Introduction
The qualified business income deduction is one of the most important aspects of the Tax Cuts and Jobs Act, which was signed into law on December 2017. This new provision provides eligible taxpayers with a deduction of up to 20% on qualified business income from partnerships, sole proprietorships, S corporations, trusts, and estates. In this article, we will explore the ins and outs of the qualified business income deduction and find out how small business owners can use it to save money on their taxes.
What is the Qualified Business Income Deduction?
The qualified business income deduction is a tax provision introduced by the Tax Cuts and Jobs Act that applies to eligible taxpayers who have qualified income from a pass-through entity, such as a sole proprietorship, partnership, S corporation, trust, or estate. The deduction allows taxpayers to reduce their taxable income by up to 20% of their qualified business income (QBI). QBI is defined as income that is effectively connected with the conduct of a U.S. trade or business. It does not include capital gains, dividends, or interest income.
The deduction is not applicable to taxable income earned from wages, salaries, and other forms of compensation paid to the taxpayer by an employer. Instead, it is designed to benefit small business owners, entrepreneurs, and self-employed individuals who generate income through their business ventures.
How to Qualify for the Qualified Business Income Deduction
In order to qualify for the qualified business income deduction, there are a number of requirements that must be met. Firstly, the taxpayer must have qualified business income (QBI) from a pass-through entity as previously mentioned. Additionally, the business must be classified as a trade or business, which is a term that has a broad definition under the Internal Revenue Code (IRC). Essentially, any activity conducted with the intention of making a profit can be classified as a trade or business, as long as it is legal and conforms to all applicable laws and regulations.
In addition to these two requirements, the taxpayer’s taxable income must fall below a certain threshold. For 2020, the threshold is set at $163,300 for single filers and $326,600 for joint filers. If a taxpayer’s taxable income exceeds these thresholds, the amount of the qualified business income deduction gradually decreases until it is completely phased out at $213,300 for single filers and $426,600 for joint filers.
The calculation of the qualified business income deduction can be complex, and it’s best to consult with a qualified tax professional to ensure that you are maximizing your deduction to its fullest potential. However, the general formula for calculating the deduction is as follows:
(QBI x the applicable percentage) – any reductions in the deduction = qualified business income deduction
The applicable percentage is determined by the taxpayer’s taxable income, their filing status, and the nature of their business. Some businesses may also be subject to additional limitations and exclusions that can affect the calculation of the deduction.
Advantages of the Qualified Business Income Deduction
The qualified business income deduction provides a number of advantages to small business owners and entrepreneurs. Firstly, it can result in significant tax savings, which can be reinvested back into the business to stimulate growth and expansion. Additionally, the deduction can reduce the overall tax liability of the taxpayer, which can free up more money to make strategic investments, hire new employees, or boost employee compensation.
Another advantage of the qualified business income deduction is that it can be used to offset the self-employment tax that many small business owners are subject to. This can further reduce the tax burden of the taxpayer and provide more cash flow for the business.
Limitations of the Qualified Business Income Deduction
Despite the many benefits of the qualified business income deduction, there are also some limitations and exclusions that taxpayers need to be aware of. Firstly, certain types of businesses are excluded from the deduction, including specified service trades or businesses (SSTBs). These include businesses in fields such as law, medicine, accounting, and consulting, among others. However, there are some exceptions to this exclusion, and it’s important to consult with a tax professional to determine if your business is eligible for the deduction.
Additionally, there are certain income thresholds that can limit the amount of the deduction that is available. As we discussed earlier, taxpayers with a taxable income above certain thresholds may see their qualified business income deduction phased out over time. There are also other reductions in the deduction that can apply for certain types of businesses or under certain circumstances. Again, consulting with a tax professional can help ensure that you are maximizing your deduction and minimizing your tax liability.
Tips for Maximizing the Qualified Business Income Deduction
If you are a small business owner or entrepreneur who is eligible for the qualified business income deduction, there are a number of strategies you can use to maximize your deduction and reduce your tax liability. Firstly, it’s important to ensure that you are properly tracking all of your business income and expenses. By maintaining accurate and up-to-date records, you can more easily identify deductions and other tax-saving opportunities.
Another tip for maximizing the qualified business income deduction is to properly classify your business activities. As we mentioned earlier, the definition of a trade or business is broad under the IRC, but certain activities may not qualify. Ensuring that all of your business activities are properly classified can help you take full advantage of the deduction.
Finally, working with a qualified tax professional can be an effective way to identify additional strategies for maximizing the qualified business income deduction. A tax professional can help you navigate the complex rules and regulations governing the deduction and help you find additional ways to reduce your tax liability.
Conclusion
The qualified business income deduction is a powerful tool for small business owners, entrepreneurs, and self-employed individuals looking to reduce their tax liability and grow their businesses. By understanding the requirements for the deduction, calculating it correctly, and taking advantage of all available strategies for maximizing the deduction, taxpayers can reap significant tax savings that can be reinvested back into their businesses to stimulate growth and expansion.
If you are unsure about whether you qualify for the deduction or are looking for additional strategies for maximizing it, it’s best to consult with a qualified tax professional who can help guide you through the process and ensure that you are taking full advantage of all available deductions and tax-saving opportunities.