If you have business income from a partnership, S corporation, or sole proprietorship, beginning in 2018 you are eligible for a new tax deduction equal to as much as 20% of that income. The deduction is known as the Section 199A deduction, qualified business income deduction, or pass-through entity deduction. It was added to U.S. tax law as part of the Tax Cuts and Jobs Act of 2017.
The deduction applies to various entities and businesses, including all “pass-through” entities, in which income from the business is not taxed at the entity level but instead is passed through the entity to be taxed on the business owner’s individual tax return. Those eligible for the deduction include:
Partnerships (including publicly traded partnerships)
Limited liability companies (LLCs) that have elected to be taxed as partnerships and single-member LLCs
Sole proprietorships (which report income on Form 1040 Schedule C)
Real estate investors (who report rental income on Form 1040 Schedule E)
Real estate investment trusts (REITs)
Trusts and estates
The deduction does not apply to C corporations, whose income tax rates were significantly reduced in a separate section of the Tax Cuts and Jobs Act of 2017.
What Income Qualifies?
The 20% tax deduction applies to qualified business income from any of the business types listed above. Qualified business income—a new term defined by the law—is generally all domestic business income of any kind other than investment income (interest, dividends, and capital gains), and can include income from services and rental real estate. It does not include reasonable compensation to an S corporation owner or guaranteed payments for services in a partnership or LLC. That is, W-2 wages of owners/partners are not included in qualified business income, only profit from the business.
Here is an example of how it works: If you own an S corporation that earns a $10,000 profit reported to you on Form K-1, then you will be able to deduct $2,000 on your individual tax return. Or if you are equal partners with three other investors in a real estate partnership having $80,000 of taxable income, then you will be able to deduct $4,000 on your individual tax return.
Note that holding real estate in an entity such as an LLC or incorporating a sole proprietor business is not required to receive the deduction. Rental real estate income reported on Schedule E and sole proprietor business income reported on Schedule C qualify for the pass-through deduction.
What Are the Limits?
This deduction has a couple of limitations. First is an income limitation. The new deduction is limited to 20% of whichever is less: (1) qualified business income or (2) taxable income before the deduction with capital gain income subtracted.
The second limitation involves a complicated set of rules that describe cases in which the deduction might be reduced or eliminated if your taxable income is in a certain range. The so-called phase-out ranges of taxable income are $315,000 to $415,000 for married couples filing a joint tax return and $157,000 to $207,500 for all other filing statuses.
This deduction phase-out works differently depending on whether your business income is from a “specified” service business or any other kind of business. Specified service businesses include any business involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, and any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. Engineering and architecture are specifically excluded from the definition.
If your business meets the definition of a specified service business, then you can take the deduction as long as your taxable income (before the deduction and including capital gains) is below the top of the phase-out range; if it’s above the top of the range, you receive no deduction. For income in the phase-out range, you lose deduction proportionally to the amount your taxable income exceeds the lower end of the range.
If your business is not a specified service business, you will not necessarily lose the deduction if your taxable income exceeds the phase-out range, but your deduction may be limited. If your taxable income is above the phase-out range, then your deduction is limited to the lessor of 20% of your qualified business income or whichever is greater: (1) 50% of the W-2 wages paid by the business or (2) the sum of 25% of the W-2 wages paid by the business and 2.5% of the cost basis at purchase of any depreciable property used in the business. The definition of W-2 wages for this rule includes wages paid to the owners of the business. As with specified service businesses, for income in the phase-out range, you lose deduction depending on how far income extends into the phase-out range.
How Is the Deduction Taken?
The deduction will be reported on your individual tax return. You will follow the flow of a personal tax return as you normally would, reporting adjusted gross income and then subtracting either the standard deduction or itemized deductions to arrive at your taxable income before the Section 199A deduction. Then you will subtract the Section 199A deduction to arrive at your taxable income. Notice that the deduction does not directly reduce your taxes as a credit would; it simply lowers the amount of income on which you are taxed. To find out how much you save in taxes with the new deduction, you will need to multiply the amount of your deduction by the tax rate for your tax bracket.
What Else Is Important to Know?
The law that created the Section 199A deduction is brand-new, and neither the Treasury Department nor the IRS has issued regulations or guidance for taxpayers and tax professionals to understand how the new law will be applied. While the information here represents a general consensus among tax professionals who have studied the new law about how it will work, we are in the early stages of a typically multiyear process to fully understand how the law will be interpreted and which tax-planning strategies will be most effective. Since the information provided on the law may change, be sure to follow developments in this important new area of tax planning.
The Section 199A deduction expires at the end of 2025 unless new legislation to extend it is passed by Congress and signed by the president. The full text of the law creating the Section 199A deduction is available here.