Now would be a good time to pause for a few definitions.
A pass-through business is a sole proprietorship, partnership, LLC (limited liability company) or S corporation. The term “pass-through” comes from the way these entities are taxed. Unlike a C corporation, which pays corporate income taxes, a pass-through entity’s business income “passes through” to the owner’s individual tax return. In other words, the business passes through its income and deductions to the owners.
Qualified business income is the net amount of a business’s income, with a few exceptions. QBI doesn’t include:
- investment income, such as capital gains or losses, or dividends
- income from businesses located outside of the U.S.
- interest income not properly allocable to a trade or business
The IRS has a full list of exceptions to QBI in its Facts About the Qualified Business Income Deduction.
Who qualifies for the QBI deduction?
The QBI deduction is only available to owners of pass-through businesses, even if you’ve opted to take the standard deduction as opposed to an itemized deduction. But the limitations don’t end there. If your business is a “specified service trade or business”, your QBI deduction may be limited or disappear entirely once your total taxable income reaches a certain limit.
A specified service trade or business (SSTB) is a service-based business (other than engineering or architecture) where the business depends on the reputation or skill of its employees or owners. That’s a broad definition, but it includes law firms, medical practices, consulting firms, professional athletes, accountants, financial services, members of the performing arts, investment management firms, and more.
If you have a specified service trade or business
You can determine whether you get the full 20 percent deduction, a limited deduction, or no deduction at all based on your total taxable income.
Total taxable income refers to all the taxpayer’s income before the QBI deduction is applied. This may include wages from other jobs, wages earned by your spouse (if married and filing a joint return), interest and dividends, capital gains, rental income, and more. For most taxpayers, this will be the adjusted gross income shown on Form 1040. Note that this means the QBI deduction does not reduce your self employment tax.
The taxable income limits for 2023 are:
The taxable income limits for 2024 are:
If you don’t have a specified service trade or business
If your business is not an SSTB, but you have taxable income greater than the income limits of $232,100 for a single filer or $464,200 for a married couple being joint filers, your QBI deduction is limited to the greater of:
- 50 percent of your share of the W-2 wages paid out in the business, or
- 25 percent of your share of the W-2 wages paid out in the business, plus 2.5 percent of qualified property
Qualified property includes all tangible, depreciable property that hasn’t reached the end of its depreciable life. For most properties, the depreciable life is 10 years. For real estate, the depreciable life may be up to 39 years.
For both SSTBs and non-SSTBs
If the business owner has dividends from a qualified real estate investment trust (called qualified REIT dividends) or publicly traded partnership income in the tax year, there is a second deduction worth up to 20 percent of that income, which gets added to the QBI deduction.
After calculating the two deductions, add them together. Then calculate your overall limitation by taking 20 percent of:
- Your taxable income for the tax year (before considering the QBI deduction), minus
- Net capital gains, including qualified dividend income taxed at capital gains rates
This overall limitation ensures that the 20 percent deduction isn’t taken against income that is already taxed at the lower capital gains tax rate.
How to calculate the QBI deduction
As you’ve probably noticed by now, the QBI deduction gets complex fast. The best way to figure out whether it applies to your business is to take it step-by-step.
Step 1: Determine whether your business is a specified service business. The IRS Qualified Business Income FAQs go into greater detail about the kinds of businesses that qualify as an SSTB.
Step 2: Calculate your total taxable income for the year. If a taxpayer’s taxable income is less than $182,100 ($364,200 if married filing jointly) then no matter the type of business, they can take the full 20 percent QBI deduction.
Step 3: If your business is an SSTB and your total taxable income is $232,100 or more ($464,200 or more for a married couple filing jointly), stop here. Your income is too high to claim the deduction.
If your business is not an SSTB, and your total taxable income is between $182,100 and $232,100 ($364,200 and $464,200 if married filing jointly), you can claim the full 20 percent deduction.
If your business is an SSTB and your total taxable income is between $182,100 and $232,100 ($364,200 and $464,200 if married filing jointly), then continue to the next step to calculate your limited deduction.
Step 4: If your business is an SSTB with income in the phase-out range, you’ll calculate your deduction by taking 20 percent of your qualified business income and applying the limitation of:
- 50 percent of your share of W-2 wages paid by the business, or
- 25 percent of those wages, plus 2.5 percent of your share of qualified property
Compare these calculations to 20 percent of your QBI and deduct the smaller amount.
How Bench can help
If you’re feeling bogged down by deductions trying to figure out how to minimize your tax bill, you’re not alone. Every year, millions of Americans overpay on their taxes, and it’s particularly easy to do this as a business owner given the wide array of tax benefits available to you.
At Bench, we’re more than just a bookkeeping solution. Beyond our year-round financial reporting support, you get access to our in-house tax advisory team. They’re here to help you figure out what you need to do to minimize your tax liability and improve your operations. No more lost hours trying to figure out the technicalities, just savings. Learn more about Bench’s tax services.
Calculating the QBI deduction: an example
To give you an example of how the QBI deduction works in the real world, say Kate is a marketing consultant with $10,000 in qualified property. She has one part-time employee who earns $20,000 per year. Kate is married, and as a consultant, she is in a specialized service business. Let’s look at three scenarios:
- Kate’s total taxable income is less than $$364,200, so her deduction is not limited,
- Kate’s total taxable income is more than $$364,200 but less than $464,200, so her deduction is limited, and
- Kate’s total taxable income is more than $464,200, so no deduction is available.
The Form 1040 Instructions and IRS Publication 535 contain worksheets you can use to calculate the deduction. Use the worksheet in the Form 1040 instructions if your taxable income before the QBI deduction isn’t more than $182,100 ($364,200 if married filing jointly). Use the Publication 535 worksheet if your taxable income before the QBI deduction is higher than the threshold amount.
As of the 2020 returns (filed in 2021), the IRS requires business owners who claim the QBI deduction to attach Form 8995 to their returns.
Learn more: What is Form 8995? A Small Business Owner’s Guide to the QBI Deduction
Bottom line
If all of this sounds confusing, it is. The QBI deduction provides a generous tax break for businesses that qualify to claim it. However, as the rules and definitions above make clear, determining who can claim the QBI deduction and calculating it is no easy task.
Small business owners benefit from staying on top of available deductions and potential tax breaks. But while it’s worth knowing the top small business tax deductions, it’s best to leave your QBI deduction calculation to a CPA or tax professional.
When you’re ready to let your tax filing be handled by a pro, let Bench do your books and file your taxes.
