Section 199A: Understanding the QBI (Qualified Business Income) Deduction

Beginning in 2018, congress passed the Tax Cuts and Jobs Act (TCJA). With the tax reform, came a huge tax break for C-Corporations: top rates went from 35% to 21%. But this didn’t help owners of other types of non-corporate businesses that operate in the United States.

Why the QBI Deduction?

Corporate income is technically a form of capital income, and not directly attributable to the labor efforts of an individual owner (in most cases). So congress wanted to even the playing field for non-corporations, but had to find a way to provide a tax break on only the capital portion of income and still tax income created by labor. Bring in the QBI Deduction.

What is the QBI Deduction?

The QBI deduction, in short, is a 20% tax deduction based on your Qualified Business Income or QBI. To simplify greatly, if you made $100,000 in your business, you would get a $20,000 reduction on your taxable income (So you would only pay tax on $80,000 of income). Like I said, this is greatly simplified, but you get the idea. So there is definitely a benefit to owning a business, especially now that miscellaneous itemized deductions are no longer available for employees.

Qualified Business Income includes any type of income generating activity that is considered a trade or business (as opposed to working as an employee or receiving interest income, for example). This would include qualified income from a partnership, LLC, S-Corp, Sole Proprietorship, qualified Publicly-Traded Partnerships, qualified REITs, and in some cases, rental properties (Under Notice 2019-07). Again, this deduction does NOT apply to C Corporations. If you received a 1099, you are more than likely eligible to receive the QBI deduction.

QBI does NOT include non-business interest income, capital gains and losses, certain dividends, W2 income including salaries for S-Corporation shareholders, and guaranteed payments.

Plain English, please. How does the QBI deduction affect soloprenuers?

Let’s say you are a freelancer with one main client, who gives you the option of working as a W2 employee or working as an independent contractor (1099). Which option is better?

As an employee, you don’t have to pay half of self-employment taxes, which is 7.65% of your income (15.3% total). You’ll still pay your own half, and the employer will withhold your income taxes for you on each paycheck.

If you become a 1099 contractor, you’ll pay the full 15.3% on your income (Unless you are an S-corp with a salary and distributions). However, you’ll gain the ability to deduct your reasonable and necessary expenses associated with the business activity, including the employer’s half of the payroll tax (such as cell phone, internet, etc). You’ll also gain the 20% QBI deduction, which has the potential to lower your taxes compared to the W2 option. If you had $10,000 of expenses, your overall tax liability with the QBI deduction would be comparable to the W2 option, so consider non-tax implications such as non-compete agreements, and control of your time, and your own ability to track deductions and make quarterly estimated payments. If you decided to become a contractor and make use of an S-election, you may be able to lower your payroll taxes even further. Keep in mind however, that S-Corp salaries also lower your QBI deduction, so you’ll want to ask a professional what the best option is for you.

Can I get the QBI Deduction if I take the standard deduction?

Yes! The QBI deduction is applied only to the business portion of your income, and is applied before calculating your other itemized deductions on Schedule A, or the standard deduction if you choose not to itemize (or don’t exceed the $12,200 deduction per person).

What if my business had a loss, can I still get the QBI deduction?

If you have more than one business, you have to figure the QBI separately for each one. If all of your businesses produced a loss, your QBI would also be reduced to zero (since you had no income, basically). The QBI deduction can’t go “negative,” so the loss is carried forward and applied to any future business income, and the loss would reduce your QBI benefit in the future. The loss would reduce your taxable income in the future as well, so this isn’t a bad thing.

Exception for Specified Service Trades or Businesses (SSTBS)

A specified service trade or business (SSTB) is a business that relies on the skill or reputation of the owner. Examples include doctors, lawyers, accountants, athletes, musicians, and more. The business does not sell products, but services based on the skill of a person. Because congress believed that product-oriented industries provide many jobs for the populace, they wanted to limit the deduction for service-based industries. Whether or not this is true is an argument for another day; just know there is a limit.

The maximum income for an SSTB before the QBI deduction is phased out is $321,400 for married filing jointly ($160,700 for single and head of household) and is completely phased out at $421,400 ($210,700 for single and head of household).

In short, this means that your deduction will be reduced if your taxable income on your individual income tax return is greater than $160,700 per person. You won’t receive any deduction if your taxable income (per person) is greater than $210,700. If this sounds like your business, contact us for some tax planning strategies to mitigate the impact of losing this deduction. It may make sense to become a C-corp to enjoy the 21% tax rate. It may save money, even with the double taxation on income and dividends, but it depends on your individual scenario.

Does My Rental Property Qualify for the QBI Deduction?

The IRS allows rental property businesses to be included for QBI purposes if it qualifies as a trade or business under IRC (Internal Revenue Code) Section 162. There is a safe harbor available for landlords to ensure that they will qualify for the QBI deduction (does not apply to triple-net leases).

Safe Harbor Requirements for Rental Properties

  1. Each rental business must maintain separate books and records to reflect business activity (income and expenses).
  2. At least 250 hours of services must be performed by the taxpayer (or a qualified contractor such as an electrician) on the property. This also includes administrative duties such as collecting rent, background checks on applicants, etc.
  3. You must maintain records of the time spent on #2. This is a log of the dates, hours, services performed with a description, and who serviced the property.

Even if your rental property does not qualify as a trade or business, you may still be able to take the QBI deduction. Contact mandy@ownitaccounting.com to find out more about how this deduction can benefit your situation.

This article is for informational purposes only and is not intended to provide legal, accounting, or tax advice, and should not be relied on as such. Before engaging in any transaction or activity, you should consult with a professional advisor or contact us for an individualized consultation.