QBI Deduction: Use It or (Possibly) Lose It

The qualified business income (QBI) deduction is available to eligible individuals through 2025. After that, it's scheduled to disappear, unless Congress passes legislation to extend it. With 2024 underway, it's now use-it-or-lose-it time for the write-off. Here's what you need to know to cash in on the QBI deduction.

The Basics

The QBI deduction can be up to 20% of:

• QBI earned from a sole proprietorship or a single-member limited liability company (LLC) that's treated as a sole proprietorship for federal income tax purposes, plus
• QBI from a pass-through business entity, meaning an S corporation, a partnership or an LLC that's treated as a partnership for federal income tax purposes.

QBI can also include up to 20% of eligible income from publicly traded partnerships and up to 20% of eligible dividends from real estate investment trusts. However, this article focuses specifically on QBI deductions from the more common kinds of pass-through businesses.  

Important: Pass-through business entities report their federal income tax items to their owners, who then take them into account on their owner-level returns. The QBI deduction, when allowed, is then written off at the owner level, and can potentially save significant tax dollars.

QBI Defined

The term "QBI" refers to qualified income and gains from an eligible business reduced by related deductions and losses. QBI from a business is reduced by the allocable deductions for the following items:

• Contributions to a self-employed retirement plan,
• 50% of your self-employment tax bill, and
• Self-employed health insurance premiums.

The following items don't count as QBI:

• Income from the business of being an employee,
• Partner salaries, which refer to guaranteed payments received by partners or LLC members treated as partners for tax purposes for services rendered to the business,
• Salary collected by an S corporation shareholder-employee, and
• Salary collected by a C corporation shareholder-employee.

On your personal return, the QBI deduction doesn't reduce your adjusted gross income (AGI). In effect, it's treated the same as an allowable itemized deduction.

Unfortunately, the QBI deduction doesn't reduce your net earnings from self-employment for purposes of the self-employment tax. Nor does it reduce your net investment income for purposes of the 3.8% net investment income tax (NIIT) on higher-income taxpayers.

Limitations

At higher income levels, unfavorable QBI deduction limitations come into play. These income limits are indexed annually for inflation. Here are the income-based phase-in thresholds for 2023 and 2024:

Phase-In Ranges for 2023 and 2024

If your income exceeds the applicable fully phased-in number, your QBI deduction is limited to the greater of:

• Your share of 50% of W-2 wages paid to employees during the tax year and properly allocable to QBI, or
• The sum of your share of 25% of such W-2 wages, plus your share of 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of qualified property.

The limitation based on the UBIA of qualified property is intended to benefit capital-intensive businesses, such as manufacturers or hotels. Qualified property means depreciable tangible property (including real estate) that's owned by a qualified business and used by that business for the production of QBI. The UBIA of qualified property generally equals its original cost when it was first put to use in your business.

Finally, your QBI deduction can't exceed 20% of your taxable income calculated before any QBI deduction and before any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). 

Special Unfavorable Rules for Service Businesses

If your business is classified as a specified service trade or business (SSTB), QBI deductions begin to be phased out when your taxable income (calculated before any QBI deduction) exceeds the applicable threshold. (For more information, see "What's an SSTB?" below.) The following phase-out ranges apply to SSTBs for 2023 and 2024:

Phase-Out Ranges for 2023 and 2024

If your taxable income for the year exceeds the applicable complete phase-out number, you're not allowed to claim any QBI deduction for that year based on income from any SSTB.

Tax Planning Moves

Here are four possible strategies to consider to help maximize QBI deductions through 2025:

1. Aggregate businesses. Electing to aggregate several businesses can allow an individual with taxable income high enough to be affected by the limitations (based on W-2 wages and the UBIA of qualified property) to claim a bigger QBI deduction than if the businesses are treated separately.

For instance, say you're a high-income individual who owns an interest in one business with significant QBI but little or no W-2 wages and an interest in a second business with minimal QBI but significant W-2 wages. Aggregating the two businesses can result in a healthy QBI deduction, while keeping them separate could result in a lower deduction, or maybe no deduction. However, you must pass certain tests set forth in IRS regulations to be allowed to aggregate businesses.

Important: You can't aggregate a SSTB with any other business, including another SSTB.

2. Claim (or forgo) first-year depreciation deductions. For tax years beginning in 2024, you can potentially claim first-year Section 179 deductions of up to $1.22 million for eligible asset additions (subject to various limitations). For eligible assets placed in service in 2024, 60% first-year bonus depreciation is available.

For 2023, the maximum Sec. 179 deduction was $1.16 million. For 2023, the bonus depreciation percentage was 80%.

First-year depreciation deductions reduce QBI—but they also reduce taxable income, which could reduce the impact of the unfavorable QBI limitations. All things being equal, lower taxable income is generally desirable. So, you may have to tread a fine line with depreciation write-offs to get the best overall federal income tax result.

Important: Under the Tax Cuts and Jobs Act, the QBI deduction is scheduled to expire after 2025. In contrast, when you forgo first-year depreciation deductions, you can still depreciate the assets over a number of years under the regular depreciation rules. If tax rates go up after 2025, depreciation deductions claimed in future years could turn out to be worth more than sizable first-year depreciation deductions claimed in earlier years.           

3. Make (or forgo) large deductible retirement plan contributions. Deductible self-employed retirement plan contributions allocable to a business that generates QBI will reduce your allowable QBI deduction. But they also reduce your taxable income, which could reduce the impact of unfavorable QBI limitations. Again, all things being equal, lower taxable income is generally desirable. So, you may have to schedule retirement plan contributions carefully to get the best overall federal income tax result.
4. Use married-filing-separately status. Say one member of a married couple operates a small business that generates QBI. It pays no W-2 wages and has only a tiny amount of UBIA of qualified property. If the couple files jointly, their combined taxable income may be high enough to greatly limit, or even wipe out, any QBI deduction, thanks to the income-based limitations. But if the spouses file separate returns, the spouse who operates the small business could potentially qualify for a substantial QBI deduction, because the QBI deduction limit wouldn't come into play or be only partially phased in on that spouse's personal return.  

Important: Filing separate returns to maximize the QBI deduction can have negative side effects elsewhere on your personal returns, such as reduced or disallowed tax credits. Your SSB tax advisor can run the numbers to see if filing separately makes sense.

What's an SSTB?

In general, a specified service trade or business (SSTB) is any trade or business involving the performance of services in one or more of the following fields:

• Health, law, accounting and actuarial science,
• Consulting,
• Financial, brokerage, investing and investment management services,
• Trading,
• Dealing in securities, partnership interests or commodities,
• Athletics and performing arts, and
• Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.

Important: Architecture and engineering firms aren't considered SSTBs.

Before the IRS issued regulations on this issue, there was concern that the last definition could snare unsuspecting businesses, such as small restaurants with well-known chefs. Thankfully, the regs limit the last item on this list to businesses that receive fees, compensation or other income for:

• Endorsing products or services,
• Using an individual's image, likeness, name, signature, voice, trademark or any other symbol associated with that individual's identity, and/or
• Appearing at an event or on radio, television or another media format.

For More Information

Under current tax law, the QBI deduction is scheduled to disappear after 2025. Given the gridlock in Congress today, you can't count on an extension, so small business owners should take advantage of this tax break before it expires—or risk losing it forever. Contact your SSB tax advisor to discuss the complex rules for claiming QBI deductions and plan how to get the best overall federal income tax results in your situation. 

©  2024