Section 199A Examples: Real-World Scenarios for Pass-Through Entities

The Section 199A deduction, introduced by the Tax Cuts and Jobs Act of 2017, allows certain pass-through businesses to deduct up to 20% of their qualified business income (QBI). This tax break reduces taxable income for small business owners, sole proprietors, and investors in eligible entities. However, eligibility rules and limitations can make it difficult to determine the exact deduction amount in different situations.

Single-Member LLC Example

A single-member LLC (SMLLC) provides liability protection while being taxed as a disregarded entity by default. The owner reports business income and expenses on Schedule C of their personal tax return, with net profit serving as the starting point for calculating QBI.

A freelance graphic designer operating as an SMLLC earns $90,000 in net profit. With no employees or significant depreciable assets, the deduction is based solely on QBI. Since their taxable income is below the 2024 phase-out threshold of $191,950 for single filers ($383,900 for joint filers), they qualify for the full 20% deduction, reducing taxable income by $18,000.

If taxable income exceeds the threshold, additional limitations apply, particularly for specified service trades or businesses (SSTBs) like consulting, law, and healthcare. The deduction phases out completely at $241,950 for single filers ($483,900 for joint filers). Tax planning strategies such as contributing to a retirement account or deferring income can help keep taxable income below the threshold to preserve the deduction.

Partnership Example

A partnership does not pay income tax at the entity level. Instead, each partner reports their share of business income on their personal tax return, making the Section 199A deduction calculation more complex.

A law firm structured as a general partnership with two equal partners generates $400,000 in net income, allocating $200,000 to each partner. Without W-2 employees or significant depreciable assets, the deduction is initially 20% of QBI, or $40,000 per partner. However, since legal services are an SSTB, the deduction phases out if taxable income exceeds $241,950 for single filers. If one partner has additional income pushing them above this threshold, their deduction could be reduced or eliminated, while the other partner, remaining below the limit, retains the full deduction.

For non-SSTB partnerships, such as a furniture-making business, the deduction may be influenced by wages paid to employees and the value of qualified property. If the business earns $600,000 in QBI and pays $200,000 in W-2 wages, the deduction may be capped at 50% of wages, or $100,000. Alternatively, if the business owns $1 million in machinery, the deduction cap could be 25% of wages ($50,000) plus 2.5% of the unadjusted basis of the machinery ($25,000), resulting in a $75,000 deduction. These rules ensure that businesses with payroll or capital investments can still benefit.

S Corporation Example

An S Corporation allows owners to reduce self-employment taxes while still qualifying for the Section 199A deduction. Unlike sole proprietors and partners, S Corp owners split their income between a salary and profit distributions, which are not subject to payroll taxes. However, they must pay themselves a reasonable salary under IRS guidelines.

A marketing consultant who elects S Corporation status generates $250,000 in net income. They pay themselves a salary of $100,000, leaving $150,000 as pass-through profit. Only the $150,000 in profit qualifies as QBI, making the potential deduction $30,000. If taxable income exceeds the phase-out range, the deduction may be subject to wage-based limitations. Since S Corp owners must take reasonable compensation, the W-2 wages they pay themselves can help meet the 50% wage threshold if applicable.

S Corporations must also consider shareholder distributions. If an owner takes excessive distributions while keeping their salary artificially low, the IRS may reclassify some distributions as wages, triggering additional payroll taxes and penalties. Proper documentation and adherence to industry salary standards help avoid scrutiny. Additionally, S Corporations have shareholder restrictions, requiring all owners to be U.S. citizens or residents and limiting the number of shareholders to 100. These rules can impact long-term growth strategies, particularly for businesses considering outside investment.

Rental Property Example

Real estate investors can qualify for the Section 199A deduction if their rental activity is considered a trade or business under IRS guidelines. This determination depends on factors such as regularity, continuity, and the owner’s level of involvement. Passive rental income typically does not qualify, but landlords who actively manage properties and perform substantial services may be eligible.

An investor who owns five residential rental properties generates $120,000 in annual net rental income. If the investor meets the trade or business standard, this income qualifies as QBI, resulting in a $24,000 deduction. If taxable income exceeds the threshold requiring wage and property-based limitations, the deduction may be restricted to 2.5% of the unadjusted basis of qualified property plus 25% of W-2 wages paid. If the investor owns $2 million in depreciable real estate and employs a property manager with $40,000 in wages, the deduction could be capped at the higher of $50,000 (2.5% of $2 million) or $10,000 (25% of $40,000), allowing them to claim the full $24,000 deduction.

Understanding these rules helps business owners and investors maximize their Section 199A deduction while ensuring compliance with IRS regulations.