Why the Qualified Business Income Deduction Can Impact Your Return

The new 20 percent deduction for pass-through businesses sounds almost too good to be true. That brand new section of the tax code is called the qualified business income deduction. It allows qualifying owners of sole proprietorships, S corporations, and partnerships to deduct 20 percent of their business income from taxable income.

As a result of the 20 percent deduction and slightly lower tax rates, the effective top tax rate on those business’ incomes goes from 40.8 percent under 2017 tax law to 29.6 percent under the new law.

Let’s break that down into a few frequently asked questions.

What is qualified business income?

According to the IRS definition, qualified business income is “the net amount of income, gain, deduction and loss from any qualified trade or business.” Also, the income must be connected with a U.S. trade or business.

Exclusions include capital gains and losses as well as specific dividends and interest income.

Do you calculate the qualified business income deduction on gross or net business income?

The deduction is 20 percent of your business income after expenses. That means it’s your net business income.

Do I really get a deduction from income that’s not related to any expenses?

Virtually all tax deductions have something to do with money you spent, whether that’s this year or in another tax year. The qualified business income deduction is unusual in that it is not the result of any money spent or cost incurred.

Does the deduction lower my Social Security taxes?

No, the deduction is claimed on Form 1040 – not on your business tax form, such as Schedule C. Therefore, it does not reduce your self-employment tax (Social Security and Medicare) directly.

Is it true that I can’t take the deduction if I own a “service” business?

Technically, that’s true. The 20 percent deduction excludes specified service trades or businesses. Basically, if your business is dependent on your name and reputation, it’s not eligible to claim the qualified business income deduction. Specifically, the law excludes:

  • accountants
  • lawyers
  • consultants
  • athletics
  • financial services
  • investing and investment management
  • trading
  • actuarial science
  • performing arts
  • healthcare services

And that’s just to name a few. There are several other types of ineligible service businesses.

A silver lining does exist, however. The rule only applies if your income exceeds $315,000 for a married couple filing a joint return or $157,500 for all other taxpayers. For most people, that means you still get the deduction.

And if you make just above those limitations, you may still claim a partial deduction. The deduction phases out after the income limitations.

Employees that provide a service on a business’ behalf are also not eligible to claim the deduction.

What other limitations are there?

If you own shares in a business and you receive income, your 20 percent deduction may be subject to other limitations. However, those limitations also only kick in when you make over $157,000 as a Single filer or $315,000 if you’re married filing jointly. Additionally, the deduction is limited by the amount of W-2 wages paid by the business and the unadjusted basis of any qualifying property held by the business after acquiring it.

There are also limitations designed to keep you from taking a deduction on capital gains or investment income, which is already taxed at a lower rate.

Where will I see this deduction on my tax return?

The qualified business deduction is applied to the business’ taxable income. That means it’s calculated after the standard deduction or any itemized deductions are subtracted from the adjusted gross income (AGI). And because it’s dependent on the business’ taxable income, each business computes the qualified business deduction separately.

Why do we have this tax break?

The qualified business income deduction is a way to level the playing field between pass-through entities and C corporations who enjoy lower tax rates.

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