What Qualifies as QBI Wages for the QBI Deduction?

The Qualified Business Income (QBI) deduction, established under Section 199A of the tax code, offers a tax benefit for owners of pass-through businesses like sole proprietorships, partnerships, and S corporations. Introduced by the Tax Cuts and Jobs Act of 2017, the deduction allows eligible owners to deduct up to 20% of their qualified business income. This deduction is scheduled to expire for tax years beginning after December 31, 2025. While the 20% deduction is significant, its calculation is not always straightforward, as rules contain limitations that can reduce the final deductible amount based on income, business type, and employee wages.

The QBI Deduction and Its Limitations

The Qualified Business Income deduction is directly tied to a taxpayer’s taxable income. For many business owners, the calculation is a simple 20% deduction of their QBI, provided their taxable income falls below certain thresholds. For the 2025 tax year, these thresholds are $191,950 for single and most other filers, and $383,900 for those married filing jointly.

Once a taxpayer’s income surpasses these levels, limitations begin to phase in. The first limitation concerns whether the business is a Specified Service Trade or Business (SSTB). An SSTB is a business where the principal asset is the reputation or skill of its employees or owners, such as in the fields of health, law, accounting, or consulting.

For taxpayers with income from an SSTB, the deduction is phased out if their taxable income is between $191,950 and $241,950 for single filers, or between $383,900 and $483,900 for married filers. The deduction is eliminated for SSTBs once income exceeds these ranges. For all other businesses, a second limitation is calculated based on the business’s W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of its qualified property. This means that for higher-income business owners, the amount of wages paid to employees becomes a determining factor in the size of their potential tax deduction.

Defining QBI Wages

The term “QBI Wages” has a specific definition. QBI wages are the total wages subject to federal income tax withholding that are paid by the business to its employees during the calendar year, as reported on Form W-2. The IRS provides specific calculation methods, including the “unmodified box method,” which uses the total from Box 5 of all W-2s filed by the business.

It is also important to understand what is not included. Guaranteed payments made to partners and distributions paid to S corporation shareholders do not qualify as wages, as these payments are returns on investment, not compensation.

An S corporation owner who also works in the business must receive a “reasonable salary” for their services, which is reported on a Form W-2 and does qualify as QBI wages. In contrast, a sole proprietor cannot pay themselves a wage, as any money they take from the business is a draw.

For partnerships and S corporations, the entity calculates the total wages and allocates that amount to the partners or shareholders. Each owner then uses their allocated share of wages to apply the limitation on their personal tax return.

Calculating the W-2 Wage Limitation

Once a business owner’s income exceeds the thresholds, the W-2 wage limitation formula is applied. This limitation dictates that the QBI deduction cannot exceed the greater of two amounts. The first is 50% of the W-2 wages paid by the business. The second is 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.

For example, consider a business with $300,000 in QBI and $80,000 in W-2 wages. The potential QBI deduction is $60,000 (20% of QBI). The W-2 wage limitation is $40,000 (50% of wages). Because the potential deduction exceeds the wage limit, the taxpayer’s deduction is capped at $40,000.

The second part of the formula provides an alternative for businesses with significant capital assets but lower payroll. A business with $400,000 in QBI, $60,000 in W-2 wages, and $2,000,000 in UBIA would have two limits. The first is $30,000 (50% of wages). The second is $65,000, which is the sum of $15,000 (25% of wages) and $50,000 (2.5% of UBIA).

The taxpayer uses the greater of the two limits, making their limitation amount $65,000. Since their potential 20% QBI deduction of $80,000 is higher than this limit, their deduction is restricted to $65,000. This dual-pronged calculation ensures that businesses with different structures can benefit, and the calculation is performed for each separate trade or business.

Aggregation and Its Impact on Wages

Taxpayers with interests in multiple businesses may have the option to aggregate them, treating them as a single entity for the QBI deduction calculation. This requires a formal election and is not automatic. To qualify for aggregation, several tests must be met.

• The same person or group must own 50% or more of each business.
• The businesses must have the same tax year.
• They must satisfy relationship criteria, such as providing products or services to each other.

The primary benefit of aggregation relates to the W-2 wage and UBIA limitations. When businesses are aggregated, their individual QBI, W-2 wages, and UBIA are combined. This allows a business with high QBI but low wages to be combined with one that has high wages but lower QBI.

For example, a taxpayer owns two businesses. Business A has $200,000 of QBI but only $10,000 in W-2 wages, resulting in a wage limit of $5,000. Business B has $50,000 of QBI but pays $120,000 in W-2 wages. By aggregating them, the taxpayer combines the QBI ($250,000) and W-2 wages ($130,000).

The new wage limitation for the combined entity becomes $65,000 (50% of $130,000), which is higher than the potential 20% QBI deduction of $50,000. Aggregation allows the wages from Business B to support the income from Business A, unlocking a much larger deduction.