Most businesses in the U.S. are “pass-through" businesses, meaning business income passes through to the owners to be taxed on their individual tax returns. Pass-through businesses include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.
The Tax Cuts and Jobs Act of 2017 gave pass-through businesses a potentially valuable tax break: Section 199A, commonly known as the qualified business income deduction.
What is the qualified business income deduction?
The qualified business income (QBI) deduction gives some owners of pass-through businesses a deduction worth up to 20% of their share of the company's qualified business income.
“Qualified business income" is similar to net income but excludes several types of income a business might show on its profit and loss statement. This includes interest, dividends, and capital gains, as well as income from businesses located outside of the U.S. You can find a full list of the types of income excluded from QBI in the IRS's Facts About the Qualified Business Income Deduction.
Who can claim the QBI deduction?
The QBI deduction isn't available to all pass-through businesses. It depends on the type of business you're in and the owner's total taxable income for the year.
It's best to take a step-by-step approach to figure out whether you can claim the QBI deduction.
Step 1: What was your total taxable income for the tax year?
For this step, determine your individual total taxable income for the year (not the business's income). This might include wages from another job, your spouse's wages, interest and dividends, capital gains, rental income, and more.
If your 2021 taxable income is less than $164,900 ($329,800 if married filing jointly), you can claim the full 20% QBI deduction by completing Form 8995, Qualified Business Income Deduction Simplified Computation and including it with your individual tax return. The QBI deduction's income limits are adjusted annually for inflation.
If your taxable income is greater than that amount, move on to Step 2.
Step 2: Is your business a specified service trade or business?
A specified service trade or business (SSTB) generally includes any service-based business where the business depends on the reputation or skill of its owners or employees. That broad definition includes medical practices, consulting firms, law firms, accountants, investment managers, financial advisors, professional athletes, performers, and more.
The IRS's Qualified Business Income FAQs provide more details on the kinds of businesses that qualify as an SSTB.
Now, select one of the following three options:
- Your business is not an SSTB and your total taxable income is between $164,900 and $214,900 ($329,800 and $429,800 if married filing jointly). You can claim the full 20% deduction. Complete Form 8995-A, Qualified Business Income Deduction, and attach it to your individual tax return.
- Your business is an SSTB and your total taxable income is between $164,900 and $214,900 ($329,800 and $429,800 if married filing jointly). You can claim the deduction, but it will be limited. Move on to Step 3 to calculate the amount you can deduct.
- Your business is an SSTB and your total taxable income is $214,900 or more ($429,800 or more if married filing jointly). Your income is too high, and you can't claim the QBI deduction.
Step 3: Apply W-2 wages and qualified property limitations
For SSTBs with income in the phase-out range, you calculate the QBI deduction by taking 20% of your qualified business income and applying the greater of:
- 50% of your share of the business's W-2 wages, or
- 25% of W-2 wages plus 2.5% of your share of the business's qualified property
Qualified property includes all of the company's tangible property (including real estate) that:
- Is owned by the business as of the end of the tax year
- Was used by the business at any point during the year to produce qualified business income
- Hasn't been fully depreciated as of the end of the tax year
Then claim the deduction using Form 8995-A.
If all of this sounds complicated, it is! The QBI deduction can be a generous tax break for businesses that qualify, but it comes with many complicated rules, definitions, and limitations.
For that reason, if you think you might benefit from claiming the QBI deduction, consider working with a qualified tax professional.