While starting a small business is a super exciting time, it can also feel like there are so many new responsibilities to take on–from finding customers and managing your invoices to estimating self-employment taxes and running payroll.
But there’s more to being a small business owner than new responsibilities; you can benefit from certain tax deductions that don’t apply to regular employees of a business. One of these deductions is the qualified business income or QBI deduction.
What Is the Qualified Business Income Deduction?
The qualified business income (QBI) deduction is a tax deduction that lets specific self-employed individuals and small business owners subtract up to 20% of their qualified business income from their taxes.
If you have business earnings and your total taxable income is less than $170,050 (or $340,100 for joint filers) in 2022, good news! You might be eligible for the full QBI deduction.
Did you make more than that?
You can claim a partial QBI deduction for income up to $220,050 (or $440,100 for joint filers). We'll go over exactly what income counts, who qualifies and how to claim this deduction, so keep reading!
What Income Counts as QBI?
The IRS defines qualified business income as earnings generated through the operations of running your business—like payments for business services or revenue from selling products. The income you report on your Schedule C of Form 1040 during tax season? That counts.
Any income not generated through your business operations—for example, capital gains, dividends, and interest income—would not qualify for this deduction. It’s also important to note that income must come from a U.S. business—which means any money earned from a business outside the U.S. wouldn’t qualify.
Finally, reasonable compensation from an S corporation (like your salary) or payments from a partnership agreement also doesn’t count towards qualified business income. Let’s explore why:
If you own an S corporation and are actively involved in business operations, you must pay yourself a salary instead of taking an owner’s draw. In general, any kind of salary that’s reported on a W-2 form doesn’t count as qualified business income since it’s not generated by your business operations.
Similarly, you may pay a partner to develop a marketing plan. That guaranteed payment is similar to a salary in an S corporation and doesn't count for this deduction since it’s not generated by selling goods or services.
Who Can Take the Qualified Business Income Deduction?
The QBI tax deduction is only available to U.S. businesses that qualify as pass-through entities. A pass-through entity is a type of business structure where the income from the business gets passed through to the owner (or owners) and reported on personal income returns.
With a pass-through entity, there’s no business tax charged on business income. Instead, owners pay personal income taxes on their business earnings. Business structures considered pass-through entities include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.
One business entity that doesn’t qualify for the QBI deduction? C corporations. In a C corporation, the business gets its own tax rate and return form that is separate from the owner’s income tax. Due to this structure, they’re not considered pass-through entities—and so owners of a C corporation cannot deduct qualified business income from their tax returns.
So, let’s say you run a business using a pass-through entity (sole proprietorship, partnership, LLC, or S corporation). Does that mean you’re automatically eligible for the QBI deduction? Not necessarily. The deduction only applies to owners of pass-through entities if their total taxable income for the year falls below certain limits.
QBI Limits for 2022
For 2022, you can claim the full QBI deduction if your total taxable income is under $170,050 for single filers and $340,100 for joint filers. If your total taxable income is greater than the limit that applies to your filing status, then your deduction might be reduced or even eliminated, depending on:
- The type of business you own,
- The amount of wages you pay employees, and
- The value of property the business owns.
One important thing to note is that the IRS limits are for your total taxable income, not just your business income. What does that mean?
Your total taxable income includes all income sources—earned and unearned. Earned income is money you receive in exchange for work that you do. It includes money from your W-2 wages, salary, tips, and self-employment income.
Unearned income, on the other hand, refers to passive income you earn without performing services, such as money you make through dividends, interest on investments, and even gambling winnings.
Let’s take a look at two examples of single tax filers:
Amanda works full-time and earns a salary of $50,000. She also freelances in her spare time for extra money, and this year she earned $20,000 as a sole proprietor. Her total taxable income is $70,000, which is below the single filer limit of $170,050. Since that’s the case and she has a pass-through entity, she automatically qualifies for the full QBI deduction.
On the other hand, Sarah runs a small LLC business, and $150,000 of business income is passed through to her. She also sold some investments for $30,000. Sarah’s total income for the tax year turned out to be $180,000, which is higher than the single filer limit. While Sarah has an eligible business entity, her total earnings are higher than the QBI limits for 2022. So Sarah does not automatically become eligible.
It would be easier to say that Sarah doesn’t qualify at all. But, as it’s the IRS, it’s never that simple…
Qualifying if You’re Over the Income Limits
There are some exceptions in which someone who owns a pass-through entity and makes more money than the QBI limits (like Sarah) can take the deduction; they just might not be eligible to take the full 20%.
The IRS introduced a phased deduction for people with incomes higher than the threshold amount. The phase-out means that, based on your income and additional factors (like how much you pay employees and your business real estate and other tangible property values), you might only be eligible for a lower deduction.
So how, exactly, does the IRS determine if high-income taxpayers qualify for the QBI deduction—and, if so, how much of a deduction do they qualify for? In particular, the IRS looks at your total taxable income and the type of business you own when deciding whether or not you can take a reduced QBI deduction. The IRS guidelines are as follows (and just as a heads up, they get complicated quickly).
Specified Service Trade or Business
If you’re a doctor, accountant, or even an actor that earns qualified business income, the IRS considers you a “specified service trade or business” (SSTB). SSTBs provide services in industries such as health, accounting, performing arts, athletics, and financial services. (You can find the full list of specified service trade businesses on the IRS website.)
If you fall into the SSTB category, you may be able to qualify for a partial QBI deduction if your income is between $170,050 and $220,250 for single filers or $340,100 to $440,100 for married people filing jointly.
But if you have a specific service trade or business and your taxable income is above the SSTB limits of $220,250 (single) or $440,100 (jointly), you can’t take the deduction.
Other Qualifying Business Types
Let’s say you have a business that generates pass-through income, but it isn’t a qualified trade. Is there anything you can do in that situation?
The answer is—it depends. There are additional guidelines for other qualifying business types to determine how much of a deduction you can take. They take into account how much you paid employees in wages, the value of any property your business owns, and other factors. (More on that in a minute.)
Ultimately, if your income is above the limits, but you want to see if you can still take the deduction, we recommend contacting a certified accounting professional (CPA). A CPA can tell you if you qualify and determine how much of a deduction you can take.
How Much Can You Deduct if You're Over the Limits?
Suppose you qualify for the QBI tax break using one of the above scenarios. In that case, the amount of income you can deduct depends on two main factors: how much you paid in W-2 wages to employees (including yourself!) and the value of any property owned by your business.
Higher salaries and business property will give you a better chance of being eligible for the QBI deduction. If you qualify for the deduction, but your income is above the limit, you’ll use Form 8995-A to file for the deduction (instead of Form 8995, which is the simplified version for people whose income falls below the threshold).
For those using Form 8995, go to the next section to see how and when to file. You can check out the IRS Tax Cuts and Jobs Act guidelines for more detail or contact a CPA to help walk you through the rules.
How to Deduct QBI
If you’re eligible for the QBI deduction, you will report it on your income tax return using Form 1040. Specifically, the amount of income you can deduct goes on line 13 of the form, and you will subtract that from your adjusted gross income.
You’ll use IRS Form 8995 to figure out how much of a deduction you can take. If you have multiple businesses that qualify for the deduction, you can report your income and loss from each company on Form 8995. The form will help determine your net income or loss from all eligible businesses.
Figuring Out How Much to Deduct
If you have qualifying business income, the next question is, “How much can I deduct from my taxes?”
The answer to that question has two parts:
- You can deduct up to 20% of your qualified business income, AND
- Your deduction must be less than or equal to 20% of your total taxable income
Let’s say we consider the example we used before with Amanda, who has $70,000 in earnings—including $20,000 worth of qualified business income. If Amanda takes the full 20% deduction on her $20,000, she’ll subtract $4,000 from her adjusted gross income. That adjusts it to $16,000. But is this $4,000 equal to (or less than) 20% of her total taxable income? It has to be to qualify.
To check her upper limit, we calculate 20% of $70,000, which equals $14,000. Amanda can take the full deduction since that $4,000 amount is lower than 20% of her total taxable income. (It’s also important to mention that you can make this deduction even if you take the standard deduction instead of itemizing your taxes.)
Take the Time to Understand Small Business Taxes
Small business taxes can be confusing, especially at first. But it’s worth taking the time to understand what types of deductions and tax benefits you can take to keep as much of your business income as possible—and, if you qualify, the QBI deduction is a great way to pocket some more of your hard-earned income.
Have more questions about the QBI deduction? Talk to your CPA; they can answer your questions and help you determine if you qualify.