Also known as QBI or 199A deduction, the TCJA introduced a new significant 20% deduction for small and medium business owners. The benefit phases out for service businesses with profits >$161/$321 (Single/MFJ), while they phase in for non-service businesses based on wages paid and property value.
Sole Proprietors, LLCs and S-Corps use pass-through taxation in which the corporate profits are taxed at the individual level. You can read more about this subject in our blog “Business Corporate Structures.” The TCJA law introduced a new significant deduction for business owners called QBI (Qualified Business Income) or 199A or Pass-Through deduction. It allows up to 20% of QBI to be deducted from the AGI (Adjusted Gross Income) as a “below the line” deduction (reduces Taxable Income but not AGI).
The QBI is the Net Business Income from Schedule C/E reduced by the self-employment related tax deductions taken on 1040 Schedule 1 Adjustment. For a comprehensive view of the steps involved in 1040 form please refer to “Income Tax Calculation Flow and Deductions.” The full QBI deduction is 20% of QBI but is limited to 20% of Taxable Income (calculated without QBI deduction) minus Capital Gains. Further limitations based on business type apply.
All businesses with taxable income less than the phase-in threshold ($161K/$321K for Singles/MFJ) are eligible for the entire 20% deduction of their QBI. Let us look at a service business example. A married couple earns $80K salary, $140K net income from a sole proprietorship and $10K from REIT. REIT is considered part of QBI. The full QBI deduction from the net business income is eligible because it is lesser than the QBI limit from the Taxable Income.
Full QBI Deduction = ($140K + $10K) x 20% = $30K
Tentative Taxable Income = ($80K + $140K + $10K) – $24K Standard Deduction
= $206K
QBI Taxable Income Limit = $206K x 20%
= $41K
QBI Deduction = $30K
If the taxable income exceeds the phase-in threshold by >$50K/$100K for Singles/MFJ, then the W2/Property limitations fully apply. In this income tier, all services businesses are phased out for QBI deductions. Let us now look at a non-service business example. An individual has $50K in Capital Gains, a S Corp that owns a factory with $2M machinery, $100K W-2 expense and $400K net income. The full QBI deduction from the net business income is reduced by the greater of Wage/Property limit and Wage-only limit.
Full QBI Deduction = $400K x 20% = $80K
Tentative Taxable Income = ($400K + $50K) – $12K Standard Deduction
= $438K
QBI Taxable Income Limit = $(438K – $50K) x 20%
= $78K
QBI Wage Limit = $100K x 50%
= $50K
QBI Wage/Property Limit = $100K x 25% + $2M x 2.5%
= $75K
QBI Deduction = $75K
In the middle tier, the taxable income exceeds the phase-in threshold by <$50K/$100K for Singles/MFJ. Here, the service business begins to phase out and W2/Property limits begin to phase in for all businesses. The phase-in percent is the proportion of taxable income in the middle tier calculated as: Phase-in % = (Taxable Income – $161K) / $50K for Singles.
For non-service business, an excess QBI deduction above the W2/Property limit is calculated and a portion of this excess amount is allowed based on the phase-in percentage of the taxable income.
Excess = 20% QBI – W2/Property Limit
Eligible QBI = 20% QBI – Excess x Phase-in %
For service businesses, the full 20% QBI and W2/Property limit is first reduced by the phase-in percentage before the Excess/Eligible QBI calculations are applied.
Phase-in 20% QBI = 20% QBI x (1 – Phase-in %)
Phase-in W2/Property Limit = W2/Property Limit x (1 – Phase-in %)
Excess = Phase-in 20% QBI – Phase-in W2/Property Limit
Eligible QBI = Phase-in 20% QBI – Excess x Phase-in %
Any negative QBI will be carried forward to future years. NOL (Net Operating Loss) carried forward from prior years are deducted when computing QBI. An overview of NOL is provided in our blog “Business Loss Treatments.”
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