How to Calculate Qualified Business Income for Your Business

Understanding how to calculate Qualified Business Income (QBI) is essential for business owners aiming to optimize their tax benefits. QBI can significantly reduce taxable income, directly affecting overall tax liability. Introduced as part of the Tax Cuts and Jobs Act, this deduction allows eligible businesses to deduct up to 20% of their qualified income.

Accurately calculating QBI involves identifying eligible businesses, recognizing excluded income sources, adjusting for deductions, and following specific calculation steps.

Businesses That May Generate QBI

The QBI deduction is a valuable tax benefit for many business owners, but not all businesses qualify. QBI typically comes from domestic businesses operating as sole proprietorships, partnerships, S corporations, or certain trusts and estates. These are pass-through entities, meaning their income is reported on the owners’ or shareholders’ personal tax returns.

Service-based businesses, such as consulting firms, law practices, and medical offices, can also generate QBI but may face restrictions. The Internal Revenue Code Section 199A outlines rules for Specified Service Trade or Businesses (SSTBs), which include fields like health, law, accounting, and consulting. For these businesses, the QBI deduction may phase out or be limited if the owner’s taxable income exceeds $182,100 for single filers or $364,200 for joint filers in 2024.

Real estate businesses, including rental property operations, may qualify for QBI if they meet certain criteria. The IRS evaluates factors such as hours spent managing properties and the regularity of rental activities to determine if rental operations qualify as a trade or business.

Income Sources Excluded from QBI

Not all income sources qualify for the QBI deduction. Investment income, such as capital gains, dividends, and interest income, is excluded because it does not stem from business operations. For example, dividends or interest from stocks and bonds owned by a business owner are not considered QBI.

Income generated outside the United States is also excluded. The deduction applies only to domestic business income, consistent with the Tax Cuts and Jobs Act’s focus on supporting U.S. economic activity. Businesses with international operations must separate domestic income from foreign income for accurate QBI reporting.

Employee wages and guaranteed payments to partners are also excluded from QBI. These are considered compensation for services, not business profits. For instance, salaries paid to employees or guaranteed payments to partners are treated as ordinary income and do not count toward QBI. This distinction is especially relevant for partnerships and S corporations, where owners may receive both guaranteed payments and a share of business profits.

Adjustments for Deductions

Adjustments for deductions are essential for accurate QBI calculations and compliance with tax regulations. These adjustments can influence the final QBI figure and the deduction amount a business owner may claim.

One key adjustment involves self-employment taxes, retirement plan contributions, and health insurance deductions. These personal deductions reduce taxable income but do not directly affect QBI. Self-employed individuals must calculate net business income before applying these personal deductions, ensuring a clear distinction between business expenses and personal deductions.

Depreciation and amortization also impact QBI adjustments. Asset depreciation used in the business affects net income. The IRS allows methods like the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation, which varies by asset type and useful life. Properly accounting for depreciation adjusts ordinary income and, by extension, the QBI figure.

QBI Calculation Steps

Calculating QBI requires methodical steps to comply with tax regulations and maximize potential deductions. A clear understanding of the business’s financials and applicable tax codes, particularly IRS Section 199A, is crucial.

Determine Net Ordinary Income

The first step is determining the net ordinary income from the business. This is done by subtracting ordinary and necessary business expenses from gross income, as defined under IRC Section 162. These expenses include rent, utilities, salaries, and supplies essential for business operations. Accurate record-keeping and documentation are critical to withstand potential IRS scrutiny. For example, a consulting firm with $500,000 in gross income and $200,000 in deductible expenses would have a net ordinary income of $300,000, which serves as the starting point for QBI calculations.

Subtract Applicable Items

Next, subtract excluded items from net ordinary income. These include investment income, foreign income, and compensation-related payments such as wages and guaranteed payments. For instance, if a business owner earns $20,000 in dividends and $10,000 in foreign income, these amounts must be deducted from net ordinary income. Continuing with the previous example, the adjusted QBI would be $270,000 after excluding $30,000 in non-qualifying income. This step ensures only eligible income is considered for the deduction.

Apply Limit Thresholds

The final step is applying limit thresholds, which may reduce the deduction. These thresholds are based on the taxpayer’s total taxable income, including wages and other income sources. For 2024, the phase-out thresholds are $182,100 for single filers and $364,200 for joint filers. If taxable income exceeds these limits, the QBI deduction may be reduced or eliminated, particularly for SSTBs. For example, if a joint filer has a taxable income of $400,000, the QBI deduction for their consulting firm may be subject to phase-out rules. Taxpayers can manage these thresholds by strategies such as income deferral or retirement contributions to optimize their deduction.