What Counts as Qualified Business Income?

The Qualified Business Income (QBI) deduction provides a tax benefit for many self-employed individuals and small business owners. Introduced as Section 199A, this provision allows eligible taxpayers to deduct up to 20% of their qualified business income. The QBI deduction primarily offers tax relief for owners of pass-through entities, such as sole proprietorships, partnerships, and S corporations, which do not pay corporate income tax directly.

Core Principles of Qualified Business Income

Qualified Business Income (QBI) refers to the net amount of income, gain, deduction, and loss derived from a qualified trade or business. The income must be effectively connected with a trade or business within the United States and included in taxable income.

A “qualified trade or business” generally encompasses any trade or business carried on by the taxpayer, with specific exclusions. This includes activities conducted with a profit motive.

A primary exclusion from a qualified trade or business is the performance of services as an employee. Income earned as a W-2 employee is not considered QBI, regardless of the employer’s business.

The concept of “net” QBI means that all ordinary and necessary business deductions attributable to the qualified trade or business must be taken into account. These include expenses directly related to generating the business income.

For instance, if a business generates $100,000 in gross revenue and incurs $40,000 in deductible expenses, the QBI would be $60,000. This amount is determined before applying any individual-level deductions not directly attributable to the business’s operations.

Types of Income Included in Qualified Business Income

Qualified Business Income encompasses income generated from various business activities structured as pass-through entities. These include sole proprietorships, partnerships, and S corporations, whose income passes through directly to the owners’ individual tax returns.

Income from a sole proprietorship, reported on Schedule C or F, generally qualifies as QBI. This includes revenue from selling goods, providing non-specified services, or other ordinary business activities.

For partnerships and S corporations, QBI is calculated at the entity level and then allocated to individual partners or shareholders. This includes their share of the ordinary business income or loss. Examples include revenue from manufacturing, retail sales, and consulting (unless it’s a specified service trade or business above income thresholds).

Certain rental real estate activities can also generate QBI if they rise to the level of a “trade or business.” This often requires meeting specific criteria, such as the IRS safe harbor for hours spent on rental activities.

The QBI includes the net income after accounting for all ordinary and necessary business deductions. This means revenue is reduced by costs of goods sold, operating expenses, and other legitimate business deductions to arrive at the net amount.

Income Excluded from Qualified Business Income

Several categories of income are explicitly excluded from QBI.

Investment income is a primary exclusion. This includes capital gains or losses from the sale of investments, dividends, interest income, and annuity income. These are generally passive and not considered to arise from an active trade or business for QBI purposes.

Compensation for services performed as an employee is another exclusion. Wages, salaries, and any other compensation received as an employee (reported on Form W-2) do not count as QBI. The QBI deduction is for self-employed individuals and owners of pass-through entities.

Guaranteed payments made to partners in a partnership are also excluded from QBI. These payments are compensation for services or use of capital, paid regardless of the partnership’s income.

Similarly, reasonable compensation paid to an S corporation shareholder-employee is excluded from the S corporation’s QBI. Only the shareholder’s share of the company’s profits can potentially qualify as QBI, not their salary.

Income from Specified Service Trades or Businesses (SSTBs) faces limitations or complete exclusion for taxpayers whose taxable income exceeds certain thresholds. An SSTB is a business primarily involving services in fields like health, law, accounting, performing arts, consulting, athletics, financial services, and brokerage. It also includes any business where the principal asset is the reputation or skill of its employees or owners.

For taxpayers below a certain taxable income threshold, SSTB income can fully qualify as QBI. However, if taxable income falls within a phase-out range, the qualifying SSTB income is gradually reduced. Once taxable income exceeds the upper limit of this range, income from an SSTB is entirely excluded from QBI.

How Business Structure Affects Qualified Business Income

The flow of Qualified Business Income depends on the business’s legal structure. Different entity types have distinct methods for calculating and reporting QBI to their owners. The QBI deduction applies to “pass-through” entities, where business income is taxed at the individual owner’s level.

For sole proprietorships, QBI is the net profit or loss reported on Schedule C or F. This is the sole proprietor’s net earnings from self-employment before certain individual deductions.

Partnerships and S corporations calculate their QBI at the entity level. This net qualified income is then passed through to individual partners or shareholders in proportion to their ownership interests, reported on Schedule K-1.

This pass-through mechanism ensures the QBI deduction’s tax benefits are realized at the individual taxpayer’s level. Owners use their share of QBI to calculate their Section 199A deduction.

Real Estate Investment Trusts (REITs) and Publicly Traded Partnerships (PTPs) can also generate income that qualifies for a similar 20% deduction. This income is treated distinctly under Section 199A, with its own rules and limitations.

Reductions to Qualified Business Income

Several factors can reduce the amount of income eligible for the Section 199A deduction. These reductions ensure the deduction is applied appropriately based on the taxpayer’s overall financial situation and the nature of their business.

Qualified Business Income is reduced by certain deductions attributable to the business, even if these are claimed at the individual level. These include the deductible portion of self-employment taxes, which represents half of the self-employment tax paid. Additionally, self-employed health insurance premiums and contributions to self-employed retirement plans decrease the QBI. These deductions are directly linked to the business’s operations and therefore reduce the net income available for the QBI deduction.

An overall taxable income limitation caps the maximum QBI deduction a taxpayer can claim. The total QBI deduction cannot exceed 20% of the taxpayer’s taxable income, calculated before the QBI deduction itself. This limitation means that a taxpayer with significant QBI but relatively low overall taxable income may not be able to utilize the full 20% of their QBI. It ties the benefit of the QBI deduction to the taxpayer’s total income level.

For taxpayers whose taxable income exceeds certain thresholds, additional limitations apply based on W-2 wages paid by the business and the unadjusted basis immediately after acquisition (UBIA) of qualified property. The QBI amount eligible for the deduction is limited to the greater of 50% of the W-2 wages paid by the qualified trade or business, or 25% of the W-2 wages plus 2.5% of the UBIA of qualified property.

These wage and property limitations are particularly relevant for businesses with few employees or minimal tangible assets, or for Specified Service Trades or Businesses (SSTBs) above the income thresholds. If a business pays minimal W-2 wages and has a low UBIA of qualified property, this limitation can significantly reduce the amount of QBI that qualifies for the deduction, even if the business otherwise generates substantial income.