
2. Calculate the QBI for each business for the tax year and your net taxable income.
What counts as QBI?
It’s the net amount of the business’ qualified items of income, gain, deduction, and loss. QBI doesn’t include investment-related items of income, gain, deduction, and loss.
Both of these rules 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
- Qualified PTP income
- Income from foreign pass-through entities
Reasonable compensation is limited to the compensation of S corporation shareholders-employees. It doesn’t apply to partnerships.
Usually, you can deduct 20% of qualified REIT dividends, qualified cooperative dividends, and qualified PTP income, but these items aren’t part of calculating your QBI.
Can I combine QBI sources?
Yes. In order to calculate your total QBI, you can combine multiple sources of income.
It can be 20% of your QBI from each of your qualified trades or businesses plus 20% of the aggregate amount of qualified REIT dividends and qualified publicly traded income.
If you have two or more trades or businesses, you can combine your QBI, W-2 wages, and the basis of qualified property for each of them to apply the W-2 wage and qualified property limitations. This isn’t required, but it’s allowed.
You do have to follow a few aggregation rules.
- You can only combine trades or businesses.
- The same person or group of people must own a majority interest in each of the businesses, either directly or indirectly. Family attribution rules apply.
- The businesses can’t be a specified service trade or business.
- Your businesses must meet two of these tests.
- The businesses provide the same product or services. Example: restaurant and food truck. Or, the product or services are provided together. Example: gas station and car wash.
- The businesses share facilities or centralized business elements. Example: accounting, legal, and IT.
- The businesses are operated in coordination with each other or rely on other businesses in the group. Example: supply chain.
Now that you’ve calculated your QBI for each of your businesses, you can calculate your limitation. This can help you determine if aggregating your businesses hurts or helps your deduction amount.
3. Apply the W-2 wages and qualified property limitation.
You don’t have to calculate your limitation if your taxable income is less than $315,000 (married filing jointly) or $157,500 (single). Even if you’re part of a specified service trade or business.
You must calculate your limitation if your taxable income is more than $315,000 or $157,500, and if you have ownership interest in a qualified trade or business that isn’t a specified service trade or business.
First, you have to know how much the company paid in W-2 wages and how much qualified property you have. These will limit your deductible amount.
Total entity W-2 wages 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.
Your QBI is either limited to the lesser of:
- 20% of your QBI
2. 50% of the company’s W-2 wages with respect to the trade or business 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 wage tests gives you a greater deduction.
4. This is your total deduction amount.
And, if the net amount of your combined QBI during the tax year is a loss, you have to carry it into the next tax year as a loss.
Next year, your QBI deduction will be reduced by 20% of the loss.
Mary is married and has a manufacturing business which generates $100,000 of QBI.
Her taxable income is more than $415,000.
She paid $30,000 in wages and has $50,000 of qualified property.
- Mary’s qualified business income is $100,000.
- Her QBI deduction is $100,000 x 20% = $20,000.
Mary’s taxable income is more than $315,000, so she can’t automatically claim the $20,000 deduction. She has to calculate her limitation.
She performs both wage tests to find the greater deduction.
- Test 1: 50% of wages → $30,000 x 50% = $15,000
- Test 2: Sum of 25% of W-2 wages + 2.5% of the unadjusted basis of all qualified property → ($30,000 x 25%) + ($50,000 x 2.5%) = $8,750
Mary chooses the greater deduction. Her QBI deduction is $15,000.
Again, this deduction can get complicated when you start looking at multiple sources of QBI, eligibility, deduction rules, and limitations. And, the IRS plans to issue more guidance which could change how this deduction is applied.
Connect with your tax professional to understand how this deduction will impact your 2018 tax returns.
Consider asking your accountant to run projections or discuss how this deduction factors into your overall tax strategy.
Have questions about calculating your QBI deduction? Let’s talk!