Overview of the qualified business income (QBI) deduction

The Tax Cuts and Jobs Act adds a new deduction for non-corporate taxpayers for qualified business income. The deduction reduces taxable income and is generally 20% of a taxpayer's qualified business income (QBI) from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to the trade or business. Certain types of investment-related items are excluded from QBI, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business).

Taxpayers whose taxable income exceeds the threshold amount of $157,500 ($315,000 in the case of a joint return) are subject to limitations based on the W-2 wages and the adjusted basis in acquired qualified property. For service related businesses, there is a separate phase-out if taxable income exceeds the threshold amount.

The deduction is taken for partnerships and S corporations at the partner or shareholder level. Trusts and estates are eligible for the deduction. W-2 wages and the adjusted basis in acquired qualified property are apportioned between the trust or estate and the beneficiaries.

Specified agricultural or horticultural cooperatives are also eligible for the deduction under special rules.

Qualified business income includes only income effectively connected with a U.S. trade or business (or Puerto Rico if all the income is subject to U.S. tax).

The deduction is intended to reduce the tax rate on qualified business income to a rate that is closer to the new corporate tax rate.

There are six main scenarios for the activity by activity level deduction with regard to the phase-in of the wages/property limits, phase-out of the credit, and if it’s a specified service business. They are broken out between the Simplified Worksheet and the Complex Worksheet for computing qualified business income.

These activity level deduction amounts will also be subject to an overall tax-return level taxable income limitation.

Publicly Traded Partnerships (PTPs), Real Estate Investment Trust (REIT), and Cooperatives bypass this activity level limitation.

This flowchart offers a graphical overview of the different scenarios for calculating the deduction, which we’ll expand on in the sections below.

Scenario 1

Not a specified service business, below taxable income threshold ($157,500, or $315,000 if MFJ).

For this scenario, the activity will get a straight 20% of QBI deduction. If the QBI for the activity is a negative amount, then a negative deduction will be computed.

Scenario 2

Specified service business, below taxable income threshold ($157,500, or $315,000 if married filing jointly).

For this scenario, the activity will get a straight 20% of QBI deduction. The fact that this is a specified service business has no impact in this scenario. If the QBI for the activity is a negative amount, then a negative deduction will be computed.

Scenario 1

Not a specified service business, above taxable income threshold, but below the maximum phase-out range (between $157,500-$207,500, or $315,000-$415,000 if MFJ).

For this scenario, the wage/property limits start to phase in. The computed 20% deduction amount will be partially limited to the higher of 50% of wages paid by the business, or 25% of the wages paid plus 2.5% of the unadjusted basis of qualified property. If the business has no wages paid, and no qualified property, a partial deduction will be allowed.

Scenario 2

Not a specified service business, above taxable income threshold, and also above the maximum phase-out range (above $207,500, or $415,000 if married filing jointly).

For this scenario, the wage/property limits are fully phased-in. The computed 20% deduction amount will be limited to the higher of 50% of wages paid by the business, or 25% of the wages paid plus 2.5% of the unadjusted basis of qualified property. If the business has no wages paid, and no qualified property, then no deduction is allowed at all.

Scenario 3

Specified service business, above taxable income threshold, but below the maximum phase-out range (between $157,500-$207,500, or $315,000-$415,000 if married filing jointly).

This is the most complex scenario. This business will be subject to both the phase-out of the deduction (due to being a specified service business), and a phase-in of the wage/property limits.

Scenario 4

Specified service business, above taxable income threshold, and also above the maximum phase-out range (above $207,500, or $415,000 if married filing jointly).

For this specified service business scenario, the deduction is completely phased out, and there is no deduction allowed.

After computing the activity by activity deduction amounts, each of these amounts get combined together along with 20% of PTP qualified business income, 20% of REIT dividends, and 20% of cooperative dividends for the return level taxable income limitation.

Basically, the overall deduction is limited to a maximum of 20% of taxable income. Any deduction amount beyond the 20% of taxable income is disallowed completely (no carryover). If the overall deduction amount is negative, that negative amount will carry forward to net against next year’s qualified business income deduction.