 Hello and welcome to this session in which we will discuss the Qualified Business Income deduction. What is the big idea of the Qualified Business Income deduction? Well, this deduction is part of the Tax Cuts and Jobs Act of 2017. So it's relatively a new deduction. So simply put, it's a deduction giving to certain businesses. Why? For what purpose? The purpose of this deduction is to level the playing field between C corporation, which is the corporation, the regular corporation, and non-corporate taxpayers. Why? Here's why. Starting in 2017, C corporation, they have a flat tax rate of 21%. Well, you can operate your business as a C corporation. You can operate your business as an S corp. You can operate your business as a sole proprietorship or you can be a partner in a partnership. So to level the playing field, since C corporation has a lower tax rate than these form of businesses. Now, what is special about these form of businesses? S corporation, sole proprietorship and partnership. These businesses, what they do is the income flows to the taxpayer and the taxpayer rate could be up to 37%. What does that mean? It means it's unfair. Just because you are operating your business differently from a legal perspective, you will pay more taxes. So what they did, they said, since corporation starting in 2017, they have a flat tax rate of 21%, we should give the other form of businesses a lower tax rate. We're not going to give them a lower tax rate. Let's give them a deduction that's going to lower their taxable income. So we level the playing field between C corporation and other type of businesses. So it allows non-corporate taxpayers, including individuals, partners, and S corporation, partnership and S corporation, they get a K1 about the business information to deduct up to 20% of the qualified business income, which we'll talk about what does that mean in a moment. Now, this provision only temporary from 2018 to 2025, most likely it will be extended permanently, but let's not predict anything. This Congress will decide this. So whoever you vote for will determine what's going to happen to those deductions. The qualified business income deduction is subject to various definitions, limitations, special rules that must be considered when calculating the deduction. And this is what we will learn in this session. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Myles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today. Now, before we proceed any further, I would like to show you exactly on the tax form where the business qualified business deduction goes. It goes right here, qualified business income deduction. You attach form 89.95 or form 89.95 a, but what I want, what I want you to see is it comes after AGI. So this is AGI line, line 11. So it's a deduction from AGI. So simply put, it's a phantom deduction that the government gives you before you get the taxable income. So it's going to lower your taxable income. And for the sake of illustration, let's assume you have 100,000 in AGI. If you have 20,000 in qualified business income, your taxable income is 80,000. Also, you're going to have standard deduction or itemized deduction. And it comes after itemized deduction and standard deduction as well, because it's a deduction from AGI. But this is physically where it's located on the tax form. This way you are familiar with it. It's not threatening to you. Now, if it's a different tax year, it might be line 12 versus 14. But remember, it comes after AGI. What are the general rule? The deduction is the lesser of. So you have to look at two figures and choose the lesser of for that deduction, the lesser of 20% of qualified business income. Now we need to define what is qualified business income or 20% of modified taxable income. We need to define what's modified taxable income. We're going to be defining a lot of terms in this session to understand, to be able to know the language of the QBI, the qualified business income deduction. Now, there are three limitations. Now you're saying 20% but is there limitations? Of course, Congress always introduced limitation. There are three limitations. There's an overall limitation based on the modified taxable income, which we'll discuss in this session, which we'll discuss in this session. There are two other limitations that applies to high income taxpayers, which we'll discuss in the next session. And the third limitation that applies to certain type of service businesses. In a nutshell, simply put, here's how the limitation work. If your modified taxable income below a certain amount, in other words, you don't make a lot of money, you're good to go. The first limitation kicks in when you have a modified taxable income above a certain amount, which we'll see the amount for this year. Then another limitation would apply if you're a high income taxpayer. Once you go through the modified taxable income, you will hit, at some point, you will be considered a high income taxpayer. In addition to that, once you're become a high income taxpayer, they look at the type of business that you operate. Then you have another limitation based on the type of business. Don't worry, we're going to work on these limitations one at a time. What we need to learn from this session are the basic terms. So once we get to the limitation, I don't have to define those terms because we're going to be adding more complication to this, to this issue. Let's put some meat on the second limitation. The second limitation, which is high income taxpayer, so what it is, for 2023, again, once I mention a year, if you're watching this in 2024, 2025, it could be different. So for 2023, as long as you are below 364,200, you're good to go, as long as you don't run a special type of business. And if you're, for all other taxpayer single or others, 182,200. So as long as you're below that limit, you pass this limitation, you're good to go. Now what do we mean by qualified business income? Let's look at the overall limitation. Whatever the case is, the Section 199A deduction, which is the qualified business income deduction, also known as Section 199A, may not exceed 20% of the modified taxable income. Now we need to, we need now to define what is modified taxable income. It cannot exceed that. Well, what's modified taxable income? Modified taxable income is taxable income calculated before taking the qualified business income deduction and after subtracting any net capital gain. Let me show it to you in a formula. Simply put, you will take your taxable income, most likely will be given to you on the CPA exam and an exercise before you take the qualified business income deduction. Then you subtract from it net capital gains. Net capital gains include qualified dividends. Simply put, you'll take your taxable income without taking into account your qualified business income deduction because this is what you want to get minus capital gains minus qualified dividend. You take those out. Why? Because those have a special tax rate, you just take them out. Then you get to modified taxable income. It's as simple as that. So this is what modified taxable income is. Now if it's given to you on the problem, you're lucky. If it's not, you have to compute this. How do you compute it? Taxable income, take out any capital gains, take out any qualified dividend. Easy peasy, good enough. What is a qualified business income? Remember, remember the formula says 20% of qualified business income, 20% of modified taxable income. We kind of took care of modified taxable income. Let's talk about qualified business income. Well, it's a business income, but it's a qualified, it's a business income. What is your business income? Well, it's the difference between your revenues and your expenses, difference between ordinary income and ordinary deduction, which is in the accounting language, revenue minus expenses or revenue minus deductions for taxes, from a qualified trade or business. Now we need to know what is qualified trade or business and you have to operate this qualified trade or business in the US of A as a sole proprietorship, as a partner, as an S corporation. Also, QBI include the taxpayer. So if you're an S corporation or a secret, an S corp or a partnership, well, you would receive a K1 telling you what is your share of income or losses from that business. Now deduction. So when we include deduction, it will include self-employment tax. It will include self-employment health insurance, any deductible to qualified retirement plan. So those are, they are counted as deductions. You can deduct those when you are computing your ordinary income from the business. What is not included in qualified business income? If you have qualified business income, you have to execute qualified business income, execute specific investment type income such as capital gains and capital losses. So when you're computing qualified business income, if there's any capital gains, capital losses, you take them out. Dividend, you take them out. Interest, unless you're in the business of lending, that's a different story. That's a legitimate expense or legitimate revenue, certain investment items. Also, it does not include compensation paid to the taxpayer in relation to any qualified trade or business. So it doesn't include your W2. It doesn't include your guaranteed payment if you are a partner. It doesn't, it does not include those. So qualified business income don't include those. Those are executed. So what is a qualified trade or business? Because notice here, I highlighted the qualified trade or business because the business has to be a qualified trade or business. What is a qualified trade or business? Well, for 2023, it's very, the term is very general, as long as you are making less than 364, 200. So below this critical amount, you're good to go. So because the definition is extensive, they don't, they don't tell you exactly what it is. But as long as you're less than that, you should be a qualified trade or business. So generally, it covers any trade or business, except for employee provided services, which we will discuss later. This is when it comes to the second and the third limitation. So as a result, this deduction is available for any practically most sole proprietorship and dependent contractor because they, they, they have scheduled to see non-corporate owners like of S corporation, partnership and LLCs. Again, it's extensive here, but we're going to see later when your income becomes high, or when you are involved in a specific type of service, specific fields, they're going to start to limited. So this limit you out. So this is where we talk about, so this is basically session two of this recording when we talk about other limitation. What happened if you're a taxpayer with multiple businesses? And that's very normal for entrepreneur. The qualified business income deduction is calculated for each individual business separately. Then we combine them. These separate calculations are combined to form a combined qualified business income amount. Then it's compared to the overall modified taxable income limit. That's the way to illustrate all these concepts start to work a few examples, show you a few examples. We have John, a married taxpayer, runs a general store as a sole proprietary with no employees. Great. In 2023, his qualified business income is 200,000. Simply put, revenues minus deduction on his schedule C is 200,000. That's his qualified business income. And we're going to assume that his business qualify. Nothing special about his business. John's adjusted gross income is 276. Well, if he's making 200,000, why is his AGI 276, he must have other income or his spouses? Well, including his spouse wages means his spouse makes money on the side with no other income or deduction. And they claim the standard deduction of 27,700 for that particular year, which could be different in another year that you are working with. Now John modified taxable income is what? Income minus the standard deduction. We have nothing to worry about. We have no capital gains, no dividend. So modified taxable income is 248,300. Well, good. Now, what is the qualified business income deduction that John qualifies for? Well, it's the lesser of modified business income or qualified business income. We saw that the qualified business income is 200,000. Right here. That's how much he earned from his business times 20% is 40,000. Modified taxable income is 248,300 times 20%. So we'll take the lesser of these two. The lesser of these two is 40,000. All in all, what is John's taxable income? Well, his, what's the John taxable income? It's 248,300. 248,300 that we computed here, which is his taxable income minus the standard deduction, which gave us 248,300. And you remember on the tax return at this point, we will deduct the 40,000. We deduct the 40,000. Remember, the QBI deduction is the last deduction minus this deduction, which will give us 208,300. So that's John's taxable income. And John will pay him and his spouse will pay taxes based on that. Now let's take a look at an example where it involved interest. Let's look at Maggie, a single taxpayer does not itemize her deduction. She runs a sole proprietorship in 2023. Her business earns 150,000 has a deduction of 50,000. Well, simply put, her ordinary income from the business is 100,000. Right. And earned $4,000 in interest income. Maybe she got a bank account and she earned $4,000 from that. With no other income or deduction, her AGI is 150 minus 50 plus 4,000. Her AGI is 104, which is the business revenue minus the business deduction plus the interest income. Now Maggie qualified business income. The income from her business is 100,000. We don't count the interest because the interest is a separate thing. Now her modified taxable income is her AGI meant minus the standard deduction. We don't have to back out anything because you don't back out the interest to come up to modified taxable income. Why? What do you back out? You back out any qualified dividend, any long term capital gain. So we're keeping this example simple. So now we know her modified taxable income. We know her qualified taxable income. Take this times 20%, take this times 20% and tell me which one is the lower of the two. We'll take 100,000 times 20% is 20,000. 90,000 150 times 20% is 18,030. Which one, the lower of the two? 18,030. Well, we're going to take, I'm going to do the whole thing. AGI 104, then she deduct her standard deduction, 13,850. She will come up to 90,015. Now it's time to deduct that last phantom deduction of $18,030 to come up to her taxable income of 72,0120. Maggie's taxable income is 72,120. Now we're going to take this example and change it a bit. We're going to assume the 4,000 is not interest. The 4,000 was qualified dividend. Whether it's a qualified dividend or capital gain, net capital gain, well, it's going to be treated differently. So the 4,000, it's not interest. She received 4,000 of qualified dividend. Her AGI will stay the same, which is from her business, 150 minus 100,000 of ordinary expenses, I'm sorry, minus 50,000 of ordinary expenses plus 4,000 of dividend, right? 104. Taxable income before AGI, it is 104 minus, which is the same, 104 minus the standard deduction, 90,015. Now when we compute her modified taxable income, what do we have to do? We have to back out, then what I have here in quote, net capital gains, it's dividend. Whether it's dividend or net capital gains, we have to back them out. Therefore, her MTI, her modified taxable income is 86,150. We multiply this by 20%. We multiply her business income, which is business income 100,000 times 20% and we'll use the lower of the two. So Maggie's qualified business income deduction is the lesser of 20,000, 100,000, which is qualified business income times 20%, or her modified taxable income times 20%. The lower of these two, the lower of these two is 17,230. So Maggie's taxable income, we're going to take 90,150, which is right here, minus the QBI deduction, which comes up to 72,920,000. So in this session, what I did is I went through the fine, very important terms. What is a qualified business income? What is modified taxable income? What is a qualified business, which is very extensive. Now, in the next session, we're going to start to say, hold on a second, now we're making too much money, and we're making too much money, and we belong to a certain group of businesses, which also would limit us. And this is what we'll discuss in the next session. So simply put, as long as you're below 364,200, Mary Fallon Joly 182,100 for year 2020, 2023, right, for the year 2023, you're in good shape until you go into the second limitation, which we'll talk about. What should you do now? Go to far hat lectures, look at additional lectures, MCQs through false additional resources that's going to help you understand this concept, qualified business income deduction is confusing for many students CPA candidate enrolled agent. I hope I can help you invest in yourself. Good luck and stay safe.