What Is Considered Qualified Business Income?

Qualified Business Income (QBI) allows many non-corporate taxpayers to deduct a portion of their business income. This deduction, established under Internal Revenue Code Section 199A by the Tax Cuts and Jobs Act (TCJA) of 2017, aims to provide parity between corporate and pass-through entity taxation. Understanding QBI is fundamental for self-employed individuals, partners in partnerships, and S corporation shareholders who may be eligible for this deduction.

Understanding Qualified Business Income

Qualified Business Income refers to the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. These items must be effectively connected with the conduct of a trade or business within the United States. QBI specifically includes ordinary income, along with other deductions and losses from the business, provided they are related to the active conduct of the trade or business.

For example, if a sole proprietor operates a consulting firm, the gross receipts from consulting services, less ordinary and necessary business expenses like rent, utilities, and supplies, would contribute to their QBI. The calculation of QBI occurs independently for each qualified trade or business operated by the taxpayer. This separate calculation ensures that income and expenses from different ventures are not commingled before determining the qualified amount for each.

Deductions directly related to the business income also reduce the QBI amount. These can include the deductible portion of self-employment taxes, self-employed health insurance premiums, and contributions made to qualified retirement plans on behalf of the self-employed individual. Such deductions are subtracted from the gross business income to arrive at the net QBI figure, reflecting the true profitability before the deduction.

Income Specifically Excluded from QBI

While many forms of business income contribute to QBI, several specific types of income and deductions are explicitly excluded from its calculation. Capital gains and losses are not considered QBI, meaning any profit from the sale of business assets or investment property held by the business does not qualify. Dividends and interest income are also generally excluded from QBI, unless the income is earned in the ordinary course of a financing or lending business, such as a bank or a mortgage company. Annuity payments are another form of income that does not qualify as QBI.

Any amounts received as reasonable compensation from an S corporation to a shareholder for services performed are explicitly excluded from QBI for that shareholder. These amounts are reported as W-2 wages and are thus treated as employee compensation, not qualified business income. Similarly, guaranteed payments for services rendered by a partner to a partnership are excluded from the partner’s QBI, as these are considered compensation for specific services rather than a share of the business’s operational income. Any amounts received by an individual as an employee are also excluded from QBI.

Identifying Qualified Trades and Businesses

For the purpose of the QBI deduction, a “trade or business” generally follows the principles used for Internal Revenue Code Section 162, which defines deductible business expenses. This typically means an activity engaged in with continuity and regularity, primarily for income or profit. Most trades or businesses, including sole proprietorships, partnerships, and S corporations, can generate qualified business income.

Some types of businesses, however, are subject to special rules and are designated as “Specified Service Trades or Businesses” (SSTBs). An 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. A business where the principal asset is the reputation or skill of one or more of its employees or owners also falls under the SSTB classification. For instance, an individual offering legal advice or managing investment portfolios would be operating an SSTB.

The classification as an SSTB has significant implications for the QBI deduction, depending on the taxpayer’s taxable income. If a taxpayer’s taxable income before the QBI deduction falls below a certain lower threshold, currently $195,300 for single filers and $390,700 for married filing jointly in 2024, an SSTB is treated as a qualified trade or business, and the deduction is fully available without specific SSTB limitations.

When a taxpayer’s taxable income is between the lower and upper thresholds (e.g., $195,300 and $245,300 for single filers in 2024), the allowable QBI, W-2 wages, and unadjusted basis of qualified property from an SSTB are phased out. For example, a consultant with taxable income within this range would see their potential QBI deduction diminish proportionally.

If a taxpayer’s taxable income exceeds the upper threshold (e.g., $245,300 for single filers in 2024), no QBI deduction is allowed for income derived from an SSTB. Consequently, a physician with taxable income above the upper threshold would not be able to claim any QBI deduction on their medical practice income.

Applying QBI for the Deduction

Once Qualified Business Income (QBI) is determined for each eligible trade or business, along with any applicable exclusions and business classifications, it is then used to calculate the deduction. The deduction is generally limited to the lesser of 20% of the taxpayer’s QBI or 20% of the taxpayer’s taxable income before the QBI deduction.

The application of the QBI deduction becomes more complex depending on the taxpayer’s taxable income. For taxpayers whose taxable income before the QBI deduction falls below the lower threshold (e.g., $195,300 for single filers or $390,700 for married filing jointly in 2024), the calculation is straightforward. In this scenario, the deduction is simply 20% of the QBI from qualified trades or businesses, or 20% of the taxable income before the deduction, whichever is less. This simpler rule applies regardless of whether the business is an SSTB.

For taxpayers with taxable income between the lower and upper thresholds (e.g., $195,300 and $245,300 for single filers in 2024), additional limitations begin to phase in. The deduction becomes subject to a limit based on the W-2 wages paid by the business and the unadjusted basis of qualified property (UBIA of qualified property) held by the business. Specifically, the deduction for each qualified trade or business cannot exceed the greater of 50% of the W-2 wages paid by the business or 25% of the W-2 wages plus 2.5% of the UBIA of qualified property.

When a taxpayer’s taxable income exceeds the upper threshold (e.g., $245,300 for single filers in 2024), the W-2 wage and UBIA of qualified property limitations apply in full. For non-SSTBs, the deduction is strictly capped by the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of UBIA of qualified property. If the business is an SSTB and taxable income is above this upper threshold, no QBI deduction is allowed at all.

The QBI deduction is taken “below the line,” meaning it is a deduction from adjusted gross income (AGI) to arrive at taxable income. It is not an itemized deduction and can be claimed even if a taxpayer takes the standard deduction.