Understanding the Qualified Business Income Deduction (QBI)

Qualified Business Income (QBI) is a term that refers to the net amount of income, gain, deduction, and loss from any qualified trade or business. Essentially, it is the profit that a business generates from its core operations. QBI includes income from partnerships, S corporations, sole proprietorships, and certain trusts. It does not encompass items like capital gains and losses, dividends, interest income, and income earned outside the United States​.

QBI is specifically designed to exclude certain types of income to ensure that the deduction targets business operations rather than investment or passive income. For instance, wages earned as an employee, guaranteed payments to partners, and reasonable compensation to S corporation shareholder-employees are not considered QBI​.

Moreover, QBI must be derived from domestic business activities, meaning the income must be connected to business operations conducted within the United States. This ensures that the tax benefits support domestic businesses and economic activities.

What is Qualified Business Income (QBI)?

Qualified Business Income (QBI) is the net amount of income, gain, deduction, and loss from any qualified trade or business. It does not include items such as capital gains and losses, dividends, interest income, and income earned outside the U.S. The QBI deduction is available to owners of pass-through entities, such as sole proprietorships, partnerships, S corporations, and some trusts and estates.

Income Limits and Phase-Outs

For the 2024 tax year, the QBI deduction phases out for single filers with taxable income between $191,951 and $241,950 and for married couples filing jointly with income between $383,901 and $483,900. If your income exceeds these thresholds, your eligibility for the deduction is limited, especially if you are involved in a Specified Service Trade or Business (SSTB).

Specified Service Trade or Business (SSTB)

A Specified Service Trade or Business (SSTB) is a classification that affects the eligibility and amount of the Qualified Business Income (QBI) deduction for certain businesses. SSTBs include fields where the principal asset is the reputation or skill of employees or owners. These fields include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and investing and investment management​.

The classification is critical because if a business is designated as an SSTB and its income exceeds the QBI phase-out thresholds, the owners might not qualify for the QBI deduction. For 2024, the income thresholds are $191,950 for single filers and $383,900 for married filing jointly​. If an SSTB's income exceeds these limits, the QBI deduction is phased out or completely eliminated.

However, not all businesses in related fields are considered SSTBs. For instance, architecture and engineering firms are explicitly excluded from the SSTB classification, allowing them to benefit from the QBI deduction regardless of income levels.

Additionally, the IRS has clarified that the SSTB definition does not trap businesses where income derives from the reputation or skill of employees unless specific criteria are met, such as receiving fees for endorsements or using an individual’s image or name.

Calculating the QBI Deduction

The QBI deduction is calculated as the lesser of:

• 20% of QBI
• 20% of taxable income minus net capital gains

For higher income levels, an additional limitation applies, where the deduction is limited to the lesser of:

• 50% of W-2 wages paid by the business
• 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property held by the business​

Maximizing Your QBI Deduction

To make the most of the Qualified Business Income (QBI) deduction, business owners should employ several strategic actions to optimize their taxable income.

1. Monitor Income Levels

Keeping your taxable income below the phase-out thresholds is critical. For the 2024 tax year, the phase-out begins at $191,951 for single filers and $383,901 for married couples filing jointly. Consider deferring income or accelerating deductions to remain below these limits. For example, making large purchases or paying for services in advance can help lower taxable income.

2. Optimize W-2 Wages

For higher-income businesses, ensuring that the business pays sufficient W-2 wages is essential. The QBI deduction for higher earners is limited to the lesser of 20% of QBI or the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of unadjusted basis immediately after acquisition (UBIA) of qualified property​.

3. Maximize Retirement Contributions

Contributing to self-employed retirement plans can reduce taxable income, potentially keeping you within the QBI phase-out thresholds. Plans such as SEP IRAs or Solo 401(k)s allow significant contributions, thus lowering your overall taxable income​.However, note that these contributions reduce QBI, so balance is necessary.

4. Evaluate Business Structure

Choosing the right business structure can significantly impact the QBI deduction. For instance, converting a sole proprietorship to an S corporation might optimize your QBI deduction by allowing you to pay reasonable compensation as W-2 wages, thereby meeting the wage limitation requirements.

By carefully planning and implementing these strategies, business owners can maximize their QBI deduction and effectively reduce their taxable income. Consulting with a tax professional can further ensure that you are taking full advantage of available tax benefits.

Case Study: Maximizing QBI Deduction

Consider a married couple running a consulting firm with a combined taxable income of $400,000. By making strategic retirement plan contributions and managing their income, they could reduce their taxable income below the $383,901 threshold, maximizing their QBI deduction.

Looking Forward

As the QBI deduction is set to expire in 2025, it's essential for business owners to take full advantage of this benefit while it's available. Effective tax planning and consultation with a tax professional can ensure you maximize your deductions and savings.

How TaxPlanIQ Can Help

Navigating complex tax strategies like the QBI deduction can be challenging. TaxPlanIQ simplifies this process by offering curated tax strategies, easy-to-understand implementation steps, and the ability to create custom-branded tax plans with just a few clicks. Sign up for a free demo of TaxPlanIQ today to see how it can help your firm grow revenue, increase client satisfaction, and streamline your tax planning services.