Many small business owners choose not to incorporate in a way that would require them to pay business taxes. Instead, they choose business structures that allow them to pass income through the corporation and file it on their personal taxes.
At CMP, our small business clients rely on us to help minimize their tax burden with deductions and credits. If you own a pass-through business, here's what you need to know about the Qualified Business Income deduction and how it works.
What is the Qualified Business Income Deduction?
The Tax Cuts and Jobs Act (TCJA) passed in 2017 included some tax advantages for small business owners. One of the most significant was the addition of the Qualified Business Income tax deduction. Like many of the business tax changes included in the bill, the Qualified Business Income tax deduction is designed to encourage entrepreneurship by minimizing the tax burden for owners of small companies.
The TCJA allowed the Qualified Business Income deduction to remain in place through 2025 with an option to extend it for an additional year. As of this writing, the Qualified Business Income deduction is still expected to expire on December 31, 2025.
How Does the Qualified Business Income Deduction Work?
Here is a simple explanation of how the Qualified Business Income deduction works. Two amounts to identify:
- 20% of your eligible pass-through business income.
- 20% of your taxable ordinary income must be calculated before taking the pass-through deduction into account.
The smaller of the two will equal the amount of the Qualified Business Income deduction. Keep in mind that multiple tests determine what qualifies as qualified business income and other eligibility tests. We’ll show you a more detailed calculation below, and you may need to consult with a tax professional to be sure you have properly calculated the deduction amount.
What Are the Benefits of the Qualified Business Income Deduction?
Three significant benefits could explain why 95% of small businesses in the United States choose a pass-through business structure.
Pass-Through Taxation Helps Business Owners Avoid Double Taxation
C corporations must pay business taxes, and the owners must also pay individual income taxes. In other words, there are two layers of taxation, resulting in a much higher tax burden than with a different organizational structure where income is passed through to the owners.
With a pass-through structure, no business income taxes are to be paid at the entity level. Instead, the profits and losses from the business are passed through the business itself and to the owners, who must report the income when they file their individual income tax returns. This is a huge benefit since it saves business owners from paying a high corporate tax rate. The deduction can benefit people who must pay the self-employment tax even though it doesn’t reduce your Medicare or Social Security taxes.
Pass-Through Organizations Have More Flexibility
The second key benefit of pass-through entities is that companies that pass income through to the owners have far more flexibility in terms of structure than C corporations. In other words, if your company has outgrown its existing structure -- for example, if you originally organized as a sole proprietorship but now believe that an LLC would better suit your needs -- making the change is easy from a tax perspective.
A sole proprietorship or partnership can file paperwork to switch to an LLC, and an LLC can be taxed like an S corporation or a C corporation. You can select the right structure for your business and still take advantage of pass-through taxation.
Pass-Through Businesses Can Save Money on Their Taxes
During the debate about the TCJA, some small business owners claimed that the reduction in the corporate tax rate from 35% to 21% favored large businesses. The result was that legislators added a new small business tax break to the legislation.
The Qualified Business Income Deduction allows pass-through organizations to deduct up to 20% of their qualified business income to reduce their tax burden. Calculating this deduction can be complex, so we advise you to work with a qualified tax accountant.
Eligibility for the 20 Percent Deduction
Business owners who qualify may take up to a 20% deduction of their net business income when they file their federal income tax returns as an individual. Whatever their share of income from the business is, they may be able to reduce their tax burden. Here are the three qualifications you must meet to take the pass-through deduction.
You Must Be a Pass-through Entity
The first qualification is that your business must be a pass-through entity. Here are the business types that qualify:
- Sole Proprietorships - Entities where a single person owns all the business assets.
- Partnerships
- Limited Liability Companies (LLCs)
- Limited Liability Partnerships (LLPs)
- S Corporations - Must choose pass-through taxation instead of corporate taxation.
If your business is one of these types, then you’ve met the first requirement to take the deduction.
You Must Have Qualified Business Income
Qualified Business Income is the net profit your business earns in a year. You can calculate this amount by subtracting your business deductions from your income.
Qualified Business Income includes rental income (provided the rental activity is business-related) and income from REITs, qualified cooperatives, and publicly traded partnerships. It does not include interest income, dividend income, short-term or long-term capital gains and losses, wages paid to S corporation shareholders, or any business income you earned outside the United States.
You Must Have Taxable Income
Finally, you must have taxable income to qualify for the pass-through deduction. Pass-through owners must have total taxable income to take the deduction. Your total taxable income is the sum of all income you earn from business, jobs, and investments, less your standard tax deduction.
As a reminder, the standard deduction is $13,850 for individuals, $27,700 for joint filers, and $20,800 for heads of household for 2023. You do not qualify for the deduction if you do not have taxable income.
Navigating taxable income requirements can be tricky, but understanding the benefits of filing a business tax extension can make a big difference. With extra time, you can ensure you're maximizing your deductions and meeting all eligibility criteria for valuable tax breaks like the pass-through deduction. Don't miss out on potential savings—learn how a small business tax extension can help you optimize your financial strategy.
How Much is the Deduction Worth?
We noted that the maximum amount allowed under the TCJA is a 20% deduction on pass-through income. It's important to note that the deduction applies only to pass-through income. If you pay yourself a salary or have income from other sources, you may not use it to calculate the deduction.
Some limitations dictate the maximum amount the deduction can be worth, which is reviewed next. Provided your business and income fall within the threshold, you can qualify for 20% tax savings.
What Are the Limitations of the Qualified Business Income Deduction?
A 20% reduction in your taxable income is undeniably attractive, but there are some limitations you'll need to understand before you claim the pass-through deduction.
Qualified Income
Let's start with what qualifies as income and what doesn't. Your profits from the business qualify. However, the following things do not:
- Reasonable compensation for employment
- Guaranteed payments (usually apply to partnerships)
- Capital gains
- Income from dividends and interest
You should subtract any income that doesn't qualify for the deduction before calculating.
Limits on Upper-Income Households
For calculating the Pass-Through Deduction, an upper-income household for the 2023 tax year has $182,100 or more of income for a single taxpayer and $364,200 or more for married taxpayers filing jointly. These income limits apply to taxpayers at the top of the 24% and three higher tax brackets. Earners in these brackets are subject to additional limitations.
If you're not a service provider (see below) and your income exceeds the limits by $50,000 if you’re single or $100,000 if you’re married, you should know that your business income will be subject to a W-2 wage and business property limitation. Your allowable deduction is limited to the higher of:
- 50% of the W-2 employee wage income paid by the business or
- 25% of the W-2 wage income you paid plus 2.5% of the acquisition cost of your depreciable business property.
There is no cap on the deduction for income from a pass-through business, but high earners are limited based on the above requirements.
If you want to reduce your tax burden, be sure to read the 7 Proactive Tax Planning Tips For A More Secure Future.
Restrictions on Certain Types of Businesses
While many pass-through businesses can take advantage of the pass-through deduction, there are restrictions that apply to business owners who provide services. If you provide services in the following areas, you won’t likely qualify for the pass-through deduction if your income exceeds certain thresholds.
- Brokerage services
- Consulting
- Financial services
- Health or medical services
- Legal services
Business owners are disallowed from counting income from a list of service trades and businesses (SSTB) in their calculations. Make sure to determine if your service business qualifies for the deduction. They are also not allowed to claim the deduction if their income source is a business where the "principal asset is the reputation or skill of one or more of its employees or owners." This limitation is because the deduction is designed to assist people who start businesses, not highly paid professionals. An individual owner who is in business for themselves must adhere to the limitations below.
If you own a service business, your deduction will phase out completely once you exceed the income limits by $50,000/$100,000, which would work out to income over $232,100 if you’re single and $464,200 if you’re married and filing jointly. In the event your income falls between the limits described in the previous section and the maximum threshold to take the deduction, you can calculate how much you qualify for by subtracting 1% from your deduction for every $1,000 over the limit if you’re single, and 2% per $1,000 over the limit if you have employees or property.
How is the Qualified Business Income Deduction Calculated?
Here are two examples of how the Qualified Business Income Deduction is calculated for profitable businesses. The first is for a business owner below the income threshold specified above.
If someone owned a pass-through business and had $100,000 of qualified business income as a single filer, they would first take the standard deduction of $13,850. After that deduction, their qualified income for the Qualified Business Income Deduction would be reduced to $86,150. They could claim 20% of that amount as a deduction of $17,230, reducing their taxable income to $68,920. Any reduction in taxable income also reduces your income tax liability.
Now let's look at an example of a married couple with income that exceeds the thresholds. They have a taxable income of $400,000 from a business they own, and they paid $125,000 in W-2 wages. They own the building where their business is located, and it has an unadjusted acquisition basis of $300,000. Their deduction would be limited to the greater of:
- 50% of the W-2 income for their employees, or $62,500; or
- 25% of the W-2 income for their employees + 2.5% of their building's $300,000 acquisition basis, or $31,250 + 7,500, for a total of 38,750
Since the first number is higher, their maximum pass-through deduction would be $62,500. Pass-through firms can use these calculations as an example of how to calculate their deduction.
How Can Taxpayers Claim the Qualified Business Income Deduction?
To claim the deduction, you must complete Form 8995 or Form 8995-A. According to the Internal Revenue Service, you should use Form 8995 if:
- You have qualified business income, qualified PTP income, or qualified REIT dividends
- Your 2023 taxable income before the deduction is less than $182,200 if filing singly and $364,200 if married and filing jointly.
- You are not a patron in a "specified agricultural or horticultural cooperative."
If you do not meet the above qualifications, you should use Form 8995-A. After calculating your deduction, you can claim it on Line 13 of your Form 1040.
Future of the Qualified Business Income Deduction: What to Expect Beyond 2025
The Qualified Business Income Deduction was enacted into law in 2017 and is set to expire at the end of 2025. There’s an option to extend the deduction for one additional year, and of course, Congress and the President can make the deduction a permanent part of the tax code.
As of January 2024, there’s no indication that Congress intends to extend the Qualified Business Income Deduction or to make it permanent. It’s an election year, so we can’t rule out the possibility that a new Congress sworn in at the beginning of 2025 will extend the deduction.
At this point, our advice is to take advantage of the Qualified Business Income Deduction while you can and take measures now to strategize for its eventual expiration. Working with one of our experienced tax professionals can help you take advantage of all available credits and deductions while preparing for the future.
Qualified Business Income Deduction is a Valuable Tax Break for Business Owners
If you’re a pass-through business owner and your business has qualified income, you can claim the Pass-Through Deduction to reduce the tax you pay. We suggest working with one of our experienced business tax accountants to ensure that you calculate your deduction correctly and claim the maximum amount allowed.
Do you need assistance preparing and filing your pass-through business taxes?
