The Qualified Business Income (QBI) deduction was created by the 2017 Tax Cuts and Jobs Act (TCJA). It’s aimed at small business owners and self-employed people, not corporations. Also called the pass-through deduction or Section 199A, it’s in effect for tax years 2018 through 2025 -- and it could provide you with significant savings come tax time.
What is the QBI deduction?
Section 199A of the Internal Revenue Code (IRC) provides a tax break called the QBI deduction.
The deduction lets pass-through entities lower their qualified business income. Your business is a pass-through entity if you don’t file a separate Corporate Tax Return (Form 1120) and instead declare all your income (including from your business) on your personal tax return (Schedule C of Form 1040).
According to the IRS, QBI is the "net total income, gains, deductions, and loss from a qualified trade or business". It basically applies to income from a trade or business, and does not include money you earn in wages or capital gains.
In general, it includes the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans, such as SEP and SIMPLE plans.
Where it gets complicated is understanding exactly who qualifies and what they qualify for. For example, while rental income counts as QBI, it only qualifies when the investor is actively managing their property. QBI does include income from PTPs and REITs.
How much money can I save with the QBI deduction?
The QBI deduction provides substantial tax savings to eligible pass-through entities.
The QBI deduction allows you to deduct the lesser of:
- 20% of your qualified business income (QBI), plus 20% of qualified real estate investment trust (REIT) dividends, and qualified publicly traded partnership (PTP) income, or
- 20% of your taxable income minus net capital gain.
With the deduction, you’ll only pay taxes on 80% of your qualified business income. If you’re in the 32% tax bracket, the 20% deduction lowers your effective tax rate to 25.6%.
If you’re eligible, you can take the deduction whether you itemize deductions on Schedule A or take the standard deduction. For the 2019 tax year, the standard deduction amounts are:
|Filing Status||Standard Deduction for 2019|
|Married filing jointly||$24,400|
|Head of household||$18,350|
|Married filing separately||$12,200|
Who can claim the QBI deduction?
There are two factors that define those eligible for the QBI deduction: whether or not you operate a pass-through entity and whether or not your taxable income fits within the IRS limits.
You can claim a deduction if you have income from a trade or business that’s operated as a pass-through entity, including:
- Sole proprietorships
- Limited liability companies (LLCs)
- S corporations
- Some trusts and estates
What doesn’t count as QBI?
You can’t take the deduction as a C corporation or while performing services as an employee. And your taxable income must comply with Internal Revenue Service (IRS) income limits (see below).
QBI doesn’t include:
- Business income earned outside the U.S.
- Capital gains and losses
- Commodities transactions or foreign currency gains or losses
- Dividends and any dividend income equivalent
- Guaranteed payments to partners in partnerships or LLC members
- Income from annuities (unless you receive it in connection with the trade or business)
- Income from wages
- Interest income that you can’t allocate to the trade or business
- Wages paid to S corporation shareholders
Income limits for QBI deductions
If your taxable income (calculated before any QBI deduction) is less than $157,500 ($315,000 for joint filers), you can claim the full 20% deduction.
The deduction is subject to limitations if your taxable income is above that income threshold.
Once you go above that income, the deduction is based on the type of business you have, and whether it’s a specified service trade or business (SSTB). Fields that are considered SSTBs include:
- Actuarial science
- Any trade or business where the main asset is the reputation or skill of one or more of its employees or owners
- Dealing in certain assets (including securities and commodities)
- Financial services
- Investing and investment management
- Performing arts
If your taxable income is between $157,5000 and $207,500 ($315,000 to $415,000 for joint filers), both SSTBs and non-SSTBs are eligible for phased-in QBI deductions.
However, once your taxable income exceeds $207,500 ($415,000 for joint filers), you can’t take a deduction if you’re an SSTB.
Non-SSTBs, however, can still take the deduction, but it will be limited to the greater of your share of:
- 50% of the W-2 wages paid to employees, or
- The sum of 25% of such W-2 wages plus 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of the qualified property.
The QBI deduction if you invest in REITs and PTPs
If you invest in REITs and PTPs, you can maximize your QBI deduction. That’s because income from qualified REITs and PTPs aren’t subject to the SSTB limitation. You can take the 20% deduction on these income sources (but you still have to consider the overall limit based on your taxable income).
Unless you’re a tax professional, get help with the QBI deduction
Many small business owners and self-employed people are eligible for the deduction. However, the rules for claiming the QBI deduction are complicated as the deduction is relatively new, and many restrictions apply. It’s recommended that you work with a qualified tax professional who can help you get the most out of this important tax break.