As a startup founder or entrepreneur, you hustle hard to grow your business. But then, every year, as tax season rolls around, you find yourself drowning in myriad business tax forms and complicated regulations, as you try your best to reduce the amount you owe Uncle Sam.
Before 2017, pass-through entities had it relatively easy, as they paid lower taxes than their corporate counterparts. However, the introduction of the Tax Cuts and Jobs Act reduced the corporate tax rate to 21%, leaving self-employed individuals feeling ignored and left out.
Thankfully, the IRS introduced Section 199A, popularly known as the Qualified Business Income Deduction (QBID), to reduce the tax burdens of entrepreneurs. The QBID allows self-employed individuals to deduct 20% of their qualified business income, leading to substantial tax savings. This deduction is a godsend for those who have to pay both personal income and self-employment taxes, as it helps offset some of the costs of paying taxes as your own boss.
However, the QBID can be a bit tricky to understand and calculate, as there are a ton of eligibility rules (with even more sub-rules). The math involved in figuring out this deduction isn't always straightforward. It's also worth noting that the QBID expires by the end of 2025, so it's crucial to take advantage of it while you still can.
In this guide, we dive into the nitty-gritty of QBID: what it is, its purpose, goals, and eligibility criteria, and tips on leveraging it.
QBI Deduction 101
The QBID is available to owners of pass-through entities like partnerships, sole proprietorships, limited liability companies, and S corporations. Simply put, if you report your share of business income on your personal tax returns, you're most likely to qualify for QBID.
One of the biggest benefits of the QBI deduction is that it's a personal write-off. This means you can claim it whether you claim standard deductions or opt for itemized personal deductions.
Definition Of Qualified Business Income (QBI) Deduction
Here's a breakdown of the key points:
What is Qualified Business Income? Qualified business income is the net income, gain, loss, and deduction from a qualified trade or business. It includes profits but excludes certain types of income like capital gains and dividends.
Who is eligible? Pass-through entities like sole proprietorships, partnerships, S corporations, and certain trusts and estates. There are income thresholds and limitations for different types of businesses.
How much is the deduction? Up to 20% of qualified business income, with limitations based on taxable income.
Purpose And Goals Of The QBI Deduction
The IRS introduced the Qualified Business Income Deduction (QBI Deduction) with two primary goals:
1. Encourage entrepreneurship and small business growth
The government aims to incentivize entrepreneurs to grow and expand their businesses by lowering their tax burden, leading to increased investment, job creation, and overall economic growth.
2. Level the playing field between different business structures
Historically, C corporations enjoyed lower tax rates compared to pass-through entities. This created an unfair advantage, potentially discouraging entrepreneurs from choosing the pass-through structure. QBID addresses this imbalance by offering a tax break to pass-through entities, making them more competitive with C corporations.
How Does QBI Deduction Work?
If your business is eligible for the QBI tax deduction, you can reduce your taxable business income by 20%. The best part is that you can claim this deduction in addition to standard, itemized, and above-the-line deductions. However, it is essential to note that the deduction cannot exceed 20% of your total taxable income.
To claim this deduction, you must first calculate your business income and expenses using Schedule C. Next, determine your adjusted gross income. Once you have that information, you can use a business tax calculator or the IRS Form 8995 (commonly known as the QBI deduction form) to calculate your eligible QBI deductions.
Eligibility Criteria For QBI Deduction
Whether you are eligible depends on your business type and your annual total taxable income. For example, you qualify if your total taxable income was under $182,100 in 2023 for single filers and $362,200 for joint returns. The limit for 2024 is raised to $191,950 and $383,900 for single and joint returns, respectively. If you're over this limit, you might be eligible for a partial deduction, depending on IRS rules.
It's worth noting that you can still take the QBI deduction even if you don't have qualified items of income on Schedule A or take the standard deduction. However, remember that the deduction is only available for tax years that begin after December 31, 2017, and end on or before December 31, 2025.
Types Of Businesses That Qualify
As mentioned above, pass-through entities are eligible for the QBI deduction. This includes:
- Sole proprietorships
- Partnerships
- S Corps
- Limited Liability Companies (LLCs) whose owners are taxed as sole proprietorships, partnerships, or S corps
C Corps are not eligible for the QBI deduction as they file corporate income taxes. Besides pass-through entities, specific individuals are also eligible for this deduction. This includes freelancers and self-employed persons with qualified dividends from a Real Estate Investment Trust (REIT) or Publicly Traded Partnership (PTP).
Income Thresholds And Limitations
While the QBID is a massive benefit for qualifying entities, certain limitations exist. Here's a QBI deduction example where there are specific limitations.
Let's say you run an SSTB (Specified Service Trades or Business) in law, accounting, or medicine. In this scenario, you face a capped deduction amount. This is determined based on the W-2 wages paid to employees. This means the deduction will not exceed the capped limit, even if your qualified business income exceeds the threshold. Similarly, certain deductions and losses are not considered qualified business income for calculating the QBI deduction.
Leverage QBI Deduction for Your Business
With careful planning and expert guidance, the QBI deduction can be a game-changer. Remember, every dollar saved is a dollar invested back in your business, fueling its growth and success.
P.S. Don't forget the QBI deduction expires at the end of 2025, so make the most of it while you can! If you're filing business taxes independently, use a QBI deduction calculator to ensure you fully take advantage of all eligible deductions.
If this is your first time filing tax returns, we recommend opting in for financial services such as hiring a tax professional or an outsourced CFO for tailored guidance on business tax preparation. Besides helping you file your taxes, they can offer strategic advice to optimize your profits and lower your tax burdens.
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