Qualified Business Income Deduction – What Is It? How Does It Work?

The qualified business income deduction is a valuable tax break for pass-through businesses, as per the provisions of Section 199A of the Tax Cuts and Jobs Act 2017. A pass-through business is a business where owners are taxed on their individual tax returns as the income of the business passes through to the owners. Some of these businesses are LLCs, sole proprietorships, partnerships, and S Corporations.

In this article, you will first learn the meaning of qualified business income deduction. Then, we shall discuss who is eligible to get a qualified business income deduction in business. Next up, we will give your details in qualified business income. Finally, we will give you a better idea of the working of the qualified business income deduction system. Hence, read on to find out more.

What Is Qualified Business Income Deduction?

If you are an owner of businesses like partnerships, sole proprietorships, S Corporations, estates, and trusts, you are eligible for qualified business income deduction as per Section 199A of the Tax Cuts and Jobs Acts 2017.

According to IRS.gov’s official website,

“The deduction allows eligible taxpayers to deduct up to 20 percent of their QBI, plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. Income earned through a C corporation or by providing services as an employee is not eligible for the deduction.”

One of the best things about this deduction system is that it is available regardless of whether you, as a taxpayer, itemize your deductions with Schedule A or just take the standard deduction technique. If you are eligible for qualified business income deductions, you can claim tax deductions starting from 31st December 2017 to 31st December 2025.

If you are a self-employed person or a small business owner, you can deduct up to 20% of your qualified business income from your taxes. As of 2023, if you are a single filer of your taxable income, then the taxable income must be under $182,100, and for joint filers, the taxable income level will be $364,200.

However, if your taxable income is over that limit, IRS will determine whether your business income qualifies for a full deduction system or a partial deduction.

Who Is Eligible For Qualified Business Income Deduction?

If you want to find out what qualifies as a trade or business under this provision, you will need to check Form 8995-A or Form 8995. Here, all pass-through businesses are not eligible for qualified business income deductions. The businesses that are eligible for qualified business income deductions include:

1. Limited Liability Companies (LLC)
2. Partnerships
3. Sole Proprietorships
4. S Corporations

However, if you are limited by the calculation of the 20% taxable income, you have the allowance to increase your taxable income through Roth Conversions. According to Investopedia,

“Since the qualified business income deduction is limited to the lesser of 20% of QBI or 20% of taxable income, in addition to the asset and wage tests, taxpayers might not have enough taxable income to get the full benefit of the QBI deduction.”

What Makes A Qualified Business Income?

A variety of income options come under the purview of qualified business income. Broadly, it means the net profit of your business, provided that your business is a pass-through business. However, that does not mean that all the incomes of your business qualify to be qualified business income.

According to IRS.gov,

“QBI is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally, this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans.”

The following are some of the incomes that are excluded from being within qualified business income:

1. Things that cannot be properly included in taxable income
2. Capital gains or capital losses
3. Interest income items that cannot be allocated to trade or business
4. The incomes that are not properly connected with US Business Conduct
5. Incomes through wages.
6. Commodities transactions or gains or losses of foreign currencies.
7. Certain types of dividends and payments in lieu of dividends
8. Gains, losses, and deductions related to national principal contracts
9. Annuities that are not received with the help of trade and business
10. Reasonable compensation amounts received from an S Corporation
11. Guaranteed payment amounts from a partnership
12. Amounts received by a partner for services other than in a capacity as a partner
13. PTP income
14. Qualified REIT dividends

How Does The Qualified Business Income Deduction Work?

One of the major benefits of qualified business income is that IRS taxes it at lower rates than other types of income options. The reason behind this is the fact that the IRS considers qualified business income to be a type of income that comes from active business activities and not passive business activities.

If you want to qualify for qualified business income, you have to prove that you are actively involved in your business and that your business is run from a profit-making standpoint. Basically, the IRS checks the time and effort that you have put into your business. It also checks whether your business is a legitimate activity or not.

Apart from that, to qualify for qualified business income, you will have to report your QBI on your individual income tax return. This means that you will have to report your income as well as all your deductions associated with your business on IRS Form 1040.

Bottom Line

Hope this article was helpful for you to gain a good idea about what a qualified business income deduction is in business. You can use these deductions to reduce your taxable income, and you can use these deductions for both federal and state taxes.

If you want to reduce the amount of taxes that you owe to the government, this is a great approach to have if your business is a pass-through business. Do you have any recommendations related to qualified business income deductions? Share some ideas with us in the comments section below.

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