You've already seen that when you expend money, you can then deduct your outlay in whole or in part. It costs you cash to advertise, but then you deduct what you spent. But just being in business as a Schedule C filer may also entitle you to a special deduction called the Qualified Business Income (QBI) deduction. It doesn't require you to spend any money to get it.

This is a personal deduction, not a business deduction, even though it's based on your business income. It doesn't reduce your income on Schedule C. It doesn't reduce your net earnings from self-employment for purposes of self-employment tax (explained in Chapter 11). It doesn't even reduce your gross income like deductions for IRA contributions and the write-off for your self-employed health insurance premiums.

The QBI deduction isn't straightforward. Depending on your taxable income and the business you're in, it can get downright complicated. Here are some key points to note.

General Rules

The QBI deduction is essentially 20% of your eligible business income. This is your net earnings from self-employment (business income minus deductible business expenses) excluding certain items (e.g., interest expense not properly allocable to a trade or business).

Your eligible business income must be reduced by personal deductions related to your business income, including:

• The deduction for one-half of self-employment tax
• The self-employed health insurance deduction
• The deduction for contributions to a self-employed retirement plan (but not an IRA)

The deduction is fairly straightforward as long as your taxable income (this is your adjusted gross income reduced by your standard deduction or itemized deductions) is no higher than a threshold amount (which can be adjusted annually). The threshold amount applicable to you depends on your filing status for the year. If taxable income is more than your applicable amount, limitations discussed next come into play. The taxable income thresholds for 2019 for each filing status are in Table 10.1.

There's a simplified form for figuring the deduction for those with taxable income below the thresholds in Table 10.1, which is Form 8995, Qualified Business Income Simplified Computation. You can find more details in the instructions to the form.

Limitations

If your taxable income exceeds the threshold for your filing status in Table 10.1, then things get more confusing. There are various limitations that come into play. First, there is a special formula used to figure the QBI deduction when taxable income exceeds amounts found in Table 10.1.

The QBI deduction is equal to the lesser of (1) 20% of the business's QBI, or (2) the greater of: (a) 50% of the W-2 wages for the business, or (b) 25% of the W-2 wages plus 2.5% of the business's unadjusted basis in all qualified property (UBIA).

• W-2 wages. This only applies if you have employees. So if you work alone, you have zero W-2 wages (your self-employment income is not wages).
• UBIA (unadjusted basis of property immediately after acquisition). This applies only if you have capital equipment and realty used in the business.

Sounds like gibberish? Too complicated? Just wait. There are more formulas to come. There's a “reduction ratio,” which is the taxable income in excess of the threshold in Table 10.1. And there's an “excess amount,” which is the QBI deduction with no W-2 wages and UBIA and the QBI deduction with W-2 wages and UBIA. These are so convoluted that it's not easy to provide a quick example here. The good news is that software or your tax return preparer will figure this for you, so you may see some benefit from the QBI deduction even though your taxable income exceeds the thresholds in Table 10.1.

Specified Service Trades or Businesses

If your business is a specified service trade or business (SSTB) and your taxable income exceeds the threshold for your filing status in Table 10.1, then an additional limitation comes into play. The amount of QBI and other items that you can take into account in figuring the deduction is reduced or phased out entirely, depending on your taxable income and filing status. Table 10.2 shows the top amount of taxable income you can have before your QBI is completely phased out so that the QBI deduction disappears.

Are you in an SSTB? You very well could be because the term applies to many service businesses. More specifically, an SSTB is any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. The reputation or skill of the owner only comes into play where income is received from endorsements, licensing of your likeness or features, or media and public appearances. SSTBs don't include engineers, architects, or writers. It doesn't apply to tradespeople (electricians, engineers, house painters), dog walkers, or Uber/Lyft drivers.

So, for SSTBs, depending on your taxable income, you may see little or no benefit from the QBI deduction. You have to run the numbers if your taxable income falls between the amounts in Table 10.1 and Table 10.2. But if you're in an SSTB and earn a lot of money, you're penalized for success.

If your taxable income is over the threshold amount in Table 10.1, the QBI deduction is figured on Form 8995-A, Qualified Business Income Deduction. There are four schedules accompanying this form. You can learn more about the QBI deduction in the instructions to the form.

What's Ahead

You've done all you can do to report your income and take the write-offs—deductions and credits—to which you are entitled. Now comes the challenging part of dealing with other tax responsibilities. If you have a profit, you owe self-employment tax. If you've been very successful, you may have additional Medicare taxes. What's more, because you aren't subject to withholding on wages, you have to pay your income tax and other taxes through estimated taxes. These subjects are discussed in the next chapter.