How to Maximize the Section 199A QBI Deduction
Insights | by Sharon Winsmith
One of the best tax benefits available to business owners is the Section 199A QBI Deduction. The deduction is also available for certain types of investment income. The QBI Deduction can significantly decrease the effective tax rate you pay on certain types of income.
We find in practice that many CPAs do not fully understand the nuances of Section 199A. Many also fail to advise their clients on how to properly compute the deduction on their return. Read more to get tips on how to maximize your QBI Deduction.
What is the QBI Deduction?
The QBI Deduction stands for the Qualified Business Income Deduction. It can be found under Section 199A of the tax code.
The QBI Deduction provides a 20% deduction against “qualified business income.” That means you can decrease your taxable income by 20% of the net income earned from your business each year.
Here is a basic example of how the deduction works in practice.
Sally is a business owner whose business is set up as an S Corporation. Sally receives a salary of $50k a year from the business. The business’s net income after taking into account Sally’s salary and other deductions is $100k.
Sally’s QBI Deduction is equal to $20k (20% x $100k net income). That means Sally’s taxable income will decrease by $20k. Sally is not entitled to a deduction against her salary paid from the business.
The QBI Deduction can also apply to other types of income in some cases. Read below for more details on the types of income that are eligible for the deduction.
CAUTION: There are several limitations on who can claim the deduction. Taxpayers must be careful to make sure they plan around any potential reductions on the amount of deduction that can be claimed.
When is the QBI Deduction Available?
The QBI Deduction was introduced with the 2017 Tax Cuts and Jobs Act and was available starting with the 2018 tax year. The deduction will sunset in 2025 unless Congress acts to extend the deduction.
That means the QBI Deduction should be available for the 2018-2025 tax years unless the law is changed or extended.
What Types of Income Are Eligible under Section 199A?
There are two categories of income that can be eligible for the deduction.
Qualified Business Income
The QBI Deduction is available for “qualified business income.” Qualified business income includes income from operating a trade or business. This includes income from a business operated through a pass-through entity. It can also include income from certain passive investments.
Qualified business income does not include the following:
- W-2 wages paid to an employee (including the salary of a business owner)
- Interest income
- Dividends (except certain qualified REIT dividends)
- Capital gains
- Annuity income
- Income from foreign operations outside the U.S.
The trade or business must be operated in the U.S. as the QBI Deduction is not available for income connected to a trade or business conducted outside the U.S.
There are some important limitations on the QBI Deduction for business income for high earning taxpayers which we cover in detail below.
REIT Dividends and PTP Income
The deduction is also available for dividends from REITs. REIT stands for Real Estate Investment Trust. REITs are companies that own, operate, or finance income-producing real estate.
REITs are typically not tax-efficient investments because REIT dividends generally do not qualify as qualified dividends subject to lower tax rates. However, the 20% QBI Deduction alleviates some of the tax inefficiencies of investing in REITs.
Income from investments in publicly traded partnerships (PTPs) is also eligible for the 20% QBI Deduction.
Importantly, the QBI Deduction for REIT dividends and PTP income is not subject to the taxable income limitations discussed further below.
Who Qualifies for the Deduction?
The Section 199A QBI Deduction applies to income received from certain pass-through entities. This includes net income from LLCs that are treated as any of the following for tax purposes:
- Sole proprietorships
- S Corporations
It will also apply to net income from businesses operated without an LLC or other separate legal entity. Some distributions from trusts and estates may also be eligible for the deduction in some cases.
The deduction is generally not available for income received from C Corporations. The Section 199A Deduction also does not apply to W-2 salary income received by an employee.
Limitations on the QBI Deduction
There are several limitations on the ability to claim the full deduction for some taxpayers. It is important that you understand each of these limitations and develop a plan to minimize any potential reductions in the QBI Deduction available.
Taxable Income Limitation
The QBI Deduction is limited to the smaller of:
- 20% of qualified business income + REIT dividends + PTP income, or
- 20% of taxable income less net capital gains before taking into account the QBI Deduction.
Therefore, if a taxpayer has little to no taxable income, the deduction may be limited.
A common example where this can happen is with a married couple where one spouse owns a business that earns a net profit and the other spouse is an Active Real Estate Professional such that the couple has little to no net taxable income on a combined basis.
Net Capital Gain Reduction
When computing the taxable income limitation discussed above, the taxable income is reduced by net capital gains. This means that net capital gains can significantly reduce your QBI Deduction. Taxpayers eligible for a QBI Deduction should monitor triggering capital gains as this could reduce or eliminate any benefit the deduction provides.
Limitation for High Earning Taxpayers
There is an additional limitation for taxpayers with income above certain income levels known as the phaseout range. Taxpayers with taxable income below the phaseout range will have no reduction in the amount of deduction available (unless one of the other limitations discussed in this section applies).
If your taxable income is within or above the phaseout range, the amount of deduction available may be limited in some cases. The limitation generally depends on the amount of W-2 wages paid to employees (including salaries paid to yourself as the owner) and your cost basis in depreciable property owned by the business. Therefore, if you pay a significant amount in salaries to W-2 employees or own large capital assets through your business, there is a chance you may not have any limitation even if you are within or above the phaseout thresholds.
Taxpayers operating a specified services trade or business are not permitted to claim a QBI Deduction if their taxable income is above the phaseout range. See below for more details on what constitutes a specified services trade or business.
For 2021, the phaseout range is $164,900 to $214,900 (for single filers) and $329,800 to $429,800 (for married filing jointly filers). For 2022, the phaseout range is $170,050 to $220,050 (for single filers) and $340,100 to $440,100 (for married filing jointly filers).
Specified Services Trades or Businesses
As previously mentioned, special rules apply to taxpayers owning businesses which are considered to be specified services trade or businesses. The list of what qualifies as a specified services trade or business is determined by the IRS.
Specified services trades or businesses include taxpayers in the business or performing services in the following fields:
- Financial services
- Actuarial science
- Performing arts
- Investing and investment management
- Businesses where a principal asset is the reputation or skill of one or more of its owners or employees
High earners with businesses providing one of the above-mentioned services may have limitations on their ability to claim a full QBI Deduction. That means if you have income above $214,900 (for single filers) or $429,800 (for married filing jointly filers), you may not be able to claim the QBI Deduction.
Carryover of Losses from Prior Years
When computing the QBI Deduction, you are required to carry forward losses from prior years for your business or investments. The loss carried over reduces your qualified business income in the current year. This means that if your business had a net loss in one tax year, you must carry forward that loss to future tax years and that loss carryover could reduce your deduction.
Let’s look at a basic example of how the carryover rules work.
In 2020, your business had a net loss of ($40,000). You were not able to claim a QBI Deduction on your 2020 tax return because you did not have net qualified business income. The ($40,000) loss is carried forward to future years.
In 2021, your business has net income of $60,000. When computing your QBI Deduction on your 2021 tax return, you are required to reduce your $60,000 qualified business income by the ($40,000) loss carryover. That means your net qualified business income will be $20,000 and the maximum QBI Deduction available is $4,000 (20% of $20,000).
The same carryover requirement applies to any losses from investments in REITs or PTPs.
QBI Deduction for Passive Investment Income and Real Estate Investments
One benefit of the QBI Deduction is that it is not limited to active business income. There are a number of situations where you may be eligible to claim the deduction against passive income from investments or businesses where you do not actively participate in the day-to-day management of operations.
Here are a few examples of types of non-business income where the QBI Deduction may apply:
- REIT dividends
- Income items reported on a K-1 from publicly traded partnerships
- Income from real estate investments (to the extent that you have net positive taxable income) other than capital gains
- Some income items reported on a K-1 from investment funds (real estate and non-real estate syndications)
- Some income from businesses in which you do not materially participate (passive business income reported on Schedule C or Schedule E)
- Mining, staking or masternode rewards for cryptocurrency activities
How to Claim the Deduction on Your Tax Return
You claim the QBI Deduction on your tax return by filing Form 8995: Qualified Business Income Deduction Simplified Computation for taxpayers below the taxable income phaseout range or Form 8995-A: Qualified Business Income Deduction for taxpayers within or above the taxable income phaseout range. The amount computed is then reported on Line 13 of your Form 1040: U.S. Individual Income Tax Return.
Notably, the deduction under Section 199A is available regardless of whether you itemize deductions on Schedule A or claim the standard deduction.
Can I Claim a QBI Deduction When I Sell My Business?
A common question we get asked is whether the 20% QBI Deduction is available on gain from the sale of a business. The QBI Deduction will not be available for a stock sale of shares in a C Corporation as the gain would all be capital gain. Moreover, a C Corporation is not eligible to claim a QBI Deduction if it sells its assets.
For a sale involving a pass-through entity, whether the QBI Deduction is available depends on the characterization of the underlying business assets that are sold. The purchase price will be allocated among the assets sold and any income characterized as ordinary income should generally be eligible for the QBI Deduction. Assets that typically give rise to ordinary income include the following:
- Accounts receivable
- Certain self-created intangible assets (such as patents, formulas, or trade secrets)
The portion of the purchase price that is allocated to capital gains should generally not be eligible for the deduction. Assets that typically give rise to capital gain include the following:
- Intangible assets purchased from a third-party (such as patents, formulas, or trade secrets)
- Buildings (not subject to depreciation recapture)
Most states do not allow the QBI Deduction in computing taxable income for state purposes. Therefore, be sure to add back the QBI Deduction from federal taxable income when estimating your state tax liability.
Examples of states that do permit a QBI Deduction include Colorado, Idaho, and North Dakota.
How to Maximize the Section 199A QBI Deduction
There are a number of ways taxpayers can make sure they maximize their QBI Deduction. Make sure you work with a professional who understands these rules in detail and how they overlap with other relevant tax provisions.
Here are a few strategies you can use to make sure you get the largest deduction possible.
- Have the right structure in place: The structure matters and you want to make sure your structure allows you to claim the deduction.
- Monitor any limitations on the deduction: Make sure you don’t do anything that is going to limit your deduction as there are a number of different limitations that could apply.
- Avoid triggering capital gains: Large capital gains can reduce the deduction you can claim so avoid triggering any capital gains if possible if that would have an impact on the deduction available.
- Stop contributions to 401ks or IRAs: The QBI Deduction is not available for distributions from a 401k or IRA. Therefore, the effective tax rate you pay on net income of your business would generally be lower than the tax rate that applies to distributions from a 401k or IRA when you factor in the impact of the QBI Deduction.
- Optimize your salary expense: If you are a high earner and potentially subject to the phaseout rules, you may be able to increase the deduction amount by paying yourself a larger salary. This may be necessary if you own a business that does not have employees. Always remember that there must be a reasonable basis for any salary you pay so you must be able to support the level of any salary paid.
- Divide businesses into separate units: If you own multiple businesses and one of those could be considered a specified services trade or business, it might be a good idea to put that business in its own LLC with separate books or records. This can allow you to claim the QBI Deduction on your other business income that is not related to a specified services trade or business if you are above the taxable income limits.
- Don’t rely on your CPA to know the rules: Because the rules have only been in place a few years, we commonly see in practice CPAs do not always have a great understanding of Section 199A. There have even been situations where CPAs were not even aware of the deduction. We have also seen a number of situations where CPAs did not understand the exceptions to the taxable income limitations and assumed their clients were not eligible for any deduction.