As tax time rolls back around, more business owners are trying to minimize the tax burden on their minds. Conversations are swirling, and naturally, this opens the door for talk of the Qualified Business Income Deduction (QBI).
As a result, business owners of S corporations, sole proprietorships, partnerships, and some trusts can reduce their taxable income when filing.
In addition to the usually allowable business expense deduction, owners can benefit from tax savings under Section 199A.
Numerous business structures may be eligible for qualified business income deduction, including:
- Sole proprietorships
- S corporations
- Limited liability companies (LLCs)
The deduction does not apply to capital gains, interest, or dividends paid out. In addition, it requires that a business owner be engaged in the trade or business activities on a continual or regular basis.
Here is a look at what makes up the deduction and the qualifications around it.
Sources of Qualifying Income
Not all sources of income may qualify for the QBI deduction.
This deduction is specifically for income from a domestic business. The business can operate as a trust, estate, S corporation, partnership, or sole proprietorship.
Additionally, income from a qualified source plus 20% percent of qualified real estate investment trust (REIT) may be eligible for deduction. The same goes for income from a publicly traded partnership plus 20% of earnings from dividends.
Components of the QBI Deduction
Owners capture their income on a Schedule C at tax time. This form is where a business’s deductions, losses, and income are listed. Calculations of values from a Schedule C are from your total taxable income. Then go to form 1040 to find adjusted gross income.
These eligible earnings are the Qualified Business Income component of the deduction in Section 199A.
The REIT/PTP Component
There is also a real estate investment trust (REIT) and publicly traded partnership (PTCP) component. That amount equals 20% of qualified REIT dividends and qualified PTP income.
This component is not limited by W-2 wages or the UBIA of qualified property. The PTP income that qualifies may depend on taxable income or the PTP’s trade.
Qualifications for the Deduction
A deduction available to owners of LLCs, S corporations, partnerships, and sole proprietorships means tax savings. However, it requires that the income is qualified.
Consequently, taxpayers can often find themselves confused and may not even take the available deduction.
Qualified income falls under earnings for businesses that are not a specified service trade or business. Finding out which companies are specified is crucial. The deduction does not exclude businesses with employees, though income earners who function as employees are not eligible. Business owners may still be eligible for the deduction.
So there is the matter of specified businesses or service trades excluded from the deduction. A few of the services are in fields such as:
- Financial services
- Performing Arts
There are exceptions that the IRS has provided in a manual published for tax purposes. For example, service-based businesses (SSTBs) cannot take the deduction, but even within that group, there are exceptions.
For example, if you are a physician, you are in a specified service-based business. However, exceptions allow rendering medical care to stand out from health-based companies.
Keeping more money in your account is invaluable and knowing how much to deduct is a part of the process.
How Much to Deduct
Limits on the QBI deduction revolve around income. That limitation is your portion of 50% of W-2 wages from a qualified business.
The amount is 25% of W-2 wages plus 2.5% of the unadjusted bias (UBIA) of qualified property. It’s often the case that 20% of the qualified business income will apply for those taking no W-2 wages from their business.
The amount deducted can be phased out if your income exceeds the IRS’ limit for the deduction.
Dealing with the Income Limit
In 2021 the filing limit for the qualified business income deduction was $165,000 or $330,000 if filing jointly. There are still exceptions to that.
According to the IRS, if the taxable income exceeds the threshold amount but does not exceed the threshold plus $50,000 for those filing single or $100,000 for those filing jointly, you may still take the deduction.
However, the amount of the deduction will phase out. Even if they are filing jointly, high-income earners that bring in well beyond the threshold may still be eligible.
There is a worthwhile conversation to have with your tax professional. There are potential benefits of creating a separate corporation that provides services to your company.
That separate corporation’s service fee is an expense that may be considered a deduction. Therefore, the resulting income may fall within the threshold.
Necessary Tax Forms
Claiming this deduction requires the completion of tax form 8995. This form allows taxpayers to figure out their qualified business income deduction.
This form captures the net amount of qualified income, gain, deduction, and loss from a qualifying trade or business.
Contributions to a Retirement Plan and QBI
Many earners who generate income from their small businesses look to retirement plans for tax savings. Tax-deductible contributions to a retirement plan create tax deferrals in many arrangements.
However, there is a conversation around the reduction to QBI that pre-tax retirement plans create.
Self-employed earners may choose a simplified employee pension plan (SEP-IRA). They also might consider a 401(k) for tax benefits since this is also a tax-deferral option.
Still, these contributions are a unique scenario. The contributions to the plans are reported as adjustments to income but do not reduce reporting for business income. Since a deduction cannot apply to this income twice for pass-through business owners, the qualified business income “deduction reduction” is necessary. The reduction in business income is minus 50% of the self-employment tax and deductible contributions made to a qualifying retirement plan.
Small business retirement plan contributions become less beneficial as the QBI decreases. Still, pre-tax contributions to a retirement plan are deductible, but only at the usual taxable rate.
Talking with a trained tax professional allows business owners to make the best decision. The tax advisor can help determine what is qualified business income related to retirement contributions.
In addition, this conversation can help decide if an inflection point is necessary. This depends on where your income places you in tax brackets. The full benefits of contributing to your retirement plan while also taking advantage of QBI relate primarily to income.
Publicly Traded Partnerships and Real Estate Investment Trusts (REITs) under Section 199A
Qualified Business Income plays out a bit differently for publicly traded partnerships and real estate investment trusts. First, a portion of business income from these entities is added to QBI deductions.
Earners will then report income that qualifies onto a Schedule K-1 for all partners within the partnership. In addition, the reporting for the earnings must be part of the partner’s share of income, credits, and deductions. Upon selling PTP units, any ordinary income will not be a part of a Schedule K-1. Instead, that income is added to other qualified income when calculating the QBI deduction.
A tax professional can help ensure this opportunity is not missing at tax time. Taking the time to review retirement plan contributions and income with a CPA is invaluable.
Owners of Multiple Businesses
Owners of multiple businesses looking to utilize the qualified business income deduction must aggregate income. This aggregation means the totaling of QBI from all companies.
Owners can then take the deduction on that amount. However, this case generally only applies if the same party owns most of the business for the tax year.
This circumstance may allow a taxpayer with a higher income to claim a higher QBI deduction. The resulting increase in tax deferral can be beneficial.
NOT included in the deduction
Not all items satisfy requirements for qualified business income deduction. Among these items are:
- Income more than $50,000 above the threshold filing Single
- Income greater than $100,000 above the threshold if filing jointly
- Items not properly includable in taxable income
- Capital gains, dividends, or losses from investments
- Wage income
- Income with no effective connection to activity within the trade on a regular or continual basis within the United States
- Income, loss, or deductions from notional principal contracts
- Payments received by a partner for services other than in a capacity as a partner
- Qualified REIT dividends
- PTP income
A simple way to think of QBI may be in the form of an expression.
It can be described as net profit minus 50% of the self-employment tax. Multiplying that value by 20% and capturing it on Form 1040 can be helpful. Additionally, a tax professional is most qualified to help navigate this deduction.
It is crucial to recognize that income earned through a C corporation or providing services as an employee is not eligible for the deduction.
Planning based on your financial circumstances is vital for healthy wealth management. That plan should include working with an accountant or tax professional. They can help make the most informed decisions for your financial future.
The IRS rules can become complicated and difficult to navigate. An effective strategy is necessary to help make success a planned event.