Posted by Elliot Kravitz, ATP

What is the Allowable Deduction From Business Income and Can You Claim It?

What is the Allowable Deduction From Business Income and Can You Claim It?

The TCJA that was passed in 2017 significantly reduced the corporate tax rate and introduced the Qualified Business Income Deduction (QBID).

The QBI deduction makes it possible to reduce the effective tax rate on pass-through entities' owners' profits: business or trade whose income is "carried forward" in the personal income tax return. This includes sole proprietorships (including independent contractors), corporations, limited liability companies, and corporations. Certain trusts and properties may also be eligible for the deduction. However, income earned by a C Corp or services rendered as an employee is not eligible.

The Qualified Business Income Deduction (QBID) can significantly reduce tax reduction for qualifying business owners. But since it is always a deduction and not a reduction in the tax rate, its effectiveness depends on the owner's level of taxation. It is a temporary measure in tax law that will stop taking effect in 2025 unless Congress takes action. It can be very, very complicated.


Key Points to Note:

  • The QBI deduction is a personal deduction for pass-through company owners, in which owners pay corporate taxes on their tax returns.

  • The write-off can be up to 20% of the QBI less net capital gains.

  • Entrepreneurs can make the deduction in addition to the deductions normally allowed for business expenses.

  • Deductions for higher-income earners may be limited or ineligible.

  • This deduction is in effect for the 2018-2025 fiscal years.

Below are answers to some frequently asked questions about the QBI deduction that can help you understand if you are eligible and, if so, how to get the most from it.


What is QBID?

A qualified business income deduction (QBID) allows small business owners and the self-employed to write-off up to 20% of their qualified business income plus 20% of dividends and income from companies listed on qualified real estate investment trust (REIT), qualified public trade partnership (TPP), or based on their taxes or 20% of the taxpayer's taxable income, less net capital gains.

Eligible REIT dividends include most of the real estate investment fund dividends that people earn. To qualify, you must have had a real estate investment fund for more than 45 days. Payment must be made by you and cannot be a capital gains dividend or an ordinary dividend. A TPP's qualifying income includes its share of a TPP's income, gains, deductions, and losses.

To be eligible for the deduction, your taxable income must be less than $ 326,000 for couples filing jointly, $ 163,300 for couples filing separately, or $ 160,700 for all other taxpayers. 

The IRS invokes a complicated set of rules that limit business or business income that qualifies for a full or partial deduction. Deduction limits include the type of business, taxable income, and W-2 salary paid by the business.


What is Qualifying Business Income?

According to the IRS, qualifying business income is the net amount of qualifying income, gains, deductions, and losses of any qualifying business or trade. It simply means your share of the company's net income. The business or trade must be located in the United States.

The IRS only takes into account items included in taxable income, such as:

  • Payments to S Corp owners

  • Investment gains or losses

  • Interest income on active accounts.

Certain items are omitted from QBI deductions when calculating qualifying income, including:  

  • Amounts paid to a taxpayer acting outside his capacity as a service partner

  • Annuities, unless they are received in the course of commercial or trade activities

  • Capital gains and losses

  • Certain dividends and interest income

  • Gains or losses on commodities, transactions, or foreign currencies

  • Guaranteed payments received from partners.

  • Reasonable remuneration received from employees who own S Corps

  • Sales generated outside the United States.

  • Wage income paid to the owner of the S Corps

The IRS also states that for Section 199A only, a safe harbor is available to individuals and owners of pass-through entities who wish to claim a Section 199A deduction for a real estate rental business. It treats a rental property business, such as a business or trade, to deduct QBI if specific criteria are met.

You must also reduce the business's eligible income through personal deductions linked to this income possession. These include:

  • A self-employed health insurance deduction.

  • Deduction of half of the self-employment tax

  • Income from transactions reported on Form 4797, including income from the sale of commercial real estate

  • Reduction for SEP, SIMPLE, or other pension plans

  • Unreimbursed professional expenses declared by a partner in his statement

Special rules apply to the treatment of various assets and the impact of losses. Also, in some cases, promoters of agricultural or horticultural cooperatives must reduce their deduction per Article 199A of the Tax Code.


Are You Eligible for the QBID?

To be eligible for a qualifying business income deduction (QBI), you must have a pass-through entity in the United States, have qualifying business income, and be precluded from making the deduction because of substantial income and operate a certain type of business. 

Sole proprietorships, S Corporations, partnership, and limited liability companies (LLCs) are all eligible as pass-through entities.

You are not qualified if your business is a C corporation or simply an employee who has no interest in a pass-through entity.

You are not eligible even if your taxable income exceeds the specified threshold in a particular fiscal year, and you carry on a particular business or service activity (SSTB).  

The SSTB exclusion does not apply to the taxable income of the taxpayer below the threshold value. In other words, SSTBs below the threshold receive the deduction like any other contractor. Also, the deduction is gradually applied to taxpayers whose taxable income exceeds the limit value.

Businesses and S corporations are eligible because they are normally not taxable and cannot deduct on their own. Rather, all S corps and partnerships report each shareholder or partner's share of qualifying business income, W-2 wages paid, UBIA of qualifying properties, qualifying dividends from real estate investment funds, and the PTP income items on a Schedule K -1, which allows shareholders or partners to determine the amount of the deduction.


How is the QBID Calculated?

Calculating QBID is not an easy task. Fortunately, your tax preparer or online filing software can handle this for you. However, to better understand the process, follow these steps:

  • Start by collecting documents containing your qualifying income. It is important to have a copy of the Schedule K-1, with the necessary information included.

  • Calculate your taxable income. This is your gross income after deducting personal deductions and exemptions.

  • Make a final decision. Decide if your income is for a qualifying business or a business in which you have a business interest.

  • Calculate the qualifying business income for each business or corporation for the fiscal year and its net taxable income: the net value of the qualifying items of income, profit, deduction, and business loss.

  • Calculate your QBI limits. Once you have calculated the qualifying professional income for each business, calculate your threshold. This will help you decide whether adding your business works for you or against you when you get the highest deduction.


Conclusion

If you're not sure if you are eligible for the business income deduction, you're not alone. This is a very complex deduction that many companies cannot claim. However, this is a deduction you should be concerned about if your business or corporation is a pass-through entity, as it offers a generous tax deduction for qualifying businesses.

One thing is certain: figuring out who can claim the QBID and calculating it is no easy task. The good news is that your tax preparer or tax software can calculate the deduction for you.


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