What Is Included in Qualified Business Income?

Qualified Business Income (QBI) is a tax concept introduced by the Tax Cuts and Jobs Act (TCJA) of 2017. It represents the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business. This calculation is a foundational step for individuals, including those who own sole proprietorships, partnerships, and S corporations, to determine their eligibility for the Section 199A deduction. The primary purpose of QBI is to serve as the basis for this deduction, which aims to provide a tax benefit to owners of pass-through entities.

Core Components of Qualified Business Income

Qualified Business Income generally includes items of income, gain, deduction, and loss that are effectively connected with the operation of a trade or business within the United States. This encompasses the revenue generated from the regular activities of a business. For example, this includes income from the sale of goods or services, rent collected from qualified rental real estate, and royalty income derived from qualified sources.

The calculation of QBI also incorporates various deductions that reduce the gross business income. These commonly include ordinary and necessary business expenses such as the cost of goods sold, salaries paid to employees, utility payments, rent for business premises, and the cost of supplies. Additionally, depreciation on business assets is factored in.

For sole proprietors, QBI typically corresponds to the net profit reported on Schedule C (Form 1040) after accounting for all allowable business deductions. In the case of partnerships and S corporations, QBI refers to the pass-through share of qualified business income or loss that is reported to the owners on Schedule K-1.

Income and Deductions Excluded from QBI

While many business-related income and deduction items are included in QBI, certain types are specifically excluded. Investment income, such as capital gains or losses, dividends, and interest income, is generally not considered QBI unless the interest income is directly related to a lending trade or business. Annuities are also excluded, unless they are received in connection with the trade or business.

Income received as W-2 wages by an employee is excluded from QBI. For S corporation shareholder-employees, any reasonable compensation paid to them is excluded from QBI. Similarly, for partners in a partnership, guaranteed payments for services rendered are excluded from QBI.

Income derived from specified service trades or businesses (SSTBs) may also be excluded from QBI if the taxpayer’s taxable income exceeds certain thresholds. SSTBs include professions such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and investing and investment management. Taxpayers with income above established thresholds may find their QBI from these service professions partially or entirely excluded. Deductions directly related to these excluded income types are also excluded from the QBI calculation.

The Role of QBI in the Section 199A Deduction

Once the Qualified Business Income is accurately determined by including and excluding the appropriate items, it serves as a foundational figure for calculating the Section 199A deduction. This deduction allows eligible taxpayers to reduce their taxable income by up to 20% of their QBI. The Section 199A deduction was introduced as part of the Tax Cuts and Jobs Act of 2017 to provide a comparable tax benefit to owners of pass-through entities, similar to the reduced corporate tax rate.

The deduction is ultimately limited to the lesser of 20% of the taxpayer’s QBI or 20% of the taxpayer’s taxable income, calculated before any Section 199A deduction and after subtracting any net capital gains. This limitation ensures the deduction does not reduce taxable income excessively. The calculation of QBI is thus the initial and central step in determining the potential amount of this significant tax benefit.