A guide to calculating tax savings from the Qualified Business Income Deduction for owners of an LLC, S Corp, partnership, or sole proprietorship
In 2017, Congress passed the Tax Cut and Jobs Act. This new law provides large tax deductions for owners of certain pass-through entities. Beginning for the 2018 tax year (and continuing every year through 2025, unless extended by Congress), owners of pass-through entities can deduct up to 20% of their share of qualified business income (“QBI”) from their personal income taxes. QBI is the profit a pass-through entity earns during the year, excluding certain types of income (like dividend income, interest income, short-term or long-term capital gains, wages paid to S Corp shareholders). How much each individual can deduct is determined by through a variety of factors input into a complicated formula. The savings from this deduction can be substantial. Below is a simplified description of how the QBI deduction works.
To begin, the deduction cannot exceed 20% of the excess of the business owner’s taxable income (total income from all sources minus deductions) subtracted by capital gains. For example, if Owner has total taxable income of $100,000 and $5,000 of capital gains, the limit imposed by this rule would be $19,000 (($100,000 – $5,000) x 20%).
Next, the calculation depends on the total amount of the business owner’s taxable income. If a pass-through owner’s taxable income is below $326,000 for joint filers and $163,000 for other filers,* then that the owner is entitled to 20% of his or her share of QBI (subject to the limitation above). The formula becomes more complex above these thresholds. Not only are higher earners are subject to additional limitations, but the IRS also makes a distinction between a “qualified trade or business” and a “specified service trade or business,” which includes, athletes, accountants, lawyers, and health-care providers, but not architects or engineers.
Qualified trades or businesses (i.e., non-service providers).
If a pass-through owner’s income is above $326,000 for joint filers and $163,000 for other filers, then the deduction is subject to another limitation. This cap is based wages paid by the business and business property. But the limitation operates differently at different income levels.
When the owner’s taxable income is above $426,600 for joint filers and $213,000 for other filers, the QBI deduction is limited to the greater of either (a) 50% of your share of W-2 wages paid by the business, or (b) 25% of your share of W-2 wages plus 2.5% of qualified business property. If either of these equations are greater than 20% of an owner’s share of QBI, then the full deduction applies. If the business has no employees or qualified business property, then the owner receives no deduction. (The intent of this deduction cap was to encourage pass-through owners to hire employees and buy property.)
When the owner’s income is between $326,000 and $426,000 for joint filers and $163,000 and $213,000 for other filers, the above limitation is gradually phased in, based on the percentage of the way through the phase-in range. To calculate the limitation on the deduction, calculate the full deduction if the limitation was not applicable (i.e., 20% of QBI). Then, calculate the wage/property cap if it were fully applicable. Next, multiply the percentage of the way through the phase-in range to the difference between the full deduction (first number) and wage/property cap (second number). Subtract that resulting number from the full deduction for the maximum allowable deduction.
Here’s an example to demonstrate:
Assume a single-filer’s taxable income is $200,500, with $100,000 QBI. The pass-through entity, solely owned by the filer, has no property but paid W-2 wages of $30,000. Ignoring taxable income for the moment, the full deduction would be $20,000 (20% of $100,000). The full wage/property cap would be $15,000 (50% of W-2 wages), which is higher than the alternative equation $7,500 (25% of W-2 wages + 2.5% of qualified business property). The difference between the numbers is $5,000. The filer’s taxable income is 75% of the way through the phase-in range ((200,500 – 163,000) / (213,000 – 163,000) = .75). Applying that percentage to the difference between the full deduction and the wage/property cap, gives $3,750 ($5,000 x 75%). Finally, subtracting $3,750 from $20,000 provides a deduction of $16,250.
Easy, right? Don’t worry, if you’re still looking for a challenge, there’s an added layer for service providers.
Specified service trade or business.
If a pass-through owner runs a service business and has an income above $326,000 for joint filers and $163,000 for other filers, then, in addition to all of the limitations discussed above, the amount available for deduction is also gradually phased out altogether.
When a service business owner’s taxable income between $326,000 and $426,000 for joint filers and $163,000 and $213,000 for other filers, the deduction is gradually phased out based on the percentage of the way through the phaseout range. The end result is that there is much less available for a deduction. (The intent of this limitation was to prevent highly compensated service employees (e.g., lawyers, consultants) from having their employers pay them as independent contractors and allow them to benefit from the QBI deduction.)
Here’s another example to demonstrate how the phaseout operates:
Imagine a service business owner filing jointly with a taxable income of $351,000, $100,000 in QBI, $30,000 in paid wages, and $0 in property. The first step is to calculate the deduction as if the company were not a service company. Here, the full deduction would be $20,000 (20% OF $100,000). The full wage/property cap would be $15,000 (50% of W-2 wages), which is higher than the alternative equation $7,500 (25% of W-2 wages + 2.5% of qualified business property). The difference between the numbers is $5,000. The filer’s taxable income is 25% of the way through the phase-in range (($351,000 – $326,000) / ($426,000 – $326,000) = .25). Applying that percentage to the difference between the full deduction and the wage/property cap, gives $1,250 ($5,000 x 25%). Subtract $1,250 from $20,000 and you get $18,750, just as you would for a qualified trade or business.
The next step, unique to specified service or trade businesses, requires that the number be further reduced based on the percentage of the way through the phaseout range. Because $351,000 is 25% of the way through the range (($351,000 – $326,000) / ($426,000 – $326,000) = .25), the deduction would be reduced to $14,062.50 ($18,750 x 75%).
If a service business owner’s taxable income has passed all the way through the phaseout range, i.e., above $426,000 for joint filers and $213,000 for other filers, then the deduction is reduced to zero.
In the end, the QBI deduction can be an added benefit for small business owners with pass-through entities. But determining whether a particular business owner qualifies for the deduction, and for how much, can be a complicated process. This simplified description is only intended to provide a general understanding of the QBI deduction. If you think you may be eligible to claim the deduction, you should talk with an attorney, accountant, or tax advisor. If you have any questions, don’t hesitate give us a call, or reach out to firstname.lastname@example.org.
*The taxable income thresholds used above were based on Tax Year 2020 levels.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.