If you watch the news, you may have heard about how easy it will be to file your taxes thanks to the new tax bill. For the majority of Americans, this will be true.
Yet, for small business owners that have what is called “pass through income,” the new tax law can be a bit hard to understand.
But not to worry, we've got you covered. In this post, we're going to go over what the Qualified Business Income (QBI) deduction is, along with how you can calculate it and then claim it.
Let's start with what QBI is.
What is QBI?
First and foremost, QBI is a 20% income tax deduction available to trades and businesses operating within the United States. Note that you determine QBI on a per business basis and not on a per taxpayer basis.
Who's Eligible to Claim The New QBI Deduction?
The new tax bill defines QBI as ordinary income (excluding deductions) you earn from a sole-proprietorship, S corporation, partnership or LLC (not taxed as C Corps). So if your business is not one of those 4, you're out of luck.
To claim the QBI deduction, you also have to be a "qualified trade or business."
A qualified trade or business is any trade or business other than a specified service trade or business.
By definition, a specified trade or business is any business where the chief asset is the reputation or skill of one or more of its employees.
As a result, if you’re in business as, for example, a lawyer, accountant, architect, consultant, artist, investment broker, writers, or doctor, you typically aren’t eligible for the QBI deduction. But read on for a possible exception. (However, architecture and engineering aren’t considered specified service trades or businesses, and thus are eligible for the QBI deduction.)
However, even if you are in a specified service trade or business, if your total taxable income for the year is less than $157k ($315k if married), you can claim the QBI deduction anyway.
You can calculate QBI several different ways. But now we're only going to focus on the most relevant way to do so.
How to Calculate Your QBI Deduction Amount
This is where things start complicating themselves real fast.
This deduction allows you to deduct 20% of your QBI when you file your taxes. The amount of QBI you can deduct is limited to the LESSER of:
- 20% of your qualified business income
- 50% of the total W-2 wages paid by your business.
("Lesser of" means the smallest of the two.)
However, if you're a business owner and your total taxable income is less than $157k ($315k if married) the 50% W-2 wage limitation doesn't apply.
Let's go over an example of how someone calculates their QBI.
Kaz is a married taxpayer who operates his business as a sole proprietor. His business has one employee who he pays $60k to in 2019. During 2019, Kaz's business earns $225k of income.
Kaz's total taxable income, after all other deductions, is $215k. This means Kaz's 20% QBI deduction will total $45k ($225k * 20%.)
The W-2 wage limitation would normally be $30k. (Multiply the $60k he paid his one employee by 50%.) But because Kaz's taxable income is less than $315k it won't apply.
What Kind of Income is Considered QBI?
Like I said earlier, QBI is the total taxable income of a business. And yes, that's kind of vague. So let's just go over what kind of income doesn't qualify as QBI:
- Investment related income
- Tax deductions
- Dividends, income equal to a dividend, or payments made instead of dividends
- Interests payments
- Any item taken into account in determining net long term capital gain or loss.
- Income from annuities
- Foreign currency gains over foreign currency losses
- Net income from notional principal contracts, except ordinary hedging transactions
An exception exists for the majority of the above if it's used in connection with the activity of a qualified trade or business.
The Bottom Line
QBI is, for most of the middle class and self-employed, a 20% tax cut. While Trump's new tax bill isn't easy to figure out, it's definitely beneficial.
Note: We couldn't go over everything related to QBI in this post, but we did cover the most important parts. (I could honestly write a book on this subject, just to give you an idea of how extensive this new tax bill is!)