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The Qualified Business Income deduction is a new deduction created for 2018 and beyond by the Tax Cuts and Jobs Act. It gives small businesses who aren’t taxed as corporations a 20-percent income tax deduction.
Who is eligible for the Qualified Business Income deduction under Section 199A?
The Section 199A deduction is available to all types of businesses. This includes retail stores, manufacturing operations, lawyers, accountants, freelancers, and side gigs such as sports officials or rideshare drivers. 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. Examples include:
- Sole proprietorships. This include independent contractors receiving a 1099 and filing Schedule C. You do not need to formally register a business to take advantage of this deduction.
How much is the QBI deduction?
The Section 199A 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. If you were in the 24% bracket, your actual tax savings would be about $4,800 ($20k x 24%).
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. A common way this could happen is if you have above-the-line, AGI-reducing deductions such as 401(k) contributions.
What is a specified service business?
The Section 199A deduction is limited based on your income and whether you’re a specified service business.
A specified service business has traditionally meant professional service fields such as law, accounting, and engineering. The definition of specified service trades or businesses also includes the phrase “where the business’s principal asset is the reputation or skill of one or more owners or employees.” So far, the IRS has generally not expanded specified service business beyond the list of businesses in the statute.
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 and adjust for inflation each year.
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 $10,000 in qualified business income would use the greater than $415,000 threshold.
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
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.
- 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 section 199A deduction work for partners and multiple shareholders?
Even though the Section 199A deduction is for business income, you qualify based on your personal income. 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.
Section 199A Deduction Planning
Because of the complex rules governing eligible business types, phaseouts, and cutoffs, smart tax planning is critical to maximize 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. Other businesses may see a benefit from splitting different portions of the business into separate business entities.