The Tax Cuts and Jobs Act of 2017 created a new deduction for certain pass-through business income, known as the Qualified Business Income Deduction (QBID). The deduction was designed to provide a potential tax break, most specifically for small business owners and the self-employed.
What is Qualified Business Income (QBI)?
QBI is essentially the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. That includes income from partnerships, S corporations, sole proprietorships, and some trusts. The QBI amount will be reduced by the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans.
How to calculate QBI deduction
The calculation of the Qualified Business Income Deduction is complex, requiring tax preparers to apply technical rules and maintain detailed recordkeeping on behalf of the taxpayer. The QBID is calculated using either Form 8995 or 8995-A, both available on TaxSlayer Pro.
The form you’ll use to calculate the QBI deduction primarily depends on the taxpayer’s taxable income (without consideration of the QBID). For taxpayers below the income threshold of $182,100 (or $364,200for married filing jointly), the QBID will be calculated on Form 8995. The IRS provides straightforward instructions for Form 8995
However, for taxpayers with income at or above the taxable income threshold, the calculation is more complicated and is subject to additional limitations. For these higher-income taxpayers, the QBID calculation is on Form 8995-A. There are also limited situations, typically involving income from a specified agricultural or horticultural cooperative, which may require a taxpayer with income below the thresholds of $182,100 (or $364,200 if married filing jointly) to use Form 8995-A.
Whichever form you use to calculate the QBID, the underlying calculation starts with a determining the Qualified Business Income (QBI) for each taxpayer’s pass-through business. The actual allowed QBID includes the qualified business income components of each pass-through business reported on the tax return.
Basically, the income or loss that qualifies must relate to the conduct of a business, and it does not include investment income, guaranteed payments to partners for services rendered to the partnership, or the “reasonable compensation” paid to an owner for services rendered to the entity.
In TaxSlayer Pro, K-1 information must be reported in certain boxes to be considered qualified business income. The area to report QBI can be found on the following forms:
- Schedule C, (Form 1040), Line 31 – Net Profit (or Loss)
- Schedule F, (Form 1040) Line 34 – Net Profit (or Loss)
- Schedule K-1 (Form 1065), Box 20, Code Z – Qualified Business Income
- Schedule K-1 (Form 1120S), Box 17V – Qualified Business Income
- Schedule K-1 (Form 1041), Box 14, Code I – The fiduciary is required to provide a statement to the beneficiary with the Schedule K-1 (Form 1041) that specifies the portion of income that has been allocated to the beneficiary that is Qualified Business Income.
Factors that affect the QBI deduction calculation
Taxpayers with income (or loss) from rental property will not be eligible for the QBI deduction when they hold the property for investment purposes. However, a taxpayer who owns rental property as a real estate business and can meet the standard of an active real estate business under the Section 199A regulations will also include their rental income (or loss) amounts reported on Schedule E, Line 26.
When the taxpayer’s income (including taxpayers that are considered Specified Service Businesses) is below $182,100 or $364,200 for married filing jointly, the QBID will be the lesser of:
- 20% of the net Qualified Business Income (or Loss) from all sources plus 20% of any qualified REIT dividends and Publicly Traded Partnerships (PTP) income (or loss) recognized on the tax return, or
- 20% of the taxpayer’s taxable income minus the net capital gains and qualified dividends recognized on the return.
This second provision is “income limitation.” It restricts taxpayers with significant capital gains and qualified dividend income from receiving the QBID on the portion of their income that has already received favorable tax treatment afforded by capital gains.
For taxpayers whose only income comes from pass-through businesses, the income limitation also reduces the allowed QBID. This occurs because the taxpayer’s taxable income before considering QBID will be lower than their income from the pass-through business because any adjustments, such as the deductible portion of self-employment taxes and the standard or itemized deduction, have reduced taxable income.
Qualified business income deduction limitations
When the taxpayer’s income is above $182,100 or $364,200 if married filing jointly, the QBID is subject to further restrictions. For taxpayers with income above the threshold amounts who have income from a Specified Service Business, the QBI deduction is phased out and eliminated once their taxable income reaches $207,500 or $415,000 if married filing jointly.
For higher-income taxpayers above the income threshold, the QBI used in determining the QBID is limited based on W-2 wages paid by the business and/or the qualified assets used by the business. Specifically, for taxpayers with income above the thresholds, the first aspect of determining the deduction is the Qualified Business Income component of the QBID. This QBI component is the lesser of the following:
- 20% of the Qualified Business Income that comes from the trade or business: If multiple pass-through businesses are reported on the return, the QBI component is determined separately for each business. Any business with a loss will have that allocated proportionately among the taxpayer’s other pass-through businesses. The QBI for those businesses will be reduced by the amount of loss allocated. You’ll need a separate form (Form 8995) to allocate losses among the QBI components for other businesses on the tax return.
- 50% of W-2 wages paid by that trade or business to generate the QBI, or if greater, 25% of W-2 wages paid by the trade or business plus 2.5% of the unadjusted basis of the qualified property used by the trade or business: For this calculation, the unadjusted basis of qualified property is generally defined as (A) the original cost of assets placed in service by the business in the past ten years that are still used by the business regardless of the asset’s condition or otherwise subjected to Section 179 or bonus depreciation treatment. And (B) the business is still depreciating the original cost of assets because the depreciation recovery period is over ten years.
For such higher-income taxpayers, you’ll determine the Qualified Business Income component based on the above criteria to obtain a total QBI component of all the separate pass-through businesses on the return. You’ll then add this total QBI component to 20% of any qualified REIT dividends and/or Publicly Traded Partnerships (PTP) income (or loss) recognized on the tax return to obtain the Qualified Business Income Deduction before the income limitation.
Then the actual allowed QBID will be the lesser of the Qualified Business Income component of all separately calculated business plus 20% of any qualified REIT dividends and/or Publicly Traded Partnerships (PTP) income (or loss). Or the income limitation, which is 20% of the taxpayer’s taxable income minus the net capital gains and qualified dividends recognized on the return.
Common errors to avoid when claiming QBI deductions
Determining whether your client qualifies for the deduction for qualified business income can be challenging, as the IRS guidelines on limitations are complex. When you assist clients in determining their eligibility for the QBI Deduction, avoid these common errors:
- Overstating or understating income: Determining qualified business income can be challenging, and it’s easy to over- or understate income, particularly for businesses with multiple income streams or complicated financial structures.
- S-Corp Shareholder not paying themselves “reasonable compensation”: This can lead to the overstating the QBI coming from the S-Corporation and thus overstating the deduction. This is a common source of letters from the IRS to the taxpayer and ultimately adjustments to tax returns.
- A business structure that doesn’t qualify: Not all entities qualify for the QBID. While sole proprietorships, partnerships, S corporations, and LLCs taxed as sole proprietorships or partnerships are generally eligible, C corporations are not.
- A business activity that doesn’t qualify: Certain types of businesses may have limitations or restrictions on the QBID. Those businesses include (but are not limited to) real estate, investment, and some service businesses.
- Failing to note wage and property thresholds: Your client may be limited in or ineligible for the QBI deduction based on their taxable income, wages paid, or qualified property.
Strategies for maximizing the QBI deduction for your tax clients
If you want to increase your tax clients’ chances of qualifying for the deduction for qualified business income, carefully consider how the deduction’s various limitations could impact them. Here are a few potential strategies that can help you maximize that QBI deduction:
- For married clients with a specified service trade or business who are subject to the phase-out, consider asking them to file separately rather than jointly, or suggest they create a separate business entity.
- If your client is subject to the wage/UBIA limits, let them know that hiring employees instead of contractors, increasing wages, purchasing assets, or becoming an S corporation rather than a partnership or sole proprietorship could enable them to meet requirements for the Qualified Business Income deduction.
- If your client is over the taxable income threshold, they could defer income and accelerate expenses or make a retirement plan contribution to reduce taxable income in the current year.
QBI deduction calculations and qualifications are often highly complex but can offer your clients valuable tax breaks. Make sure you familiarize yourself with the kinds of businesses and business activities that qualify as well as the current taxable income thresholds.
To access more information on how to calculate QBI deductions, check out exclusive resources for tax preparers.
