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REG CPA Practice Questions Explained: How to Calculate the QBI Deduction

How to Calculate the QBI Deduction

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In this video, we walk through 5 REG practice questions demonstrating how to calculate the QBI Deduction. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.

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How to Calculate the QBI Deduction

The Qualified Business Income (QBI) deduction is a tax deduction for eligible self-employed individuals, partnerships, S corporations, trusts, and estates engaged in qualified trades or businesses (QTBs). Here’s a detailed overview:

Qualified Trade or Business (QTB): A Qualified Trade or Business (QTB) under Section 199A of the Internal Revenue Code is broadly defined as any trade or business except for the trade or business of performing services as an employee. A QTB typically includes any for-profit activity that is regular and continuous. Most businesses that are not specifically excluded as a Specified Service Trade or Business (SSTB) will fall under this category. The income from a QTB is eligible for the QBI deduction subject to certain limitations.

Specified Service Trade or Business (SSTB): An SSTB is a trade or business that involves the performance of services in specified fields. These fields include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. For SSTBs, the eligibility for the QBI deduction is subject to income thresholds and phase-outs, which can reduce or eliminate the deduction based on the taxpayer’s taxable income.

Basic QBI Deduction: The QBI deduction generally allows eligible taxpayers to deduct up to 20% of their qualified business income from a QTB or their share of income from a pass-through entity. This deduction is taken on the taxpayer’s personal tax return and is available whether the taxpayer itemizes deductions or takes the standard deduction.

General QBI Limit: The QBI deduction has an overall limitation based on the taxpayer’s taxable income. If a taxpayer’s taxable income before the QBI deduction is below a certain threshold (which varies based on filing status), they can take the lesser of all deductions on their qualified business income OR 20% of taxable income less net capital gains. However, once the taxpayer’s taxable income exceeds this threshold, other limitations may apply.

Limitations for QTBs Over the Threshold:

For QTBs, when a taxpayer’s taxable income exceeds the threshold amount, the QBI deduction is subject to additional limitations which are phased in:

W-2 Wages and Qualified Property Limitation:

  • The deduction may be limited to the greater of 50% of the W-2 wages paid by the business or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property used in the business.
  • This limitation ensures that businesses with substantial labor or capital investments can still benefit from the deduction, even when income is high.

    Limitations for SSTBs Over the Threshold:

    The limitations for SSTBs, such as businesses in health, law, consulting, and other specified services, are stricter once the taxable income exceeds the threshold:

    Phase-Out Range:

    • For SSTBs, if the taxpayer’s taxable income falls within a certain phase-out range above the threshold, the QBI deduction is gradually reduced.
    • The deduction decreases incrementally within this range and is eventually reduced to zero.

    Above the Phase-Out Range:

    • For incomes exceeding the phase-out range, the QBI deduction is completely disallowed for SSTBs. No deduction can be taken regardless of the business’s W-2 wages or qualified property.

      Key Points to Remember:

      • The specific thresholds and phase-out ranges are adjusted annually for inflation.
      • The QBI deduction does not reduce self-employment tax or net investment income tax.

      In essence, the QBI deduction can be a significant tax benefit for small business owners and eligible pass-through entities, but it requires careful attention to income levels and the type of business income to determine the correct deduction amount.

      Example:

      Sarah operates a graphic design business as a sole proprietor. For the tax year, her business reports a net profit of $100,000. This net profit represents her qualified business income. She has no other significant deductions or complex financial situations to consider.

      Calculation of QBI Deduction:

      1. Determine Qualified Business Income (QBI): Sarah’s QBI is the net profit from her business, which is $100,000.
      2. Calculate 20% of QBI: The QBI deduction allows for a deduction of up to 20% of the QBI. So, 20% of $100,000 equals $20,000.
      3. Apply the Deduction: Sarah can deduct $20,000 from her taxable income on her personal tax return.

      Result: With a QBI deduction of $20,000, Sarah’s taxable income can potentially be reduced from $100,000 to $80,000, leading to lower overall tax liability for the year.

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