Congress enacted the 20 percent business deduction beginning in 2018 to coincide with the tax rate reduction provided to corporations. The 20 percent business income deduction effectively reduces the maximum tax rate on an individual’s business income to 29.6 percent (80 percent of the maximum income tax rate of 37 percent). The business income deduction is not allowed when calculating self-employment income. The business income deduction is limited to 20 percent of taxable income.
WHAT IS BUSINESS INCOME?
The Internal Revenue Code allows individuals to deduct 20 percent of business income in computing taxable income. For sole proprietors, business income is calculated as the amount reflected on schedule C adjusted for items discussed below. Business income includes income from rental real estate properties if the taxpayer spends at least 250 hours per year managing and maintaining the rental properties.
For sole proprietors, business income is calculated as the amount reflected on schedule C less the self-employed health insurance deduction, the deductible portion of the self-employment tax, and pension plan contributions related to the taxpayer’s business. Business income does not include income from the sale of business assets treated as long-term capital gains.
CALCULATION OF BUSINESS INCOME DEDUCTION
An example of the calculation of the business income deduction is as follows:
John and Mary file a 2022 joint return and have taxable income of $300,000 before calculating the business income deduction. Mary’s business income is $280,000. The business income deduction allowed on their joint tax return is calculated as the lesser of 1) 300,000 x 0.2 = $60,000 or 2) $280,000 x 0.2 = $56,000. The business income deduction allowed on John and Mary’s joint tax return is $56,000.
In the above example the business income deduction is not limited by taxable income. If a taxpayer’s only source of income is derived from a sole proprietorship, the business income deduction will be limited to 20 percent of taxable income because the taxpayer is entitled to a standard deduction available to all taxpayers.
HIGHER INCOME TAXPAYERS
The business income deduction for higher income taxpayers is either phased out or limited. For service businesses, the business income deduction is reduced or eliminated. For non-service businesses, the maximum business deduction is subject to additional limitations based on wages paid by the business and the cost of property used in the business.
Service businesses include businesses providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, and athletics. Businesses providing financial and brokerage services, investing services, and trading and dealing in securities are also considered service businesses under the business income deduction rules.
For taxpayers operating a service business, the business income deduction is reduced if taxable income is between $170,050 and $220,050 for single filers and between $340,100 and $440,100 for joint filers. For taxpayers operating a service business the deduction is eliminated for single individuals with taxable income exceeding $220,050 and for married individuals filing a joint return with taxable income exceeding $440,100. The phase-out ranges are applicable to the 2022 tax year and are adjusted annually for inflation.
For taxpayers operating non-service businesses, the business income deduction is not eliminated but additional limitation apply. For single individuals with taxable income exceeding $220,050 and for married taxpayers filing a joint return with taxable income more than $440,100 the 20 percent business deduction is limited based on the rules discussed above and is further limited to the greater of 50 percent of wages paid or 25 percent of wages paid plus 2.5 percent of the cost of property used in the taxpayer’s business.