Small businesses are an essential part of the modern economy. Not only do they provide opportunities for entrepreneurs, but they also create jobs that many workers find more satisfying than traditional corporate or government positions. They also enable neighborhoods and communities to flourish by encouraging local spending.
For reasons like these, the Internal Revenue Service (IRS) has always encouraged small business development by offering owners a decent number of tax deductions. From $5,000 off your startup costs to reasonable deductions for equipment, professional development, and business use of a motor vehicle, there are several ways that you can reduce your taxable business income.
When Congress passed the Tax Cuts and Jobs Act in 2017, it was arguably the most significant tax reform measure since the Tax Reform Act of 1986, especially for small businesses. For example:
- The corporate income tax rate dropped from 35 to 21%, representing a reduction of 40%.
- Income tax rates for individuals dropped within most brackets, which was especially welcome news for small business owners who operate their enterprises as pass-through entities.
- Bonus depreciation increased from 50% to 100% for qualified property (such as business vehicles) purchased and used before January 1, 2023.
One especially welcome measure was the Section 199A deduction, otherwise known as the qualified business income deduction. This tax advantage, which is in effect for tax years 2018 through 2025, allows owners of pass-through entities to deduct up to 20% of qualified business income, in addition to the usual allowed business expense deductions.
The IRS reported that as of July 25, 2019, nearly 11% of U.S. taxpayers had claimed the deduction on their 2018 returns. Let’s take a closer look at whether your small business can benefit from this increasingly popular tax break.
What Is Qualified Business Income?
The IRS defines qualified business income as the net amount of qualified income, gains, deductions, and losses for qualified businesses and trades belonging to or practiced by U.S. taxpayers. In general terms, it refers to the net profit of your company.
How Do You Know If Your Business Qualifies?
To determine whether your business qualifies for this tax deduction, there are multiple factors that need to be taken into account, namely:
- The legal structure of your business (for example, s-corporation vs. c-corporation)
- Your net income from the business for the year
- Your taxable income for the year. If it exceeds a certain threshold, the amount you can deduct may be reduced or, in some cases, you might not be able to claim it at all.
As stated previously, the qualified business income deduction is only available to pass-through entities, which are businesses whose income is taxed on the owner’s personal return. They are:
- Sole proprietorships, which are owned and run by one person and have no legal separation from their owners. In 2018, there were an estimated 23 million sole proprietorships being operated in the U.S.
- Partnerships, which are business relationships formed between two or more co-owners. The most common is a general partnership in which all owners agree to share the profits, assets, and liabilities.
- S-corporations that use Form 1120-S to file their taxes. S-corporations are corporate structures that pass business income, losses, credits, and deductions through to shareholders for federal tax purposes.
- Single-member LLCs who use a Schedule C to file their federal income taxes. This means that they choose to be taxed as individuals and are not treating the LLC as a corporation for tax purposes.
- Multi-member LLCs that file their taxes as a partnership instead of a corporation.
Real estate investors who complete a Schedule E at tax time, REITs, trusts and estates, and qualified cooperatives can also claim the qualified business income (QBI) deduction because they are pass-through entities.
Corporations, on the other hand, are ineligible because their income is separated from that of the owner(s) for taxation purposes.
What Are The Approved Income Types?
Not all business income applies for the purposes of determining QBI eligibility. You can’t include the following sources:
- Wages (employment income)
- Business investment income
- Guaranteed payments made to one of the partners
- Wages paid to the owner of an S-corporation
- Business income made outside the U.S.
- Annuities that are not received in connection with the business
- Items that do not count as taxable income
What Are The Income Limits?
To claim the deduction, income from approved sources have to be below the limits set out by the IRS. If you are single, your 2019 taxable income must be no more than $160,700. Married couples who file jointly have a limit of $321,450.
What if you (or you and your spouse) make more? Do you lose out entirely?
Not quite, although the amount you can claim may be reduced.
Specified Service Trades or Businesses
Specified Service Trades or Businesses, or SSTBs, are generally professional businesses and trades or those with income based on the skill or reputation of the owners or employees. Examples include:
- Healthcare services businesses, such as doctors’ offices and dental practices
- Law offices
- Accounting firms and other financial services
- Trading companies
- Investment companies
- Performing arts agencies
- Paid athletes or actors
The main asset of a business or trade is the skill or reputation of its owners or employees if it receives income from:
- Endorsing commercial goods or services
- Using the person’s likeness, image, voice, or other attributes associated with their identity
- Appearances at media outlets such as television shows and radio programs
If you run an SSTB and your total taxable income exceeds the standard limits, you may still be able to claim the QBI deduction, but it will be reduced. If your income is over $210,700 (if you’re single) and $421,450 if you’re filing with your spouse, you are no longer eligible for the deduction.
If you own a business that doesn’t meet the definition of an SSTB and your income is above the threshold, there are tests applied to determine how much of the QBI deduction you can claim.
The calculation takes into account how much you pay your employees (and yourself) in salary or wages and the value of property owned by the businesses. The higher the result, the better your chances of being able to claim the deduction.
How Is the QBI Deduction Calculated?
How you calculate the deduction varies according to the structure of your business, whether or not you have employees, and the value of qualified business property. If you make more than the approved threshold (in other words, more than $160,700 if you are single), the amount you can claim is the lesser of:
- 20% of your QBI OR
- The greater of 50% of your W-2 payments to employees or 25% of these payments plus 2.5% of the value of all qualified assets, such as business vehicles.
Let’s assume that you own a single-member LLC with no employees and are taxed as a sole proprietor. In 2019, you have a total qualified income from your business of $80,000. You also teach other entrepreneurs part-time, and earned $25,000 this year.
Your total taxable income is $105,000, which is under the limit for a single filer, so the business income of $80,000 can be used when calculating your QBI deduction. $80,000 multiplied by 20% gives you a deduction of $20,000. You can still claim your other allowable business expenses on your schedule C, such as startup costs, equipment purchases, and education.
On the other hand, your brother is an accountant who set up his business as an S-corporation. After paying himself $50,000 in W-2 wages, his net qualified business income is $100,000. Although he is in a specified service trade, he earns less than $160,700, so he can take advantage of the 20% deduction.
Now let’s take a look at your sister. She owns property that she bought for one million dollars and earns $500,000 a year in rental income. The following calculations would need to be applied to determine her deduction:
- 20% of her qualified business income of $500,000 is $100,000.
- She doesn’t pay herself W-2 wages, so the 50% wage calculation doesn’t apply. 2.5% of her million-dollar investment is $25,000.
Her deduction is the lesser of the two calculations, which in this case would be the $25,000 in depreciable assets.
If you run a sole proprietorship or single-member LLC, you calculate the QBI deduction on a worksheet that comes with the instructions for IRS Form 1040 and enter the total on line 9 of your 1040 form.
If you own an S-corporation, a partnership, or multi-member LLC, the process is a little different: the QBI for the business is calculated first, followed by each owner’s share of the QBI, which is entered on their Schedule K-1 along with their other income. This Schedule K-1 information is then included with the owner’s other income on their personal tax return.
The IRS noted that the majority of business owners fall below the income thresholds and don’t have to worry about things like W-2 limits, property purchases, and limitations interfering with their ability to benefit from the QBI.
Those with higher income can work with their accountants or financial advisors to ensure that they don’t miss out on what deductions are available.