What Does Qualified Business Income Mean?

Qualified Business Income (QBI) is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. This income is primarily relevant for determining eligibility for the Section 199A deduction, which allows eligible taxpayers to deduct up to 20% of their QBI. The deduction aims to provide tax relief to self-employed individuals and owners of pass-through entities, similar to the tax rate reduction provided to C corporations.

Understanding Qualified Business Income

The net taxable income from a qualified trade or business conducted within the United States includes income from sole proprietorships, partnerships, and S corporations. The income must arise from an active trade or business, distinguishing it from passive investment activities or portfolio income. QBI specifically excludes income from C corporations, as these entities are subject to their own corporate income tax rates.

The Internal Revenue Service (IRS) guidance defines QBI as the excess of qualified items of income and gain over qualified deductions and losses. These items must be effectively connected with the conduct of a trade or business within the United States. For example, if a sole proprietor earns revenue from selling goods and incurs expenses related to those sales, the net profit before any personal deductions generally contributes to QBI.

What Income Qualifies and What Does Not

Qualifying Income

Income that qualifies as QBI typically includes net income from the core operations of a business, such as revenue from sales of goods or fees for services rendered. Rental income can also qualify if the rental activity rises to the level of a trade or business, which can be demonstrated through factors like active management or meeting specific safe harbor provisions outlined in IRS Notice 2019-07. This safe harbor often requires a certain number of hours of rental services performed annually. Income from cooperative dividends, publicly traded partnerships, and real estate investment trusts also generally qualifies for the deduction.

Excluded Income

Capital gains or losses, such as those from selling business property or investments, do not count. Dividends, interest income, and annuity income are also generally excluded unless they are properly allocable to a trade or business. Wages received as an employee are not considered QBI, nor is reasonable compensation paid to an S corporation shareholder-employee for services performed for the business. Guaranteed payments made to a partner for services rendered or for the use of capital are likewise excluded from QBI. Income earned from certain specified foreign sources also falls outside the definition of QBI.

Types of Businesses That Generate Qualified Business Income

A “qualified trade or business” is generally any trade or business other than a “specified service trade or business (SSTB)” or the trade or business of performing services as an employee. The distinction between a qualified trade or business and an SSTB is particularly important due to income limitations.

A Specified Service Trade or Business (SSTB) is any trade or business involving the performance of services in fields such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. It also includes any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. This “reputation or skill” clause is designed to capture certain activities not explicitly listed but which rely heavily on an individual’s personal expertise. For instance, a celebrity’s endorsement income might fall under this category.

Income thresholds significantly impact QBI from an SSTB. If a taxpayer’s total taxable income falls below a certain threshold, QBI from an SSTB may fully qualify for the deduction, allowing for the full 20% deduction without limitation. As taxable income increases above this lower threshold, the QBI deduction for an SSTB begins to phase out proportionally. Once taxable income exceeds an upper threshold, all QBI from an SSTB is entirely excluded from the deduction. These income thresholds are adjusted annually for inflation, meaning the specific amounts change each tax year.

Calculating Your Qualified Business Income

To calculate Qualified Business Income for a specific trade or business, identify the gross income generated by that business. After identifying gross income, all ordinary and necessary deductions directly connected to that trade or business are subtracted. These deductions must be allowable under Section 162 of the Internal Revenue Code, which permits deductions for expenses paid or incurred during the taxable year in carrying on any trade or business.

Examples of deductions that reduce QBI include the deductible portion of self-employment taxes, which is half of the amount paid for Social Security and Medicare. Self-employed health insurance premiums are also deductible expenses that reduce QBI. Contributions made to self-employed retirement plans, such as a Simplified Employee Pension (SEP) IRA or a Savings Incentive Match Plan for Employees (SIMPLE) IRA, also reduce QBI. These deductions are typically reported on Schedule C (Form 1040) for sole proprietorships or included in the calculations for partnerships and S corporations.

It is important to remember that the types of excluded income discussed earlier, such as capital gains or employee wages, are never part of the QBI calculation. The QBI is determined for each qualified trade or business independently. This per-business calculation occurs before any individual-level limitations or aggregations are considered for the overall deduction.