Section 199A: Qualified Business Income Deduction (QBID)

Calculating QBI in the Tax Cuts and Jobs Act (TCJA) Era

Disclaimer:

The following information is not intended to be written advice concerning one or more Federal tax matters subject to the requirements of Treasury Department Circular 230.

The information that follows is general in nature and is not intended to apply to any individual’s or entity’s particular circumstances. Although the information provided is intended to be timely and accurate, we cannot guarantee its accuracy on the date received or future dates. No individual or entity should act on such information without the advice of a professional and careful consideration of the particular circumstances.

Contents

PART 1

PART 2


PART 1: Qualified business income deduction (Section 199A)

When Congress passed the Tax Cuts and Jobs Act (TCJA), it reduced the C corporation tax rate from 35% to 21%. Congress did not want to disadvantage owners of pass-through entities (sole proprietors, S corporations, and partnerships) by leaving them with a substantially higher tax liability (potentially as high as 37%) than C corporations. Congress reduced this burden by creating the Qualified Business Income Deduction (QBID).

The QBID is the last deduction before determining a taxpayer’s taxable income. It is based on determining qualified business income (QBI). The QBID is a Below-the-line deduction. Thus, the QBID can be paired with either the standard deduction or itemized deductions.

QBI must come from a flow-through entity. This includes business income from a sole proprietorship (reported on Schedule C of Form 1040), a partnership (reported on Form 1065) or an S-Corporation (reported on Form 1120S).

  • A taxpayer’s share of an S-Corporation’s or partnership’s qualified business income and wages and property (discussed below) will be reported to them on Schedule K-1.

QBI must also be income that is effectively connected with the conduct of a trade or business within the United States or Puerto Rico and income that is included in determining taxable income for the tax year. However, amounts paid to taxpayers for reasonable compensation (i.e., wages and guaranteed payments) do not count as QBI. For Sec. 199A, Congress divided pass-through entities into two categories:

  • Specified service trades or businesses
  • Qualified trades or businesses

Specified service trades or businesses

In general, a specified service trade or business (SSTB) is any trade or business in which the principal asset is the reputation or skill of one or more of its employees. Specifically, SSTBs include the following types of trades and businesses:

  • Health (e.g., physicians, nurses, dentists, and other similar healthcare professionals)
    • Health does not include services not directly related to a medical field, such as medical device sales, coding, billing, and payment processing.
  • Law
  • Accounting
  • Actuarial science
  • Performing arts
  • Consulting
  • Athletics
  • Financial services (e.g. financial advisors, wealth planners, retirement advisors, investment bankers, brokerage services, and other professionals performing similar services)
    • This includes any professional service consisting of investing, investment management, trading or dealing in securities, partnership interests, or commodities.

Also, an SSTB is any trade or business wherein a principal earns income (e.g., fees, licenses, or compensation) for any of the following activities:

  • Endorsing products or services
  • Use of the principal’s likeness, image, name, etc.
  • Appearance fees for an event or media performance (e.g., radio, TV, etc.)

Trades and businesses that are specifically not considered SSTBs include

  • Architects
  • Engineers
  • Real estate agents and brokers
  • Insurance agents and brokers

Qualified trades or businesses

In general, a qualified trade or business is any pass-through entity not considered an SSTB. Specifically, a pass-through entity can be identified as a qualified trade or business if it has QBI.

Overall limitation

The QBID on line 9 of page 2 of Form 1040 is limited due to an overall limitationThe overall limitation is the lesser of

  • 20% × Qualified business income or
  • 20% × (Taxable income ˗ Net capital gains).

Therefore, if a taxpayer has net capital gains, the taxpayer’s net capital gains may decrease his or her QBID. For this deduction, net capital gains are long-term gains and qualified dividends, minus short-term losses. Before a taxpayer can apply the overall limitation, (s)he has to determine the combined QBID before the taxable income limitation. Determining the QBID is a three-step process. After the three steps have been used to determine the QBID, the taxpayer must apply overall limitation, which becomes Step 4.

Calculating Qualified Business Income Deduction

In the next section, we break the QBID calculation into a 4-step process. Conceptually, before introducing the 4 steps, it’s helpful to think of the deduction being limited as follows:

  • A taxpayer is never going to be able to take a deduction greater than 20% of QBI.
  • This deduction will be less than 20% of QBI if the taxpayer is single and makes more than $157,500 or is married filed jointly and makes more than $315,000.
  • As the last step, taxpayers may need to further reduce their deduction by overall limitation (discussed above).

If you understand these 3 steps, it’s harder to get lost in the weeds as we go into more detail on how to calculate the QBID.

How to calculate Qualified Business Income

To calculate the combined Qualified Business Income Deduction and ultimately the QBID, the following must be completed:

Step 1–every pass-through entity must first determine its QBI. This information will be reported on a Schedule K-1 (or a Schedule C if the entity is a sole proprietorship). Thus, this step is completed or determined by the pass-through entity and is provided to the taxpayer. This step should be “easy” for the individual since the information is provided by the entity. In practice, many tax professionals will be completing both the pass-through entity’s tax forms and the individual’s tax forms.

The details of this process are described under Determining What Constitutes Qualified Business Income Deduction.

Step 2–In general, the most a taxpayer will be able to deduct is 20% of the QBI. In Step 2, the allowed QBID for each pass-through entity can be reduced to less than 20% if the taxpayer’s taxable income is above a threshold. If the taxpayer is in the phase-in range (of W-2 wage limit) or upper threshold, the QBID for each respective pass-through entity may be reduced or limited. This reduction is the allowed amount of QBID for each respective pass-through entity. Single taxpayers reach the phase-in range once taxable income exceeds $157,500 and enter the upper threshold at $207,500. Married Filing Jointly taxpayers reach the phase-in threshold when taxable income exceeds $315,000 and enter the upper threshold at $415,000.

The details of this process are described under Qualified Business Income Deduction Allowed Per Entity.

Step 3–This step occurs if the taxpayer has more than one pass-through entity with QBI. A taxpayer determines the applicable combined QBID by adding together the allowed QBID amount for each respective entity to arrive at a total (or combined) QBID. If there is only one pass-through entity, then the QBID for the one entity is the QBID for Step 3.

The details of this process are described under Combined Qualified Business Income Deduction Process.

Step 4–The final step is for the taxpayer to apply the overall limitation to total QBID to determine the correct amount to deduct. This amount is then reported on line 9 of Form 1040.

The details of this process are described under Overall Limitation.

Determining what constitutes Qualified Business Income (Step 1)

To determine QBI:

  • Ensure the entity is a relevant pass-through entity (i.e., sole proprietor, S corporation, partnership, estate, or trust).
  • Determine whether the entity is directly owned by the taxpayer (e.g., a K-1 is sent directly to the taxpayer as a direct owner of a pass-through entity or business income is reported on Schedule C).
  • Calculate the net amount of income, gain, deduction, and loss with respect to any trade or business, limited to amounts:
    • Effectively connected with the conduct of a trade or business within the United States and Puerto Rico AND
    • Included or allowed in determining taxable income for the taxable year.
  • The last step is to further reduce net income by:
    • Capital gains and losses
    • Dividends
    • Non-operating interest income
    • Interest income attributable to working capital
    • Gains or losses relating to transactions in commodities
    • Foreign currency gains
      • The IRS lists “excess foreign currency gains.” For most taxpayers, this effectively means any foreign currency gains.
    • The amount of any less-than-reasonable salary payment to owners.
      • If the taxpayer paid himself or herself a salary (or guaranteed payment) less than a reasonable amount to receive a higher QBI deduction, the taxpayer must reduce QBI by the amount of the less-than-reasonable salary payment.

Notes on the information above:

There are more reductions in total than those listed in the bullets above, but these are the big-picture items that are most likely to affect most taxpayers.

Qualified business income deduction allowed per entity (Step 2)

During this calculation of Step 2, Qualified Business Income Deduction is limited to 20% of QBI. In other words, at best, a taxpayer will be able to ultimately deduct 20% of QBI. Depending on the taxpayer’s taxable income, the QBID may be further reduced beyond 20% of QBI. A taxpayer’s taxable income is divided into three categories: a lower threshold, an upper threshold, and a phase-in range (the range between the two thresholds, i.e. the phase-in of the W-2 wage limit).

  • Lower threshold (≤ $157,500 Single or ≤ $315,000 Married Filing Jointly)
  • Phase-in range
  • Upper threshold (≥ $207,500 Single or ≥ $415,000 Married Filing Jointly)

If the taxpayer is above the lower threshold, the taxpayer’s QBID for each entity begins to be limited. In the case of taxable income being higher than the lower threshold, the QBID allowed from each entity is limited by the amount of the entity’s W-2 wages or a combination of W-2 wages and unadjusted basis of assets. Within the phase-out range, qualifying businesses are partially limited by the W-2 wage limit, while SSTBs are limited first to a total phase-out range and then by the W-2 wage limit. If the taxpayer is in the upper threshold, there is no Qualified Business Income Deduction deduction allowed for income from SSTBs. The chart below goes into more depth and should be closely reviewed by candidates.

Click here to download a printable PDF

Aggregation rules

Aggregation is a choice a taxpayer can make on their own. Aggregation allows a taxpayer to combine multiple businesses and treat them as one business for the purposes of “Step 2 – Calculating the Qualified Business Income Deduction for each respective pass-through entity.” The reason a taxpayer may do this is if one business has a higher payroll than others and the taxpayer wishes to spread or share the higher payroll of one business among other businesses with lower payrolls when calculating the QBID. This can effectively increase the QBID for the taxpayer in some instances.

A business owner may own multiple businesses that are each separate legal entities. For example, a business owner may own multiple gas stations, each of which is a separate S corporation. The IRS will allow a business owner to aggregate these businesses when calculating the allowed QBID if:

  • All aggregated businesses have the same tax year, excluding short years, and
  • The same person or group of persons owns 50% or more of each trade or business and the businesses to be aggregated satisfy two of the following three criteria:
    • Products and services of the businesses are the same or customarily offered together.
    • Facilities or significant centralized business elements such as HR, accounting, purchasing, IT, etc., are shared.
    • The businesses operate in coordination with or reliance upon one or more of the businesses in the aggregated group.

Each individual owner may decide whether to aggregate. The decision need not apply to each entire group of businesses and their owners. For example, Shareholder A could choose to aggregate the businesses on his return while Shareholder B may not.

The election to aggregate is a one-time decision, so each subsequent year must be aggregated the same way once aggregation is elected.

Aggregation is not allowed for SSTBs.

In terms of meeting the 50% ownership threshold, families are able to aggregate based on their total ownership.

  • Families include spouses, children, grandchildren, and grandparents.

EXAMPLE
(Aggregation rules)

Percentage of Ownership

Entity A

Entity B

Entity C

Grandfather

60%

20%

Daughter

30%

40%

Grandson

60%

Total Ownership

60%

50%

100%

Grandfather, Daughter, and Grandson can aggregate Entities A, B, and C.

Combined QBID process (Step 3)

After determining the QBID allowed for each specific company, all of the individual QBIDs are combined (or summed) into one amount.

EXAMPLE

Combined QBI Process

Entity

 

Step 1
Determine QBI

Step 2

 

Step 3
Sum QBID Allowed

Entity 1

QBI

Calculate QBID Allowed

QBID Allowed

Entity 2

QBI

Calculate QBID Allowed

QBID Allowed

Entity 3, 4, and 5

QBI

Calculate QBID Allowed

QBID Allowed

Entity 6

QBI

Calculate QBID Allowed

QBID Allowed

Combined QBID Total

Sum of QBID Allowed

Overall limitation process (Step 4)

After combining all of the allowed QBIDs, there is one final limitation that determines the amount an individual taxpayer can deduct on line 9 of Form 1040 (i.e., QBID). Which is the lesser of the following:

  • Combined Qualified Business Income Deduction*
  • 20% × (Taxable income ˗ Net capital gains)

*Depicted in the previous table as Sum of QBID Allowed

EXAMPLE
(Overall Limitation / Final Step)

A single taxpayer had net capital gains of $15,000 in the tax year. Assume QBI is provided by entity.

Qualified Business Income Deduction loss carryover

If the net QBI (i.e. Step 1, here) for the year from all entities is a negative (before any Step 2 calculation), then QBI is treated as a Qualified Business Loss (QBL). A QBL amount is carried forward to the following year (loss cannot be carried back). Carried forward qualified business loss reduces the amount of qualified business income that is subject to the QBI deduction in future years. A cumulative qualified business income/profit is required to be eligible for the QBI deduction in order to prevent unjust enrichment.

  • The W-2 wages and unadjusted basis immediately after acquisition do not carry over to future years; only the QBL carries over.
  • QBL in the subsequent year can be visualized as an entity in the pool of QBI entities and allocated proportionately among that year’s QBID per entity.

Other section 199A rules

The Sec. 199A deduction does not affect the taxpayer’s basis (outside adjusted basis or shareholder’s AAA) in the pass-through entity.

In addition to SSTBs and qualified trades or businesses, taxpayers can deduct qualified REIT dividends and qualified publicly-traded partnership income. The IRS defines qualified REIT dividend income as neither a capital gain dividend nor a qualified dividend income. Due to these extensive limitations, many tax professionals are waiting for further guidance from the IRS to determine how a REIT dividend could practically be considered a qualified REIT dividend. For the purposes of the CPA Exam, candidates could see a conceptual-level question in which qualified REIT dividend income is also a component of the QBID.


PART 2: Putting the Qualified Business Income Deduction into practice

In Part 1, we discussed the basics of the qualifying business income deduction (QBID).Essentially, calculating the deduction requires (1) determination of qualifying business income (QBI), (2) determination of qualifying business income allowed per entity and application of the phase-out range if applicable, (3) calculation of the combined QBI deduction for all entities, and (4) application of the overall QBID limitation. In Part 2, we’ll be going through a few examples where we apply the QBID to help make the steps more concrete.

Example 1: Applying the Qualified Business Income Deduction for taxpayers under the phase-in threshold

James and Mary are each 25% partners in JMS Partnership, a domestic partnership, and have joint taxable income before the QBI deduction of $200,000, which includes $50,000 of capital gains. JMS had income of $91,000 for 2018, which includes $7,000 of capital gains and $4,000 of dividends.

Step 1 – Calculate Qualified Business Income Deduction

Assuming that James and Mary are married and file a joint return, they will receive a distributive share of 50% of total partnership income. Their qualifying business income will equal 50% of total partnership income reduced by applicable non-business income, such as capital gains and dividends received. James and Mary’s qualifying business income is calculated as follows:

Distributive share of partnership income ($91,000×50%)
Less: Distributive share of capital gains ($7,000×50%)
Less: Distributive share of dividend income ($4,000×50%)
Qualifying business income
$45,500
($3,500)
($2,000)
$40,000

Step 2 – Calculate Qualified Business Income Deduction Allowed per Entity

James and Mary have taxable income of $200,000, which is below the phase-in threshold of $315,000 for married filing jointly. Therefore, James and Mary will be able to deduct the full 20% of their partnership income, subject to the taxable income limitation. James and Mary’s QBID allowed per JMS will be:

Qualifying business income
x QBI deduction percentage
QBID allowed per JMS
$40,000
x 20%
$8,000

When outside of the phase-in threshold, it is irrelevant whether a pass-through entity is a qualifying business of a specified service trade or business (SSTB). The deduction would remain the same.

Step 3 – Combined Qualified Business Income Deduction

James and Mary are only members of one pass-through entity, and therefore the combined QBID will be $8,000.

Step 4 – Overall Limitation

After the calculation of all deductions allowed, the QBID is compared to the taxable income of the joint taxpayers.

Lower of:
Combined QBID allowed
(Taxable income – capital gains)*20%
QBI Deduction
$8,000
$30,000
$8,000

Example 2: Applying the Qualified Business Income Deduction for taxpayers within the phase-in threshold

Tim and Georgina are married and intend to file a joint return for 2018. They have joint taxable income before the QBI deduction of $375,000, which does not include any capital gains. Tim is a 50% partner of a qualifying business which received $200,000 of taxable business income. Georgina is a 50% partner of an accounting firm, which qualifies as an SSTB, that also received 200,000 of taxable business income. Each partnership paid employee wages of $10,000 and have an unadjusted basis in assets of $20,000.

Step 1 – Calculate Qualified Business Income

In this example, the QBI calculation is fairly straight-forward. As Tim and Georgina are 50% partners in their respective partnerships, each has a QBI of $100,000.

Step 2 – Calculate Qualified Business Income Deduction allowed per entity

Because Tim and Georgina have a joint taxable income that falls within the phase-in range, the calculation of the Qualified Business Income Deduction allowed for the qualifying business and the SSTB will be slightly different. Also, Tim’s and Georgina’s partnerships cannot be aggregated because Georgina’s partnership is an SSTB. However, the reduction ratio will be the same for all entities, calculated by subtracting the lower phase-in income amount from taxable income and dividing the difference by the difference between the lower and upper phase-in thresholds (or the “phase-in range”), calculated as follows:

Taxable income – Lower phase-in amount (MFJ)
Phase-in range (MFJ)

$375,000 – $315,000
$100,000

This yields a reduction ratio of 60%. The reduction ratio can also be thought of as the extent to which taxable income falls within the phase-in range. The applicable percentage used in calculations is equal to (1 – reduction ratio), or 40%.

We will now calculate the allowable Qualified Business Income Deduction for each entity.

Qualifying Business (Tim’s partnership)

Within the phase-in range, Tim’s Qualified Business Income deduction allowed will be limited, to an extent, by the greater of 50% of the W-2 wages paid by the partnership and 25% of the W-2 wages paid by the partnership plus 2.5% of the unadjusted basis of assets in the partnership. From the above fact pattern, we know that Tim’s partnership paid $10,000 of employee wages and has an unadjusted basis in assets of $20,000. We will now calculate the W-2 wage limit:

Greater of:

50% of W-2 wages paid OR

$5,000

25% of W-2 wages paid

$2,500

PLUS 2.5% of the unadjusted basis of assets

$500

$3,000

Knowing the W-2 wage limit, we can now determine how the QBI deduction allowed will be affected. Without the effect of the phase-in, Tim’s QBI deduction allowed would be equal to 20% of his distributive share, or $20,000. With the phase-out, the deduction amount that falls within the W-2 wage limit is allowed in full, but the excess will be subject to reduction. The allowable Qualified Business Income Deduction is calculated as follows:

20% of QBI
Less: W-2 wage limitation
Excess over wage limitation
x Applicable percentage
Excess deduction allowed
Plus: W-2 limitation
Allowable QBID
$20,000
($5,000)
$15,000
x 40%
$6,000
$5,000
$11,000

As is shown, the deduction is fully allowable to the extent it does not exceed the W-2 wage limitation, and any excess deduction is reduced based on the applicable percentage (1 – reduction ratio). If the taxpayer’s taxable income were $415,000 or higher (i.e. the upper limit of the phase-in), no amount of the excess deduction over the W-2 wage limitation would be allowed.

Specified service trade or business (Georgina’s partnership)

Calculation of the QBI deduction allowed for an SSTB within the phase-in range is very similar to that of a qualifying business, with one additional step. For an SSTB, you must first calculate the allowable QBI, which is equal to the QBI multiplied by the applicable percentage.

Qualified business income
x Applicable percentage
Allowable QBI
$100,000
x 40%
$40,000

Additionally, the W-2 wage limitation (which, due to identical income, wage, and asset figures, would be calculated in the same way as that of Tim’s partnership), is subject to the applicable percentage.

W-2 wage limitation
x Applicable percentage
Allowable Wages
x 50% of employee wages
Allowable wage limitation
$10,000
x 40%
$4,000
x 50%
$2,000

This initial application of the applicable percentage illustrates the gradual phase-out of the entire deduction throughout the phase-in range, as no QBI deduction is allowed for SSTBs if a taxpayer’s income exceeds the upper threshold.

Other than this additional calculation, the allowable Qualified Business Income Deduction for Georgina’s SSTB will be identical to the calculation of allowable QBID for a qualifying business:

20% of allowable QBI
Less: W-2 wage limitation
Excess over wage limitation
x Applicable percentage
Excess deduction allowed
Plus: W-2 limitation
Allowable QBID
$8,000
($2,000)
$6,000
x 40%
$2,400
$2,000
$4,400

Step 3 – Combined Qualified Business Income Deduction

In this step, we must add up all allowed QBI deductions for each business entity owned by the joint taxpayer:

Tim’s partnership allowable QBID
Georgina’s partnership allowable QBID
Combined allowable Qualified Business Income Deduction
$11,000
$4,400
$15,400

Step 4 – Overall Limitation

After combining all of the allowed QBI deductions, we will subject the combined Qualified Business Income Deduction total to the overall limitation.

Lower of:

Combined QBID allowed
(Taxable income – capital gains)*20%
QBI Deduction
$15,400
$75,000
$15,400

We have also illustrated the calculation of the QBI deduction for Example 2 in the flow chart below (or click here for a PDF):

Garrett Gleim Author

Reviewed by Garrett Gleim

Garrett W. Gleim, CPA, CGMA, leads production of the CPA, CMA, CIA, and EA exam review systems at Gleim. He holds a Bachelor of Science in Economics with a concentration in Accounting from the Wharton School, University of Pennsylvania. He is a member of the American Institute of Certified Public Accountants (AICPA) and the Florida Institute of Certified Public Accountants (FICPA). Also an active supporter of the local business community, Garrett serves as an adviser to several startups. He is an avid pilot and is certified as a flight instructor and commercial pilot.