The QBI Deduction: Owners of Pass-Through Business Entities Can Claim the 20%
The qualified business income (QBI) tax deduction allows taxpayers who are self-employed or businesses run as pass-through entities to deduct up to 20% of their QBI. QBI is the net income you collected from your business during the year.
The QBI deduction was added to the U.S. Tax Code by the 2017 Tax Cuts and Jobs Act (TCJA) and has been available to eligible freelancers, independent contractors, and business owners since January 1, 2018.
The Qualified Business Income deduction--sometimes known as the Section 199A deduction--provides a tax break to taxpayers who receive pass-through income from a business that they own. The owners of domestic pass-through entities are usually not taxed separately from their owners, who report the business’s income on their personal tax returns. Eligible pass-through entities include:
- Sole proprietorships;
- S corporations;
- Limited Liability Companies (LLCs); and
- Certain trusts and estates.
Shareholders in traditional C corporations are not eligible to claim the QBI deduction. The QBI is available regardless of whether the taxpayer itemizes his or her deductions or takes the standard deduction.
How is the QBI Deduction Calculated?
The 1099 deduction is usually equal to 20% of QBI generated from an eligible domestic pass-through entity. However, if a partner recently purchased an interest in a partnership, he or she may be subject to additional limitations on the size of their deduction (discussed below). Additionally, QBI does not include the following types of income:
- Wage income;
- Reasonable compensation from an S corporation;
- Guaranteed payments from a partnership;
- Payments for services provided a partnership that was not in the capacity of a partner;
- Income that is unconnected to business conducted in the U.S.;
- Investment items such as capital gains, capital losses, or dividends;
- Commodities transactions;
- Annuities not received in connection with a trade or business;
- Interest income not allocated to a trade or business;
- Dividends from a qualified real estate investment trust (REIT);
- Income from a publicly traded partnership (PTP); and
- Foreign currency gains or losses.
When you claim a QBI deduction on your personal income tax return you will only be taxed on 80% of your QBI. Thus, if you are in the 22% federal income tax bracket and have $50,000 in QBI, you will effectively pay a 17.6% tax rate on your QBI income, saving you $2,200 in federal taxes.
In September 2019, the IRS issued final regulations providing a “safe harbor” for some taxpayers owning rental real estate businesses that allows for them to claim the QBI deduction if certain conditions are met. Those conditions generally relate to the hours of rental services performed by the taxpayer. Those rental real estate businesses will be treated as a qualified trade or business eligible for the deduction. Those that do not qualify may still be treated as an eligible trade or business if they otherwise qualify for the QBI deduction.
When a taxpayer’s QBI is less than zero, it will be treated as a loss from a qualified business that can be carried forward to the next tax year.
The QBI Deduction and the Self-Employment Tax
After You cannot lower the amount of self-employment tax you owed by claiming the QBI deduction. This is because the QBI deduction does not reduce the income reported on your federal Schedule SE (Form 1040), Self-Employment Tax. This is the form the IRS uses to determine the tax that is due on your net earnings from self-employment.
The QBI Deduction Can Impact Retirement Planning
The QBI deduction can complicate strategies for retirement plan contributions. This is because pre-tax contributions reduce both your taxable income and QBI because the contributions are a business expense attributable to QBI in proportion to your gross income from the business.
Specified Service Trades or Businesses Limitations
Section 199A singles out specified service trades and businesses (SSTBs) for special treatment when it comes to claiming the QBI deduction. SSTBs are any type of business that has as its principal asset the skill or reputation of at least one employee. According to the IRS, SSTBs include the following types of service businesses:
- Financial services;
- Investment and investment management;
- Actuarial science
- Performing arts; and
The QBI deduction for the owners of SSTBs is not available if his or her income exceeds certain thresholds. There is an SSTB limitation. For the 2020 tax year, the deduction begins phasing out at the $323,600 income threshold for a married couple filing a joint return and is phased out entirely when their income reaches $426,600. The SSTB QBI deduction starts its phase-out at $163,300 in annual income for single filers, and it phased out entirely at $213,300.
For those SSTB owners whose income falls below those thresholds, the amount of the QBI that is deductible will be the lesser of:
- 20% of the taxpayer’s QBI, plus 20% of his or her REIT dividends and PTP income; or
- 20% of the taxpayer’s taxable income minus net capital gains.
The Limitation on Recently Purchased Partnership Interests
The limitation on recently bought partnership interest limits the QBI deduction to a percentage of his or her wages and the unadjusted basis immediately after acquisition (UBIA). This limitation is important for partners who own businesses involved in real estate.
When the limitation applies, the size of a taxpayer’s QBI deduction is capped at the sum of:
- 25% of the W-2 wages for a business; and
- 2.5% of its UBIA.
The UBIA used to calculate the partner’s QBI deduction must be calculated by the individual or entity that directly conducts the qualified business.
Investors in REITs Now Benefit from QBI Deduction
The benefits of the QBI deduction extend to investors in real estate investment trusts (REITs). The TCJA included REITs in Section 199A’s definition of eligible pass-through business and investors are now allowed to claim a 20% QBI deduction for any qualified dividends they receive. Qualified REIT dividends are not dividends from capital gains the trust may enjoy when it sells some of its real estate holdings.
An REIT is a company that was formed to own, operate, or finance income-generating real estate. REITs are modeled after mutual funds and pool the capital of many investors. This allows the investors to earn income from real estate investments without purchasing or managing the property themselves. Some REITs are traded on major securities exchanges and shares in the companies may be bought and sold like traditional stocks.
While direct real estate investments may also qualify for the QBI deduction, direct real estate investments only qualify when the investment activities amount to a real estate business. This means that income earned from a taxpayer’s passive investment in a real estate activity does not qualify for the QBI deduction. The practical result of this situation is that if you are a passive real estate investor, you can only take advantage of the QBI deduction if you invest in an REIT.
RIC Shareholders Can Claim QBI Deduction on REIT Dividends
The dividends a regulated investment company (RIC) receives from an REIT are reported to shareholders as Section 199A dividends. Thus, an RIC shareholder may often treat the dividend as a qualified REIT dividend for the purposes of calculating the QBI deduction.
RICs are associations that are treated as corporations for federal income tax purposes. Most mutual funds and many unit trusts are organized as RICs. RIC investors own units in a trust, not the underlying assets. When it follows the IRS requirements regarding the types of assets it holds, portfolio diversification, minimum distributions, and year-end reporting, an RIC is treated as a pass-through entity.
What About Pass-Through Income from Multiple Businesses?
Many small business owners operate more than one business, often as pass-through entities. Usually, if you have interests in multiple businesses eligible for the QBI deduction, you calculate each business's deduction and then combine them on your tax return as a single entry.
However, in some cases, it will benefit a taxpayer to lump their businesses together to calculate their QBI deduction. If this is the case for you, then aggregating your business interests will allow you to take a larger QBI deduction. To qualify for aggregation, you must meet the following five conditions:
- The same person or group of persons must own at least 50% of each business being aggregated;
- That ownership of at least 50% of the businesses must exist for more than half the year;
- The tax items that are attributed to each business must be reported on tax forms utilizing the same calendar year; and
- None of the businesses is an SSTB.
Additionally, the aggregated businesses must meet at least two of the following requirements:
- They provide products and services that are either the same or are usually provided together;
- The businesses share facilities or have significant centralized business elements;
- The businesses rely on each other or operate in coordination with each other.
If one of the aggregated businesses has a negative QBI, the positive QBI of each business in the aggregated group must be offset by a portion of the negative QBI. If the aggregated QBI of the businesses is negative for the year it is treated as a loss from a qualified business the following year.
If you elect to aggregate your pass-through businesses, you must continue to aggregate them in future tax years unless one of the businesses no longer qualifies for aggregation. But no new businesses may be added to the aggregated groups.
Speak with a CPA or other tax professional about claiming your QBI deduction.
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