Recently proposed IRS regulations on the new deduction for qualified business income (QBI) provide guidance on how to compute limitations on the deduction based on W-2 wages. As you've probably heard, the QBI deduction is complicated, and numerous rules and restrictions apply.
Important note: While new QBI deduction regulations are in proposed form, taxpayers can rely on them until final regulations are issued.
The QBI deduction can be up to 20% of:
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.
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:
The following items don't count as QBI:
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.
In general, the limitations on the QBI deduction begin to phase in when the individual's (the pass-through entity owner's) taxable income (calculated before any QBI deduction) exceeds $157,500 or $315,000 for married couples who file jointly.
The limitations are fully phased in once taxable income exceeds $207,500 or $415,000 for married couples who file jointly. Above those thresholds, the QBI deduction for income from a non-service business is limited to the greater of:
The limitation based on the UBIA of qualified property is for the benefit of capital-intensive businesses. The UBIA of qualified property generally equals its original cost.
Qualified property means depreciable tangible property (including real estate) that:
Under a special disallowance rule for specified service trades or businesses (SSTBs), QBI deductions based on SSTB income are phased out between taxable income (before any QBI deduction) of: 1) $157,500 and $207,500 or 2) $315,000 and $415,000 for a married joint-filing couple. If the upper limit is exceeded, the individual cannot claim any QBI deduction based on income from any SSTB, regardless of how much QBI or W-2 wages the SSTB may have.
Under a special rule, the rental or licensing of tangible or intangible property to a related business is treated as a business for QBI deduction purposes. The special rule applies only if the rental or licensing activity and the other business are commonly controlled (50% common ownership).
The final regulations clarify that this special rule is limited to situations in which the rental is to another business owned by the taxpayer or to a pass-through entity that's commonly controlled. For example, if an individual rents property to his or her 100%-owned S corporation, the rental activity would count as a business for QBI deduction purposes. On the other hand, renting property to a controlled C corporation won't count as a business for QBI deduction purposes.
Taxpayers with investment interest expense (typically from brokerage firm margin accounts) can elect to treat net long-term capital gains and qualified dividends as ordinary investment income. This treatment can increase the taxpayer's allowable deduction for investment interest expense.
If this election is made, the final regulations clarify that it does not change the individual's net capital gain amount for purposes of the overall QBI deduction limitation.
For purposes of calculating W-2 wages for the QBI deduction limitation, the term "W-2 wages" refers to the total amount of compensation paid to an employee, including salary-reduction contributions to retirement plans (elective deferrals) and designated Roth contributions to retirement plans. W-2 wages don't include any amounts that aren't properly reported to recipients on Forms W-2.
W-2 wages must be determined separately for each qualified trade or business that's owned directly:
If W-2 wages are allocable to more than one trade or business, the percentage of total W-2 wages allocable to each trade or business follows the percentage allocation of deductions associated with those wages to each trade or business.
W-2 wages paid by a pass-through entity must be separately determined for each qualified trade or business conducted by the entity and separately reported to owners. An owner's allocable share of W-2 wages for QBI deduction purposes is determined in the same manner as the owner's allocable share of those wages under the normal federal income tax rules.
The individual can then choose to aggregate one or more businesses, and the W-2 wages paid by those businesses, if such aggregation is allowed.
If an individual's total QBI amount is less than zero, the negative amount is treated as negative QBI from a separate business in the individual's following tax year. This carryover rule doesn't affect the deductibility of losses under any other tax code provisions.
Important: W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified property from a business that produces negative QBI for the current tax year aren't taken into account for purposes of the W-2 wage and UBIA of qualified property limitations. In addition, those W-2 wages and the UBIA of qualified property aren't carried over to the following tax year.
In calculating the UBIA of qualified property, the final regulations set forth the following rules:
In addition, a basis adjustment to a partner's (LLC member's) share of partnership (LLC) qualified property when a partnership (LLC) interest is transferred is treated as qualified property to the extent the basis adjustment reflects an increase in the fair market value of the underlying partnership property. The final regulations include a procedure to implement this rule. The basis adjustment is treated as a separate item of qualified property that's placed in service when the transfer of the partnership (LLC) interest occurs.
The IRS issued Notice 2018-64 on the same day as the proposed QBI deduction regulations were issued. Notice 2018-64 sets forth the following methods for calculating W-2 wages for QBI deduction limitation purposes:
Unmodified box method. This technique calculates W-2 wages by taking into account, without modification, the lesser of:
Tracking wages method. Here, the taxpayer tracks total wages subject to federal income tax withholding and makes appropriate modifications. Specifically, W-2 wages are calculated under this method by:
Any of these methods can be used by taxpayers that use a fiscal year end, rather than a calendar year end for federal income tax purposes. If the taxpayer doesn't use the calendar year, W-2 wages are calculated based on wages paid to employees during the calendar year that ends with or within the taxpayer's tax year.
The tracking wages method must be used to calculate W-2 wages for short years (years with less than 12 months). If the taxpayer has a short tax year, W-2 wages include only wages paid to employees during the short tax year plus employee salary-reduction contributions to retirement plans made during the short tax year.
Under the overall limitation, an individual's QBI deduction can't exceed the lesser of:
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 tax advisor can run the numbers to see if filing separately makes sense.
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 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.
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:
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:
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