What Are the QBI Deduction Limitations?

The Qualified Business Income (QBI) deduction, established under Section 199A of the tax code, offers a tax benefit for owners of pass-through businesses. This deduction allows eligible owners of sole proprietorships, partnerships, and S corporations to deduct up to 20% of their qualified business income. It was introduced as part of the Tax Cuts and Jobs Act of 2017 to provide tax relief to smaller businesses. While the QBI deduction can lower an owner’s tax liability, the Internal Revenue Service (IRS) has established limitations that can reduce or eliminate it based on income level and the nature of the business.

Taxable Income Thresholds

The QBI deduction’s limitations are tied to a taxpayer’s taxable income before the deduction is applied. The IRS sets income thresholds each year that determine how the rules apply. For the 2024 tax year, the lower threshold is $191,950 for single, head of household, and married filing separately filers, and $383,900 for those married filing jointly. The upper threshold is $241,950 for single filers and $483,900 for joint filers.

If a taxpayer’s income is below the lower threshold, the main limitations do not apply, and they can generally take the full 20% deduction. For taxpayers with income above the upper threshold, the limitations apply in their entirety. Those with income between the lower and upper thresholds are in a “phase-in range,” where the limitations are gradually applied, requiring a more detailed calculation.

Specified Service Trade or Business Rules

The QBI limitations include special rules for what the IRS defines as a Specified Service Trade or Business (SSTB). An SSTB is any trade or business involving the performance of services where the principal asset is the reputation or skill of its employees. These fields include:

• Health
• Law
• Accounting
• Actuarial science
• Performing arts
• Consulting
• Athletics
• Financial services

The regulations exclude engineering and architecture from this definition. The classification of a business as an SSTB has consequences that are directly linked to the income thresholds. If an SSTB owner’s taxable income is below the lower threshold, they can claim the full QBI deduction. If their income is above the upper threshold, the QBI deduction is completely disallowed. For SSTB owners with income inside the phase-in range, the deduction is reduced as their income increases.

The IRS also provides a de minimis rule. If a business has gross receipts of $25 million or less and less than 10% of those receipts come from an SSTB field, it will not be considered an SSTB.

The W-2 Wage and UBIA Limitation

For taxpayers with income above the lower income threshold, the QBI deduction becomes subject to a limitation based on wages and property. This rule is fully phased in for those with income over the upper threshold. The deduction is limited to the lesser of 20% of the taxpayer’s QBI or the greater of two separately calculated amounts.

The first amount is 50% of the W-2 wages paid by the business that are allocable to the QBI. “W-2 wages” for this purpose include wages subject to income tax withholding and other employee compensation reported on Form W-2. The second amount is 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.

Qualified property includes tangible, depreciable assets like buildings and machinery used to generate QBI, and the UBIA is the original cost of the asset. This alternative calculation benefits capital-intensive businesses that may have significant investments in property but a smaller payroll.

For example, a business owner has $400,000 in QBI, paid $100,000 in W-2 wages, and has qualified property with a UBIA of $1,000,000. The first calculation is 50% of wages ($50,000). The second is 25% of wages ($25,000) plus 2.5% of property UBIA ($25,000), which also totals $50,000. The owner uses the greater figure, $50,000, as the limit. Their deduction is the lesser of 20% of QBI ($80,000) or the $50,000 limit, resulting in a QBI deduction of $50,000.

Overall Deduction Limitation

A final ceiling applies to the QBI deduction after all other limitations are considered. The final deduction amount cannot exceed 20% of the taxpayer’s taxable income, calculated before the QBI deduction, minus their net capital gain. Net capital gain for this purpose includes net long-term capital gains over net short-term capital losses, as well as any qualified dividends. This rule prevents the QBI deduction from offsetting income already taxed at preferential rates.

For instance, a taxpayer calculates a potential QBI deduction of $40,000. Their taxable income before the QBI deduction is $220,000, which includes $30,000 in net capital gains. The overall limitation is 20% of ($220,000 – $30,000), or $38,000. In this case, their final, allowable QBI deduction is capped at $38,000.