What Is Qualified Business Income Deduction?

The Qualified Business Income (QBI) deduction, established by the Tax Cuts and Jobs Act of 2017, offers a tax benefit to eligible self-employed individuals and owners of pass-through businesses. This deduction allows taxpayers to deduct up to 20% of their qualified business income. Its purpose is to reduce the effective tax rate on business profits for these individuals, providing a tax cut comparable to the corporate tax rate reduction.

Understanding Qualified Business Income

Qualified Business Income (QBI) refers to the net amount of income, gain, deduction, and loss from any qualified trade or business. A qualified trade or business generally includes any trade or business other than a specified service trade or business (SSTB) at higher income levels. This includes income generated from sole proprietorships, partnerships, and S corporations. For example, net profit reported on a Schedule C (Form 1040) for a sole proprietor, or a partner’s share of ordinary business income from a partnership (Schedule K-1), is considered QBI. Income from farming activities (Schedule F) also qualifies.

Certain types of income and deductions are excluded from QBI. Investment income, such as capital gains or losses, dividends, and interest income, does not qualify. Reasonable compensation paid to an S-corporation shareholder for services, and guaranteed payments made to a partner for services, are not included in QBI. Wages earned as an employee are also excluded from the definition of QBI, as the deduction is intended for business owners rather than employees.

Who is Eligible for the QBI Deduction

The QBI deduction is available to individuals, trusts, and estates that are owners of pass-through entities. These entities, such as sole proprietorships, partnerships, S corporations, and certain limited liability companies (LLCs), pass their income directly to their owners, who then report it on their personal tax returns. The deduction is not available to C corporations or their shareholders for income earned through the corporation.

A business may be classified as a Specified Service Trade or Business (SSTB). An SSTB is any trade or business involving services in fields like health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. It also includes businesses where the principal asset is the reputation or skill of employees or owners. Engineering and architecture services are specifically excluded from the SSTB definition, allowing these professionals to qualify for the full deduction.

The application of SSTB rules and other limitations depends on the taxpayer’s taxable income for the year, calculated before any QBI deduction. For tax year 2024, if a taxpayer’s taxable income is below $195,300 for single filers or $390,700 for married filing jointly, the SSTB rules and other limitations do not apply, allowing the full deduction if otherwise eligible. If taxable income falls between these lower and upper thresholds (e.g., up to $245,300 for single filers or $490,700 for married filing jointly in 2024), the deduction for SSTBs begins to phase out, and the W-2 wage and unadjusted basis of qualified property limitations may start to apply. When taxable income exceeds the upper threshold, no QBI deduction is allowed for income derived from an SSTB.

How to Calculate Your QBI Deduction

The calculation of the QBI deduction begins with 20% of your qualified business income. However, this initial calculation is subject to several limitations that can reduce the final deductible amount. The first overarching limitation is that the deduction cannot exceed 20% of the taxpayer’s taxable income before any QBI deduction. This ensures the deduction does not reduce taxable income below a certain point.

When a taxpayer’s taxable income exceeds the lower threshold (e.g., $195,300 for single filers or $390,700 for married filing jointly in 2024), additional limitations apply. For each qualified trade or business, the deduction is limited to the greater of 50% of the W-2 wages paid by the business, or 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property. Qualified property refers to tangible depreciable property held by the business at the end of the tax year and used in the production of QBI.

For non-SSTBs with taxable income above the upper threshold (e.g., $245,300 for single filers or $490,700 for married filing jointly in 2024), the deduction is fully subject to the W-2 wage and UBIA limitations. For example, if a business has $100,000 of QBI but pays no W-2 wages and has no qualified property, and the taxpayer’s income is above the upper threshold, the QBI deduction would be zero. The final calculation compares the 20% of QBI amount to the W-2 wage/UBIA limitation, and then applies the overall taxable income limitation.

Reporting the QBI Deduction on Your Tax Return

The Qualified Business Income deduction is reported on an individual’s federal income tax return, Form 1040, on Schedule 1, “Additional Income and Adjustments to Income.” This is an “above-the-line” deduction, meaning it reduces a taxpayer’s adjusted gross income (AGI).

The reduction in AGI is beneficial because adjusted gross income serves as a benchmark for various other tax calculations, including eligibility for certain credits and deductions. Unlike itemized deductions, the QBI deduction is available whether the taxpayer chooses to itemize their deductions or takes the standard deduction. After being entered on Schedule 1, the total adjustments to income, including the QBI deduction, flow to the main Form 1040, where they reduce the taxpayer’s gross income to arrive at AGI.

Taxpayers should maintain accurate records of their qualified business income, W-2 wages paid by the business, and the unadjusted basis of qualified property. Maintaining these detailed records is essential for substantiating the calculation of the deduction in the event of an IRS inquiry or audit. The IRS provides guidance and worksheets in Publication 535, “Business Expenses,” to assist taxpayers in calculating and reporting their QBI deduction.