The 20% deduction for pass-through business income has been a crucial benefit for many business owners since its implementation through the Tax Cuts and Jobs Act (TCJA) in 2017. This tax incentive allows business owners to significantly reduce their tax burden, a benefit that has been especially valuable for small businesses in San Fernando City, CA. However, this deduction is set to expire at the end of 2025, creating uncertainty among local entrepreneurs. In this blog, we will break down the key details of the deduction and its potential impact on the business community.
1. What is the Qualified Business Income (QBI) Deduction?
The QBI deduction allows owners of pass-through businesses to deduct up to 20% of their qualified business income (QBI). This benefit was designed to equalize tax rates for small businesses with those of corporations, which enjoy a fixed tax rate of 21%. The QBI deduction applies to various types of business entities, including partnerships, S corporations, and LLCs. To qualify, the income must be considered “qualified,” and there are specific rules about how it is calculated and which incomes are eligible.
Importance of the QBI Deduction
Since its introduction, the QBI deduction has provided relief for many small business owners. It enables entrepreneurs to reduce their taxable income, resulting in lower taxes owed. For many small businesses, this can mean a significant difference in cash flow and the ability to reinvest in their operations.
2. Who Qualifies for the QBI Deduction?
To benefit from the QBI deduction, the business must be a pass-through entity. This includes structures such as:
- Sole proprietorships: Where the owner is responsible for all tax obligations and reports income on their personal return.
- Partnerships: Where income is distributed among partners and reported on their individual returns.
- S corporations: Which allow income and losses to pass through to shareholders to avoid double taxation.
- LLCs and LLPs: Which offer flexibility in structure and income distribution.
Exceptions to the Rule
It is important to note that C corporations are not eligible for this deduction, limiting its scope primarily to small and medium-sized business owners. This difference may influence how owners choose to structure their businesses to maximize tax benefits.
3. How is the QBI Deduction Calculated?
The deduction is based on the business’s net income, determined by subtracting regular business deductions from total income. For the year 2023, owners earning less than $182,100 (or $364,200 if married) can deduct up to 20% of their QBI without additional complications.
Example Calculation
Consider a small business owner in San Fernando City with a QBI of $100,000. If their total taxable income is $120,000, they may qualify for a deduction of up to $20,000. This not only reduces their taxable income but also decreases their overall tax burden, allowing the entrepreneur to reinvest in their business or use those funds for other expenses.
However, those whose incomes exceed established thresholds will face limitations based on salaries paid to employees and the value of depreciable properties. For example, if an LLC owner in San Fernando City has an income of $400,000, their deduction will be limited by the salaries they pay to employees and the depreciation of any property used in the business.
4. The Imminent Expiration of the QBI Deduction
Without legislative changes, the QBI deduction will expire as of January 1, 2026. This outlook has raised significant concerns among business owners, who fear that the elimination of this tax benefit will lead to a drastic increase in their tax burden. According to experts like Howard Gleckman from the Urban-Brookings Tax Policy Center, “it’s something that is very important for many private businesses.”
Impact on the Business Community
The potential disappearance of this deduction will affect a considerable portion of the business community. With approximately 25.9 million QBI claims in 2021, the removal of this benefit could lead to financial challenges for many local entrepreneurs. This could result in a decline in investment and growth of small businesses, negatively impacting the local economy.
5. Possible Actions and Recommendations
In light of the imminent expiration of the QBI deduction, entrepreneurs in San Fernando City should prepare adequately. Here are some recommendations for navigating this change:
- Consult an Expert: It is essential to speak with a local tax advisor who can provide personalized guidance on how to maximize current deductions and prepare for future changes. A professional can help identify areas where tax structure can be optimized and ensure compliance with all tax regulations.
- Review Business Structure: Ensuring that the business structure is most beneficial for taking full advantage of current tax deductions is key. Considering converting to a pass-through structure if currently operating as a C corporation could be a valuable option.
- Stay Informed: Keeping up with legislative updates and potential extensions to the QBI deduction can help business owners plan their tax strategy. Participating in workshops or seminars on tax and legislative changes can be very beneficial.
- Plan for the Future: It is crucial for business owners to start planning how they will manage their finances if the QBI deduction expires. This may include adjusting budgets, reviewing expenses, and considering other tax strategies that could mitigate the impact of losing this deduction.
