QBI Deduction Phase-Out: How It Works and What to Know
Understand how the QBI deduction phase-out works, including key income thresholds and factors that impact eligibility for business owners.
The Qualified Business Income (QBI) deduction offers significant tax savings for eligible business owners, but limitations reduce or eliminate the benefit at higher income levels. Understanding how this phase-out works is essential for planning and maximizing deductions.
How the Deduction Is Calculated
The QBI deduction is based on qualified business income, wages paid to employees, and the value of certain business assets. These factors determine the final deduction amount, particularly for those with higher taxable income.
QBI
Qualified Business Income (QBI) refers to net income from a trade or business, excluding capital gains, dividends, and interest income. It is calculated before deductions for self-employment taxes, health insurance, or retirement contributions. For sole proprietors, partnerships, and S corporations, QBI generally consists of ordinary business income after expenses.
If a taxpayer owns multiple businesses, QBI must be calculated separately for each before being combined. The deduction is typically 20% of QBI but is subject to limitations based on taxable income. If a sole proprietor reports $100,000 in QBI, the base deduction before adjustments would be $20,000. However, if taxable income exceeds certain thresholds, restrictions may reduce or eliminate the deduction.
W-2 Wages
For taxpayers above certain income levels, the deduction cannot exceed 50% of total W-2 wages paid by the business or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. W-2 wages include salaries, bonuses, and taxable compensation paid to employees but exclude payments to independent contractors.
This limitation affects businesses without employees, as they may see their deduction reduced or eliminated if taxable income is too high. For example, if a business has $300,000 in QBI but only pays $50,000 in wages, the deduction might be capped at $25,000 (50% of wages) rather than 20% of QBI. Proper payroll planning can help maximize the deduction.
Qualified Property
Qualified property includes tangible, depreciable assets such as buildings, machinery, and equipment used in the business. The calculation allows for 2.5% of the unadjusted basis of these assets, meaning the original cost before depreciation.
This provision benefits businesses with significant capital investments but low payroll expenses, such as real estate rental operations. If a taxpayer owns property with an unadjusted basis of $1 million, they may be able to claim an additional deduction of $25,000 (2.5% of $1 million) if their income exceeds the phase-out range and their W-2 wages are insufficient to support the full deduction. Accurate records of property values and depreciation schedules are essential for maximizing this benefit.
Income Thresholds Triggering the Phase-Out
The QBI deduction begins to phase out once taxable income exceeds certain thresholds. For 2024, these thresholds are $191,950 for single filers and $383,900 for married couples filing jointly. Once income surpasses these amounts, additional restrictions gradually reduce the deduction until it is fully phased out at $241,950 for single filers and $483,900 for joint filers.
The phase-out operates on a sliding scale, meaning that as income increases within the phase-out range, the deduction percentage is reduced proportionally. Taxpayers with income just above the threshold may still qualify for a partial deduction, but once taxable income reaches the upper limit, the deduction is eliminated unless the business qualifies under alternative limitations.
For pass-through entities, owners must consider how their total taxable income—including earnings from other sources—affects eligibility. Since the phase-out is based on overall taxable income rather than just business earnings, additional income from investments, rental properties, or spousal earnings can push a taxpayer above the threshold, reducing or eliminating the deduction.
Phase-Out for Specified Service Trades or Businesses
Certain businesses face additional restrictions, particularly those classified as Specified Service Trades or Businesses (SSTBs). The IRS defines SSTBs as businesses where the principal asset is the skill or reputation of one or more owners or employees. This includes law, accounting, healthcare, consulting, financial services, and performing arts. Unlike other pass-through entities, SSTBs lose eligibility for the deduction entirely once taxable income exceeds the phase-out range.
The classification of an SSTB is not always straightforward, as some businesses operate in multiple fields. For example, a medical practice that provides both patient care and sells health-related products may be partially classified as an SSTB. The IRS applies a “de minimis rule,” which states that if less than 10% of gross receipts (or 5% for businesses with revenue over $25 million) come from SSTB activities, the entire business may avoid SSTB classification. Structuring revenue streams carefully can help businesses remain eligible for the deduction.
Some business owners restructure their operations to mitigate SSTB restrictions. One approach involves separating ancillary services into a distinct legal entity that does not fall under SSTB classification. For example, a law firm might create a separate company to provide legal research or document preparation services, potentially preserving QBI eligibility for that portion of income. However, the IRS has issued anti-abuse regulations to prevent artificial separation of SSTB activities solely for tax benefits, so any restructuring must have a legitimate business purpose beyond tax savings.