The Qualified Business Income deduction or QBI deduction is an automatic 20% income tax deduction on your income taxes if you’re self-employed or own a business entity that isn’t taxed as a corporation. Like other tax deductions, there are income limits and other restrictions on the QBI deduction. Keep reading to find out if you qualify and for how much.
What is the background of the QBI Deduction?
The QBI deduction was created in 2018 as part of the Tax Cuts and Jobs Act. It can be found under Section 199A of the tax code.
The TCJA gave corporations a tax cut down to 21%. Since owners of other types of businesses pay income taxes at their personal income tax rates, the QBI deduction was created to match the tax break given to corporations.
Because of Congressional budget rules, much of the TCJA, including the QBI deduction, will expire in 2025. This means the QBI deduction will no longer be available from 2026 on unless Congress extends it.
Who is eligible for the Qualified Business Income deduction?
The QBI deduction is available to all types of businesses that are taxed as a pass-through entity. This includes retail stores, manufacturing operations, lawyers, lawn care businesses, sports officials, Lyft drivers, and more. For certain types of businesses, the deduction has income limits (more below).
What’s a pass-through entity or business?
A pass-through business is a business that pays tax via its owner’s tax return. It’s basically any business type except a corporation or an LLC that chooses to be taxed as a corporation. This includes:
- Sole proprietorships. This includes independent contractors receiving a 1099 and filing Schedule C. You do not need to formally register a business to take advantage of this deduction.
- Limited Liability Companies (that did not elect to be taxed as a corporation).
How much is the QBI deduction?
The QBI deduction is up to 20 percent of qualified business income. In most cases, qualified business income is simply equal to your share of the profits.
For example, if you have $100,000 in sole proprietor profits, you get a $20,000 deduction. Remember that this is a deduction, not a credit. The $20,000 is subtracted from your income not your tax bill. So in this example, you’d get taxed based on $80,000 in income.
The following items are not qualified business income, so you’d have to subtract them from your profit before calculating your deduction.
- Capital gains and losses.
- Certain dividends received.
- Certain interest income.
- Other items that aren’t effectively connected with the conduct of a trade or business within the United States.
What if your qualified business income is greater than your taxable income?
If your qualified business income is greater than your taxable income, the deduction is limited to 20% of your taxable income adjusted for capital gains. This frequently happens if most or all of your income is business income. That’s because your taxable income is your net profit minus other deductions like the standard deduction or retirement account contributions.
For example, say you had $100,000 in business profits, no other income, and contributed $10,000 to your solo 401(k). Your filing status is married filing a joint return. For easy math, I will round the standard deduction to $25,000. Your taxable income before the QBI deduction is $65,000 ($100,000 – $10,000 – $25,000). Your QBI deduction would be 20% of $65,000 or $13,000. You’d end up paying income taxes on a taxable income of $52,000 ($65,000 – $13,000).
Does the QBI deduction reduce self-employment tax?
The QBI deduction only reduces income taxes. Self-employment tax still applies to your net business profit before taking the QBI deduction.
What is a specified service business?
The Section 199A deduction is limited based on your income and whether you’re a specified service business.
26 CFR § 1.199A-5 defines what specified service trades or businesses are.
The list of specified service businesses includes:
- Health (physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar professionals)
- Law (lawyers, paralegals, legal arbitrators, mediators, and similar professionals)
- Accounting (accountants, enrolled agents, return preparers, financial auditors, and similar professionals)
- Actuarial science
- Performing arts (actors, singers, musicians, entertainers, directors, and similar professionals)
- Consulting (providing advice and counsel to assist the client in achieving goals and solving problems)
- Athletics (athletes, coaches, and managers when using skills unique to the athletic competition — does not apply to operational jobs)
- Financial services (wealth management, financial advice, retirement planning, wealth transition planning, valuations, mergers, acquisitions, dispositions, underwriting, or similar services)
- Brokerage services
- Investing and investment management (fees for investing, asset management, or investment management services including advice — does not include directly managing real property)
- Trading (trading securities, commodities, or partnership interests)
- Dealing in securities, partnerships, or commodities
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners (as specifically defined below)
The last bullet initially created a lot of confusion because just about anything could be read as being a service trade. However, the IRS regulations later defined it only as one of the following activities:
- Receiving compensation for endorsing products or services
- Receiving compensation for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with an individual’s identity
- Receiving compensation for appearing at an event, on the radio, on TV, or on another media format
The above lists are only a summary, so please consult with a tax professional if you believe you may fall under one of the above areas.
What are the income limits for the Qualified Business Income deduction?
The deduction has limits based on your total taxable income. The below numbers are the starting point when the law was passed and adjust for inflation each year. The inflation-adjust numbers are here.
Total taxable income means all of your income, not just your qualified business income. For example, a married filer with $450,000 in wages and only $10,000 in qualified business income would not qualify.
All Businesses: Income Up to $157,500 (Single) or $315,000 (Joint)
The calculation is simply 20% of qualified business income. If your income is within this range, you get the full deduction even if you’re a specified service business.
Specified Service Businesses with Higher Incomes
If you’re on the specified service businesses list, the deduction gradually drops from 20% to 0% as you go from $157,500/$315,000 to $207,500/$415,000.
Unlike tax brackets, the same percentage applies to your entire income. If you’re a single filer with $207,501 in qualified business income, you do not get a single cent from the deduction.
All Other Businesses with Higher Incomes
For other businesses, the calculation is more complex at higher incomes. The deduction if you’re above $207,500/$415,000 is the lowest of:
- 20% of qualified business income.
- 50% of W-2 wages paid to your employees.
- 25% of W-2 wages paid plus 2.5% of the basis at acquisition of qualified property (that you use in the business and isn’t fully depreciated).
If you’re between $157,500/$315,000 to $207,500/$415,000, the two calculation methods are blended together.
How does the QBI deduction work for partners and multiple shareholders?
Even though the QBI deduction is for business income, you qualify based on your personal income. It does not matter how much the business made in total.
Each partner or shareholder calculates their own deduction based on their own share of the profits and their other personal income. A partner can be eligible even if the other partner isn’t. Further, the income limits are based on each individual’s own income rather than the business’s total income.
QBI Deduction Planning
Because of the complex rules governing eligible business types, phaseouts, and cutoffs, smart tax planning is critical to maximizing this deduction. For example, a specified service business owner might be able to go from no deduction to a full 20% by putting more money into a tax-deferred retirement account to get their taxable income under the limits.
Other businesses may see a benefit from splitting different portions of the business into separate business entities. You’d want to split out activities that give qualifying business income, so you go from no deduction or a limited deduction to some deduction or a higher deduction. There are many accountants who specialize in this area, and it really isn’t something you want to try on your own.
Frequently Asked Questions
Yes, independent contractor income reported on Form 1099-NEC or 1099-K can qualify for the QBI deduction if you meet the other requirements.
Almost any type of business activity qualifies unless you chose to be taxed as a corporation.
Generally, qualified business income is business profits made from selling goods or services.
No, the QBI deduction is a completely separate deduction. You don’t need to itemize to take it.
You’re either on the list or you’re not (see above). The IRS specifically defined these types of businesses, so you don’t have to figure out if your reputation or skill is the principal asset of your trade or business.
Not necessarily, but the reason many accountants recommend that you do is to show you’re actually operating as a business and eligible for the QBI deduction. Also, there are large fines if you don’t issue 1099s when required.
Attorneys are eligible, but they’re considered a specified service business and subject to income limits. In addition, the QBI only applies to law firm owners and partners. Associates paid as employees don’t qualify because the QBI deduction doesn’t apply to wage income.
The QBI deduction applies to almost any type of business income unless your business is taxed as a corporation. If you’re under the income thresholds, it’s basically a free 20% deduction. If your income is higher, you may want to work with a tax professional to figure out how to maximize your deduction.