The odds are often stacked against the self-employed and small business owners come tax time. Tax deductions are essential to offset a mix of high taxes rates and self-employment taxes, uneven income and overhead costs. The qualified business income (QBI) deduction is one such provision that could significantly reduce your tax burden. Learn whether you’re eligible, how to calculate QBI and the key strategies for optimizing your QBI tax deduction.
What Is QBI and How Much Is the QBI Deduction?
Qualified business income measures how much your business actually earns after accounting for all the ups and downs of running it. That net qualified income, however, cannot include certain items, some of which include:
- Capital gains or losses from investing activities
- W-2 income or reasonable compensation from an S corporation
- Guaranteed payments from a partnership
- Income from business activity outside of the U.S.
- Commodities transactions
Introduced as part of the Tax Cuts and Jobs Act of 2017, the QBI tax deduction allows eligible business owners to deduct up to 20% of their net business income before calculating personal income tax. Taxpayers may also deduct up to 20% of all qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income. This deduction will be available until the 2026 tax year. For small business owners, the qualified business income deduction potentially translates into considerable tax savings.
Who Qualifies for the QBI Deduction?
The QBI deduction is designed for those with pass-through businesses. If you’re a sole proprietor, a partner in a partnership or a shareholder in an S corporation, you can qualify for the QBI deduction. You must operate your business within the U.S. and report business income on your personal tax returns.
QBI is subject to annually-adjusted income thresholds that can reduce your deduction. These thresholds are based on taxable income before calculating QBI. For the 2023 taxable year, that threshold is $182,100 or more for single filers and $364,200 or more for married couples filing jointly. In 2024, the income thresholds are $191,950 for single filers and $383,900 for married couples filing jointly.
Unfortunately, not all businesses are considered equal in the eyes of the IRS. Your business may be considered a specified service trade or business (SSTB), in which case, your deduction can be further impacted.
- Businesses built on the skill and reputation of the person or people in it, such as consulting, athletics, performing arts and some services within health, law and accounting
- Services based on investing, trading or securities
Luckily, SSTBs that fall at or below the income threshold can calculate their QBI deduction as they would any other business. However, it’s important to discuss the specifics of your business with a CPA, because the definition can be a gray area for many businesses.
How to Calculate QBI for Your Small Business
For Businesses Under the Income Threshold
All businesses below the threshold, including SSTBs, will choose the lesser of the following:
- QBI (the net amount of income, gain, deduction, and loss from any qualified trade or business) multiplied by 20%
- Taxable income multiplied by 20% minus net capital gains and qualified dividends
Your QBI dedication cannot exceed 20% of your taxable income. What does this mean?
Consider this hypothetical scenario involving Alex, who runs a graphic design business structured as a sole proprietorship:
- Alex’s net profit from the graphic design business—his QBI—for the year is $120,000.
- Alex calculates 20% of that figure and gets $24,000.
- His total taxable income for the year was $150,000.
- Alex calculates 20% of that figure and gets $30,000.
In this simplified scenario, Alex would claim a QBI deduction of $24,000 on his tax return.
For Businesses Above the Income Threshold
Businesses above the threshold must choose between the lesser of the following (not exceeding 20% of taxable income in either scenario):
- 20% of QBI
- The greater of 50% of the W-2 wages paid by the business or 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of all qualified property
It’s important to consult a CPA, especially if your business is potentially defined as an SSTB. SSTBs that fall in a specified phase-out range above the income threshold may receive partial deduction, but those over the phase-out range will not qualify for the deduction. For example, a single-filer SSTB with total taxable income above the 2023 threshold of $182,100 but below the upper threshold of $232,100, can receive a partial deduction. An SSTB over this upper threshold cannot.
How to Maximize Qualified Business Income Benefits
Here’s how you can make the most of the QBI deduction:
- Keep detailed records of all business transactions to substantiate your deduction claim.
- Strategize income realization, especially if you’re near an income threshold.
- Choose the proper business structure for your tax needs.
Consult Our Experts for Personalized Tax Strategies
The qualified business income deduction offers many small business owners a clear path to substantial tax relief. However, consulting with a tax professional is crucial if your situation involves complexities like income thresholds and SSTBs. Even if your tax situation seems straightforward, consulting with a tax expert can ensure you’re not leaving money on the table.
Don’t leave things to chance (or an audit). Get personalized tax filing and consultation services from the tax experts at Paro.