If you’re operating a small business on a strict budget, where each dollar plays a role in your future success, you may be concerned what that could mean for incoming revenue when tax time arrives. That’s why knowing the deductions you have access to, such as the qualified business income (QBI) deduction, can be highly beneficial.
Created by the Tax Cuts and Jobs Act (TCJA) of 2017, the QBI deduction allows certain small business owners and sole proprietors to claim up to a 20% deduction of qualified income, which can provide a much-welcome major tax break.
With this deduction, you may be able to divert possible major tax payments back into your business to expand. Of course, that is only an option if you know what qualifications exist to receive the deduction. Below, we’ll delve further into what the QBI deduction is, what income qualifies, and how to claim it.
- The qualified business income deduction is a tax deduction that allows for pass-through business owners to deduct up to 20% of their qualified business income on their taxes.
- Business owners who can claim QBI deduction include individuals who report business income on their personal tax returns, such as small business owners and sole proprietors. Corporations are excluded.
- There are many limitations defined around claiming the QBI deduction; in particular, total taxable income thresholds depending on filing status.
- Depending on your business structure or situation, IRS Form 8895 or 8895-A must be attached to your tax return if you’re claiming a QBI deduction.
What Is Qualified Business Income?
The qualified business income (QBI) deduction, which is also known as the section 199A deduction, was introduced in the TCJA. This deduction allows for small business owners, sole proprietors, and other owners of pass-through businesses to deduct up to 20% on their qualified business income if they meet certain guidelines.
For pass-through business owners, taking a QBI deduction first means calculating qualified business income. The deduction applies only to your QBI, which generally refers to your business’s net income. The IRS defines qualified business income as the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business.
The QBI deduction only applies to domestic businesses, and income earned outside of the U.S. does not qualify. Businesses owned or income created outside of the U.S. is not considered QBI, although it may affect your threshold limit because U.S. taxpayers are taxed on their worldwide income.
What doesn’t qualify as QBI is just as important for you to identify in order to determine whether you can take the deduction. Some items not considered qualified business income include:
- Capital gains and losses
- Interest income
- W-2 income
- Specific wage and payments made to partners or corporations
W-2 wages or salaries paid to employees and the unadjusted basis immediately after acquisition (UBIA) also act as limitations to what you can deduct. The UBIA refers to the cost of property owned and recently purchased by the business.
Can You Claim a Qualified Business Income Deduction?
The QBI deduction is available for individuals who use the pass-through process to report business income on their personal tax returns and be taxed at individual income tax rates. These entities include:
- Sole proprietorships
- S corporations
- Limited liability corporations (LLCs)
However, there are other specific limitations and qualifications that afford or deny pass-through entities the ability to take up to 20% deduction. Finding out what you can claim as a QBI deduction means identifying your operation as a qualified business, under or at the threshold amount, and considering other income factors such as a real estate investment trust (REIT) and UBIA.
One of the most important qualifiers of receiving the QBI deduction is the threshold income amounts set by the IRS each year. For example, in tax year 2021, you may qualify if your taxable income is at or below $329,800 for married joint filers, $164,925 for married separate filers, or $164,900 for single filers.
There are also phase-out levels for qualifying for the QBI deduction for each filing status. You may still be eligible to receive a deduction of up to 20% of your income that doesn’t exceed $429,800 for married joint filers, $214,925 for married separate filers, and $214,900 for single filers.
The QBI is the portion of your tax return that receives the deduction of up to 20% based on qualifications. However, threshold amounts account for your total taxable income as represented on your tax return, meaning other income outside of business income.
Qualified Trade or Business
The IRS defines a qualified trade or business as any 162 section trade or business, but three exceptions to the rule exist.
- A business operating as a C corporation is ineligible as the corporation's income is taxed apart from its owner.
- Services you carry out as an employee are ineligible.
- Specified services trades or business (SSTB) that exceed the income threshold are ineligible to receive the deduction.
An SSTB’s prime asset is the skill and reputation of the employees or owner, who conducts business in the fields of health, law, performing arts, consulting, trading, or athletics to name a few. However, an SSTB that makes at or below the threshold amount can take the deduction up to 20%.
How To Claim a Qualified Business Income Deduction
Let’s say you are eligible to receive the QBI deduction after meeting the necessary guidelines and income thresholds. You now have two different processes, depending on the complexity of business operations and total taxable income.
Forms 8995 and 8995-A are recent additions from the IRS that impact tax returns. These forms must be attached to your tax return if you’re claiming a QBI deduction. The IRS did not request a form for tax returns prior to 2019, so you may be new to the process if you haven’t submitted a deduction claim since 2018.
The IRS Form 8995 is best for simplified tax returns and a straightforward QBI deduction for a business owner. You can use this to figure out your deduction if you have QBI; you are not a patron of specific cooperatives; and you meet the threshold limits of $164,900, $164,925, or $329,800 depending on your filing status.
Use this form if you are involved in a more complex business situation, such as an SSTB, if taxable income is over the threshold, or if you or your business are patrons of specific cooperatives.
Before starting Form 8995-A, you’ll want to complete an applicable Schedule A, B, or C on Form 1040 depending on your business situation. Schedule A reports itemized deductions, Schedule B reports interest and ordinary dividends, and Schedule C reports profit or loss for sole proprietors.
Frequently Asked Questions (FAQs)
How is the qualified business deduction calculated?
Use Form 8995 if you are submitting a simplified claim for a QBI deduction. This means you meet the total taxable income threshold limits in that given tax year. For 2021, thresholds are $164,900 for single filers, $329,800 for married joint filers, and $164,925 for married separate filers. Use Form 8995-A if you’re submitting a more complex claim for a QBI deduction, namely if you are over the income threshold.
Can you claim qualified business deductions on your rental property if you’re not a business owner?
Real estate may be cause for claiming a QBI deduction if the real estate is considered at the level of trade or business as defined by the IRS. The IRS would consider real estate a trade or business if the taxpayer is actively and regularly involved with the rental property with the primary purpose of creating income or profit.