Everything You Need to Know About Qualified Business Income

A business’s net income or revenue and profit are not the same things. In simple terms, the income a business makes simply refers to how much money it brought in from selling its products or services. But the profit tells you how much your business earned to be used to expand the business or be tucked away for a rainy day. Among other major metrics, small business owners should learn what their business’s qualified business income is. Qualified business income is not only important so you can determine the health of your business. It’s also crucial if you want to take advantage of a special tax break that could save you thousands of dollars each year. Not sure where to start? Let us explain everything you need to know about qualified business income now.

What is Qualified Business Income?

In a nutshell, your qualified business income or QBI is the “net amount of qualified items of income, gain, deduction and loss with respect to any trade or business,” according to the IRS. In other words, your QBI is the net profit your business brings in during its fiscal year. Small business owners need to identify their qualified business income to take advantage of certain tax breaks and better understand how their business performs in general.

What’s Excluded from QBI?

However, your business’s QBI doesn’t include all the income you might get from your business operations, investments, and more. In fact, QBI specifically excludes:

• Any capital gains or losses, such as those you might get from the stock market trading
• Dividends from holding stocks or other financial assets
• Income from interest on properties or other financial arrangements
• Any income you earn outside the US
• Certain types of wages or guaranteed payments made to shareholders or partners in your company

Why Does QBI Matter?

As mentioned above, your business’s QBI is primarily important so you can benefit from special tax breaks. In addition to this advantage, knowing your QBI will help you figure out how much net profit your business brings in every year, which is distinct from other numbers like total revenue or income. QBI enables you to run your business more wisely.

What’s the QBI Deduction?

According to Section 199A of the IRC or Internal Revenue Code, businesses can take advantage of a special tax break called the QBI deduction . In brief, the QBI deduction allows various business entities, especially small businesses, to lower their reported earnings. This effectively tells the IRS that they made less money than they brought in. Like other types of business or personal deductions, this may result in you having to pay fewer taxes in a given fiscal year. However, it’s important to know that the QBI deduction includes various other deductions that you might otherwise take separately. These include the deductible portion of your self-employment tax, the deductible portion of your self-employed health insurance, deductions for any contributions you make to retirement plans, and more. It’s a catchall deduction you can use in place of the standard deduction (which most people take when filing personal tax returns). Although the QBI deduction can be very helpful, only some businesses apply and can take advantage of it.

Does Everyone Qualify for the QBI Deduction?

No. According to the IRS, only pass-through entities qualify for the QBI deduction . Your business counts as a pass-through entity if:

• You do not file a separate corporate tax return (also called Form 1120)
• You declare all your income, including that from your business, on your tax return (on Schedule C of Form 1040)

Because of these limitations, it’s primarily small business owners who can use the QBI deduction for financial gain.

How Much Money Can You Save With the QBI Deduction?

That depends on your business’s net income and a variety of other factors. If your business is eligible for the deduction, you can deduct the lesser of two options, either:

• 20% of your qualified business income, plus another 20% of any qualified real estate investment trust dividends or REIT dividends, plus qualified PTP or publicly traded partnership income
• 20% of your total taxable income (all the income recorded on your tax return) minus your net capital gain

Put more simply, if you take the QBI deduction, you only need to pay taxes on 80% of the qualified business income your business made. Here’s an example – if your business income puts you in the 32% tax bracket, the QBI deduction will lower your tax rate to 25.6% in reality.

How to Know if You Qualify for the QBI Deduction

Not sure whether your business counts as a pass-through entity? The IRS recognizes the following entities as eligible for the qualified business income deduction:

• Sole proprietorships, which are typically single-person-owned businesses with very limited income. Freelancers may also fall into this category if they formed an official company
• Partnerships, which are small companies that typically only include two or three people
• S corporations but not C corporations
• LLCs or limited liability companies

Naturally, you must also have qualified business income in the first place. If you formed a company but only make a profit because of dividends or capital gains and losses, you will not qualify for the QBI deduction. Additionally, your total taxable income may determine whether your business qualifies for the deduction.

• If your total taxable income, which includes both your personal and business income, is at or below $163,300 or $326,600 for single and joint filers, respectively, you may qualify for the 20% QBI deduction.
• Note that, for 2021, the income limits will rise to $164,900 for single filing businesses/owners and $329,800 for joint filers.

What if your income is above these limits? You may still qualify for the QBI deduction, but it depends on the nature of your business. Furthermore, the nature of your business may determine whether you qualify for the full 20% QBI deduction or only part of it.

Other Businesses That Qualify

If your business counts as a “specified service trade or business”, such as a doctor, lawyer, actor, financial planner, and so on, you may qualify provided your total taxable income does not hit single or joint filing values of $213,300 or $426,600, respectively. The IRS regulations go into more detail, including explaining how much of the deduction you can take. For many businesses, the deduction’s amount will be based on how much you paying wages to your employees, including yourself, in addition to the total value of any property owned by the business. If the figures are higher, your income technically goes down since some of your profits must be used to pay for those expenses. Thus, you may qualify for more of the QBI deduction.

Should You Take the QBI Deduction?

If you qualify for it, absolutely. While it’s technically possible that hiring a tax expert to go through your tax return line by line may result in slightly higher savings, most business owners will simply find it easier and more convenient to take the QBI deduction. Remember, the QBI deduction includes all of the major single-line deductions you might otherwise take if you fill out your tax form with an exacting eye for savings. Furthermore, some businesses may even save more by simply taking the 20% QBI deduction than they would by finding individual tax breaks digging through the details of their business and expenses. It’s also typically faster for you to simply determine whether you qualify for the QBI deduction than it is to go through your tax return line by line, looking for potential savings. Our advice? Take the deduction if you qualify and benefit from extra savings on your upcoming tax return.

Summary

As you can see, qualified business income is an important metric that all business owners should know. But it’s especially crucial for small business owners since it may determine whether they qualify for the QBI deduction: a major way to save money on their tax returns. Since small businesses typically have thinner margins between profit and loss, saving as much money on taxes as possible is a great way to make sure your business succeeds in the long term. Want to know more about saving money as a small business owner, or need to know where you can get funding for an upcoming expansion or other business needs? Check out Seek Capital today and let us know how we can help your business succeed! Sources: Facts About the Qualified Business Income Deduction | IRS Qualified Business Income Deduction - What Is It & Its Limitations | TaxAct Blog 199A, Qualified Business Income Deduction | IRS QBI Deductions: What You Need to Know | Motley Fool Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs | IRS