For some businesses, one of the most valuable tax benefits available is the deduction for qualified business income (QBI). Under the right circumstances, the deduction allows a business owner to shelter 20% of net profits from taxation.
Created by the Tax Cuts and Jobs Act of 2017 (TCJA), the QBI deduction was introduced for the 2018 tax year but will expire at the end of 2025. Since the TCJA lowered the corporate tax rate from 35% to 21%, the QBI deduction was introduced as tax relief to businesses not subject to the lower corporate tax rate.
In general, the 20% deduction applies to net business income from pass-through entities such as sole proprietorships, partnerships, LLCs, and S Corps. The deduction can also apply to certain income generated from trusts and estates.
Who is eligible?
While the deduction is available to both non-service and service businesses, there is a limit on the deduction for “specified service businesses” (think doctors, accountants, CPAs, financial planners, financial advisors) with a phaseout triggered depending on the amount of household taxable income.
Highlights of the QBI deduction:
- Applies to businesses that are structured as pass-through entities for taxation purposes (sole proprietorship, LLC, partnership, S Corp)
- There are certain exclusions from calculating the deduction including, for example, pretax retirement contributions, and investment income
- At higher income levels, specified service trade or businesses (SSTBs) are not allowed to take the deduction. According to the law, “A specified service activity means any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests, or commodities.”
- For businesses considered “specified service trade or businesses,” the 20% deduction on qualified business income begins to be phased out as household taxable income exceeds $340,100 (married, filing jointly) or $170,050 (single).
How the 20% QBI deduction works
Source: Internal Revenue Service, 2022. The wage limitation refers to an alternate test that must be applied to determine the deduction for QBI (for non-specified service businesses) when taxable income exceeds $170,050 for individuals and $340,100 for couples. The alternate test is the greater of (a) 50% of total wages paid by the business or (b) 25% of wages plus 2.5% of unadjusted cost basis of qualified property.
Ideas for maximizing deductions
Planning for the income threshold
- Consider the timing of income if subject to an income threshold for phaseout of the deduction. Investors should focus on transactions that could increase overall income, such as the sale of a stock or property or managing the timing of business expenses and receipts
- Use strategies to reduce taxable income such as funding a retirement plan or a health savings account
Separating non-professional services from the core business
- Some larger-scale professional service businesses (law and CPA firms) may consider separating non-professional services (administration, information technology, property management, etc.) from the core business into a separate entity such as an LLC
- This may allow the pass-through income derived from the newly created non-professional LLC to benefit from the deduction for qualified business income
Lastly, for non-service businesses subject to the wage limitation, consider hiring employees instead of independent contractors to increase overall wages. This may result in a larger QBI deduction.
Consult an advisor or tax expert
Small-business owners may consider meeting with their financial advisor or tax consultant to learn how to best optimize the 20% deduction, and how the timing of income and other actions may impact the deduction. It may also be an opportune time to evaluate the status of a business. Business owners may want to consider what type of business structure or taxation method makes the most sense from a tax perspective. For example, an LLC may choose to be taxed as a flow-through partnership or as a C Corporation.
It is important for business owners to work with a qualified tax or legal professional to understand the impact of the income restrictions and if they could benefit from these planning strategies around the deduction limitations. In addition, this deduction expires in 2025. Unless Congress acts, the tax deduction will not be extended or made permanent. Investors may want to consider taking advantage of the deduction, and maximizing its potential tax benefit, in the near term.
More in: Taxes