Understanding what constitutes a qualified trade or business under Section 199A is crucial for taxpayers seeking to maximize the Qualified Business Income (QBI) deduction. This provision, part of the Tax Cuts and Jobs Act, allows eligible businesses to deduct up to 20% of their QBI and potentially reduce taxable income significantly.
Qualifying Activities
To qualify for the QBI deduction under Section 199A, the IRS defines a trade or business as any activity engaged in for profit with continuity and regularity. This broad definition includes activities ranging from retail operations to professional services, provided they are conducted with the intent to generate income. However, the IRS enforces guidelines to ensure only legitimate business activities benefit.
Rental real estate can qualify if it rises to the level of a trade or business, and a special safe harbor lets a “rental real estate enterprise” be treated as a trade or business for QBI when specific conditions are met, such as keeping separate books and records, performing 250 hours of rental services, maintaining contemporaneous records, and attaching a required statement to the return. 1Internal Revenue Service. Rev. Proc. 2019-38 (Rental Real Estate Safe Harbor)
Income such as capital gains, most dividends, interest not properly allocable to a business, reasonable compensation paid by an S corporation, and guaranteed payments to partners is excluded from QBI. 2Internal Revenue Service. Qualified Business Income Deduction
Specified Service Trades
Specified service trades or businesses (SSTBs) face particular restrictions under Section 199A. The IRS identifies fields such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services as SSTBs. For these fields, the deduction begins to phase out once taxable income exceeds $191,950 for single filers and $383,900 for joint filers for 2024. Beyond these thresholds, the deduction is gradually reduced until phased out entirely.
High-income earners in SSTBs must carefully manage taxable income. Strategies like income deferral or employing family members can help remain within allowable limits. Determining whether a business qualifies as an SSTB requires a facts-and-circumstances test, which examines the nature of services, the skills of the workforce, and the type of clients served. Businesses may need to document or restructure operations to avoid SSTB classification or comply with the rules governing these trades.
Income Thresholds
Income thresholds determine the extent to which taxpayers can benefit from the QBI deduction. For 2024, the IRS set the threshold at $191,950 for single filers (and all other returns) and $383,900 for joint filers. 3Internal Revenue Service. Instructions for Form 8995 (2024)
Taxpayers near these thresholds should strategically manage taxable income. Tactics such as accelerating expenses, deferring income, or contributing to retirement or health savings accounts can reduce taxable income and preserve eligibility. Businesses must maintain meticulous records and forecast income fluctuations to optimize tax outcomes.
Entity Types
The type of business entity influences how the QBI deduction is calculated and applied. Each entity—sole proprietorships, partnerships, and S corporations—has unique characteristics affecting the deduction.
Sole Proprietorship
Sole proprietors report business income and expenses on their personal tax returns using Schedule C. The QBI deduction is based on net business income after allowable expenses. Sole proprietors must meet the IRS’s definition of a trade or business and account for self-employment taxes, which can affect overall tax liability. Accurate record-keeping and strategic expense management are essential to maximize the deduction.
Partnerships
Partnerships, including LLCs taxed as partnerships, pass income, deductions, and credits to partners, who report these items on their individual tax returns. The QBI deduction is calculated at the partner level based on each partner’s share of qualified business income. Guaranteed payments do not qualify as QBI, so partnerships must carefully coordinate reporting and allocation among partners. Effective communication and planning are key to optimizing tax benefits.
S Corporations
S corporations pass income, deductions, and credits to shareholders. However, reasonable compensation paid to shareholder-employees is subject to payroll taxes and does not qualify as QBI. Balancing salary and distributions is critical to maximizing the deduction while adhering to IRS guidelines. Shareholders must ensure compensation is justifiable and well-documented to avoid scrutiny. Compliance with record-keeping and filing requirements is essential to ensure proper application of the QBI deduction.
Aggregation Elections
Aggregation elections allow businesses with multiple qualified trades or businesses to combine them for QBI deduction purposes. This strategy benefits businesses with shared ownership, common control, or interdependent operations by enabling them to pool income and expenses.
To qualify for aggregation, businesses must show 50% or more common ownership for most of the year (including the last day), none of the businesses can be an SSTB, and the businesses must meet at least two of these factors: offer the same or customarily offered-together products/services; share facilities or significant centralized business elements; or operate in coordination with or reliance on one another. Once elected, aggregation must be consistently applied in future tax years. 4Internal Revenue Service. Instructions for Form 8995-A (2024)
Aggregation impacts deduction calculations, including wage allocation and the unadjusted basis of qualified property. Proper documentation and analysis are critical to substantiate the election and comply with IRS regulations.
Documenting Business Status
Accurate documentation is essential for claiming the QBI deduction. Taxpayers must maintain detailed records to support the legitimacy of business activities and compliance with IRS requirements.
Key records include contracts, invoices, financial statements, and payroll records, which substantiate the business’s active engagement in qualified activities. Documentation of aggregation elections, including ownership details and the rationale for aggregation, is also necessary. Proper record-keeping ensures compliance and provides protection in the event of an IRS audit.