The U.S. tax code has always acknowledged the existence of different sorts of income. Each of those different incomes is treated differently, with unique requirements and tax cuts. One of those incomes is named, “Qualified Business Income”, and it comes with its own standards for deduction rates that differ from other sorts of income. Today, we’re going to explore what this is and how it can affect your taxes.
What is Qualified Business Income?
Qualified business income is the net amount of income (including gain, deduction, and loss) that can be qualified against your trade or business, which, of course, should also be qualified.
To get your total qualified business income, you should combine the net business income from sole proprietorships, partnerships, and S corporations, in addition to pass-through income, such as income from real estate trusts, publicly-traded partnerships, and qualified agricultural coops.
However, qualified business income does not include guaranteed payments, W2 wages from your business, or investment income.
Once the total has been determined for the allowable income sources, a portion of that is allowed to be entered as a deduction on your taxes.
Does the Qualified Business Income Deduction Come With a Catch?
There are certain limits in place with this deduction. It’s important to make sure that you follow these limits to get the best tax break possible while still paying the IRS their due portion.
The first limitation is dependent on the amount of taxable income you have after adjusting for your income and itemized deductions. If your remaining taxable income exceeds $157,500 (or double that in the case of joint filers) your QBI deduction is limited depending on which is greater: 50% of W2 wages paid to that activity, or 25% of the W2 wages plus 2.5% of the initial cost of any and all tangible property used for that activity.
The second limitation is derived from just what qualified business or trade you engaged in. Should the business or trade rely on the “reputation or skill of one or more employees” (medicine, law, accounting, and other service-oriented businesses will especially count on this) your deduction is reduced, sometimes all the way to zero, depending on the amount of taxable income generated beyond $157,500 – $207,500 (again, doubled for joint filing). The final limitation is what gives this deduction the moniker, “The 20% Pass-Through Deduction”. In a nutshell, your overall QBI deduction can be no more than 20% of your taxable income each year. Unfortunately, this means that any unused deduction cannot be carried over, but if you have a loss that particular year, the loss can count on the next taxable year.
How Can I Use the Qualified Business Income Deduction?
There are many tips and tricks to best utilize this deduction. Some of it is simple – creating yourself as a W2 employee (while following certain steps to stay within the bounds of the IRS); separating services and certain business activities so you can specify where the deduction should be placed; even dividing up certain investments to ensure that you can beat the limits in place for the deduction.
But this is a lot more complicated than it seems. Taking advantage of this deduction is certainly a great way to save more money – who wouldn’t want a 20% deduction on their business income? However, the maneuvering it can take to meet the requirements meted out by the IRS can be an acrobatic feat unto itself.
If you’re interested in reading deeper into the Qualified Business Income Deduction and learning more about how to use it, please download my free e-book, “10 Most Expensive Tax Mistakes That Cost Business Owners Thousands”.