Being an entrepreneur is filled with challenges, and one of the most daunting can be navigating the complex world of taxation. For startups, every financial decision can have a significant impact on growth trajectories and long-term success.
Many entrepreneurs miss out on tax deductions, which could mean leaving a lot of money on the table.One major opportunity was introduced in 2017: the Qualified Business Income (QBI) deduction. This deduction can offer significant tax relief to business owners and self-employed individuals, but understanding its intricacies is crucial.
In this comprehensive guide, we'll dive deep into the QBI, explore its role in the taxation landscape, uncover eligibility criteria and exclusions, and reveal strategies to maximize its benefits. Read on to learn how to fortify your startup's financial strategy and potentially reduce your tax burden.
What Is Qualified Business Income (QBI)?
QBI is the net income of certain types of businesses in the United States. These businesses include sole proprietorships, partnerships, S corporations, and some LLCs. Net income is simply the total amount of money a business earns minus any expenses it incurs during the year. This means that QBI is essentially the profit or loss for tax purposes.
QBI can also include cooperative dividends, publicly traded partnerships (PTP), and real estate investment trusts (REIT). The Tax Cuts and Jobs Act created the QBI deduction in 201. This is one of many small business and startup tax deductions meant to help business owners and self-employed individuals reduce their taxes.
The QBI deduction benefits owners of pass-through entities by reducing their tax obligations. It's not exactly a business tax credit, but it helps these entities receive benefits similar to those of corporations.
The Role of QBI in Taxation
C corporations pay their own taxes, but pass-through businesses work differently. In pass-through businesses, the company's profits go to the owners. Then, these owners put this money on their personal tax returns.
The QBI deduction allows qualifying individuals the chance to deduct up to 20% of their QBI, which lowers their taxable income. However, there are limitations based on the individual's total income and their business type.
New businesses need to understand QBI if they fall under the pass-through entity category. Properly using it can result in significant tax advantages. However, you must meet specific requirements to take advantage of this opportunity.
Eligibility and Exclusions
The QBI deduction has eligibility criteria and exclusions to help the right businesses benefit. It's available for eligible taxpayers as a deduction for years beginning after December 31, 2017, and ending on or before December 31, 2025. The following are some additional eligibility requirements and exclusions for the QBI deduction.
Eligible Business Types
QBI helps businesses that pass their income directly to owners or shareholders, who report it on personal tax returns instead of paying corporate taxes. This includes both taxpayers who took a standard deduction or an itemized deduction. The following are the types of business structures that can receive benefits from QBI.
- Sole Proprietorships: Individuals running their own businesses without a formal business structure fall under this category.
- Partnerships: Businesses operated by two or more individuals where they share partnership income, losses, and responsibilities.
- S-Corporations: A special type of corporation that elects to pass corporate income, losses, tax deductions, and tax credits to their shareholders.
- Limited Liability Companies (LLCs): Depending on their tax structure, LLCs can also qualify for QBI deductions. This is typically for LLCs taxed as sole proprietorships or partnerships.
Exclusions and Limitations of QBI
QBI aims to help smaller businesses, but there are exceptions based on business type and income limits.
- C corporations: C corporations pay business taxes separately from their owners, so they aren't eligible for QBI deductions.
- Specified Service Trades or Businesses (SSTBs): Some business activities and business types, like health, law, and accounting, have restrictions if they earn too much. For example, law firms with taxable business income above the set threshold may not be eligible for QBI deductions.
- Income thresholds: The full QBI deduction is available for those with taxable income below a set threshold (adjusted annually for inflation). For married couples filing a joint return, the threshold is $364,200 for 2023. For married couples filing separately and single individuals who are heads of households, the threshold is $182,100. Above this threshold, limitations may apply depending on the type of business.
- Wage and capital limitations: Some businesses with taxable income above the threshold may be subject to limitations on QBI deductions based on wage income paid and investment in qualified property. These regulations on business finances help to prevent excessive deductions for high-income earners.
- Other Exclusions: There are additional exclusions from QBI deductions. Some of these exclusions include interest income, income from principal contracts, capital gains, dividends, and income from certain foreign sources.
How Is QBI Calculated?
Startups can improve their financial decisions by learning how to calculate qualified business income, which is the net income from their business operations. However, figuring out what counts towards this income and what doesn't can be challenging. The following is a broad outline of the QBI calculation process.
- Typically applies to sole proprietors, partnerships, S-corporations, and some LLCs in the conduct of business in the United States.
- Some service-based businesses, like those in health, law, consulting, athletics, financial services, and a few others, may face restrictions or limitations if the taxpayer’s taxable income exceeds certain thresholds.
Calculate Your QBI:
QBI is the net amount of income, gain, deduction, and loss from any qualified business. Only qualified income earned within the U.S. counts. Things like capital gains/losses, dividend income, interest income (unless it's related to the business), and wages paid to S-corporation shareholders aren’t considered qualified items under QBI.
Begin with your business's total revenue and net profit or loss. You can find this figure on your Schedule C for sole proprietors or the K-1 for partnerships and S-corporations. You will then figure out your adjusted gross income.
Determine Your Deduction:
Generally, the QBI deduction is the lesser of:
- 20% of the taxpayer's QBI, or
- 20% of the taxpayer's taxable income minus net capital gains.
If your taxable income exceeds the threshold amount, limitations related to W-2 wages paid by the business and the unadjusted basis of certain property acquired by the business may reduce the QBI deduction amount.
Service Businesses Limitation:
If your business is one of the specified service trades or businesses (SSTBs) and your taxable income exceeds the threshold, the QBI deduction may be reduced or eliminated.
Deductible Amount for Partners or S-corporation shareholders:
If you’re a partner in a partnership or a shareholder in an S-corporation, the business will provide you with your share of QBI, W-2 wages, and the unadjusted basis of qualified property. You’ll then use this information to compute your QBI deduction.
REIT Dividends and PTP Income:
Taxpayers can also take a QBI deduction on 20% of their combined qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership (PTP) income. This is calculated separately from the QBI from a pass-through entity.
Total QBI Deduction:
Add together the QBI amounts from each business plus the amount from REIT dividends and PTP income. The sum will be your total QBI deduction. However, you must limit your deduction to 20% of taxable income minus net capital gains.
Report on Tax Return:
Once calculated, you can claim the QBI deduction on your personal tax return. It's taken as a deduction reducing taxable income and is not an itemized deduction, so you can take it in addition to the standard deduction.
Strategies for Maximizing QBI
By understanding QBI, startups can employ strategies to maximize their deductions. Here's a closer look at a few:
- Managing Business Income and Expenses: Regularly review and adjust business income and expenses to stay within favorable QBI deduction thresholds.
- Structuring Your Startup for QBI Optimization: The structure of your business plays a significant role in the calculation of its QBI. Restructuring or reclassifying your business can lead to better tax advantages. It's advisable to consult with tax professionals to determine the best structure for QBI optimization.
- Coordination with Other Tax Planning Strategies: The qualified business income component is just one piece of the larger tax planning puzzle. Work with your finance team to combine QBI planning with other tax strategies, like adjusting income timing or maximizing retirement contributions. This holistic approach can enhance the overall tax benefits for your startup.
Stay Compliant and Empower Your Startup's Financial Strategy
Startups can channel every penny they save into reinvestment, helping fuel growth. Understanding and leveraging the qualified business income deduction can mean significant tax savings.
By delving deep into QBI, adhering to its guidelines, and seeking expert counsel, you can position yourself and your startup for greater financial success.
Whether you're just starting out or looking to optimize your existing business, keep QBI in mind as a powerful tool in your financial arsenal.
Don't leave money on the table — explore modern financial solutions and consult with seasoned experts to ensure you're maximizing every opportunity available to your business.