What Are Special Deductions for Tax Purposes?

In the U.S. tax system, deductions reduce a taxpayer’s taxable income. A separate category known as special deductions exists, established by tax law to target specific policy goals, encourage certain economic activities, or provide relief to particular types of taxpayers.

These special deductions are not universally available; their application depends on the taxpayer’s entity structure and the nature of their income. For instance, certain deductions are designed exclusively for corporate entities to address issues of multiple layers of taxation. Other deductions have been created to provide tax relief to owners of unincorporated businesses.

Corporate Special Deductions

For C corporations, special deductions are a set of subtractions from income claimed after calculating gross profit but before arriving at the final taxable income figure. These are not tied to the direct costs of generating revenue, such as the cost of goods sold or employee salaries. The most well-known of these is the Dividends Received Deduction (DRD), which is intended to mitigate the impact of triple taxation.

Triple taxation occurs when a corporation receives dividends from another corporation in which it holds stock. The first layer of tax occurs when the subsidiary corporation earns a profit. The second layer hits when that subsidiary pays dividends out of its after-tax profit to its corporate shareholder. Without the DRD, a third layer of tax would be imposed when the parent corporation distributes its own profits to its individual shareholders. The DRD provides relief by allowing the corporate shareholder to deduct a portion of the dividends it receives from its own taxable income.

The percentage of the dividend that a corporation can deduct depends directly on its level of ownership in the distributing corporation.

• If the recipient corporation owns less than 20% of the dividend-paying corporation, it can deduct 50% of the dividends received. For example, if a corporation receives $10,000 in dividends from a company in which it owns a 5% stake, it can claim a $5,000 special deduction.
• When the ownership stake is 20% or more, but less than 80%, the deduction increases to 65% of the dividends received.
• In cases where the ownership is 80% or more, such as a parent-subsidiary relationship, the deduction is 100%, effectively eliminating the second layer of tax on dividends paid within the consolidated group.

Another special deduction for corporations is for Net Operating Losses (NOLs). An NOL occurs when a corporation’s allowable tax deductions exceed its gross income for a given tax year, resulting in a negative taxable income. Instead of simply being a zero-income year, this loss can be used to offset taxable income in other years. Current federal rules permit corporations to carry these losses forward indefinitely to future tax years.

There is a limitation on the use of NOLs generated in tax years beginning after 2017. The NOL deduction in any single future year is limited to 80% of the corporation’s taxable income for that year. For instance, if a corporation has a $500,000 NOL from a prior year and generates $200,000 in taxable income in the current year, its NOL deduction is capped at $160,000 (80% of $200,000). The remaining NOL of $340,000 can then be carried forward to subsequent years, still subject to the 80% limitation.

The Qualified Business Income Deduction

The Qualified Business Income (QBI) deduction, established under Section 199A of the tax code, benefits owners of pass-through businesses, where profits are taxed on the owners’ individual returns. Eligible taxpayers include sole proprietors, partners in a partnership, and shareholders of an S corporation. The deduction allows them to subtract up to 20% of their QBI from their taxable income.

Qualified Business Income is the net profit from a qualified domestic trade or business. It does not include certain types of investment income, such as capital gains or dividends. It also excludes reasonable compensation paid to S corporation shareholders or guaranteed payments made to partners for services rendered.

The full 20% deduction is available to any eligible taxpayer whose taxable income before the QBI deduction is at or below a specific threshold. For the 2024 tax year, this threshold is $191,950 for single filers and $383,900 for those married filing jointly. Taxpayers below this income level can take the 20% deduction regardless of the nature of their business. For example, a single consultant operating as a sole proprietorship with $100,000 of QBI and overall taxable income below the threshold would be entitled to a $20,000 QBI deduction.

High-Income Taxpayer Limitations

The rules become more complex for taxpayers with taxable income above these thresholds. For these individuals, two limitations may apply, potentially reducing or eliminating the deduction.

Specified Service Trade or Business (SSTB)

The first limitation relates to whether the business is classified as a Specified Service Trade or Business (SSTB). SSTBs are businesses in fields such as health, law, accounting, consulting, and financial services, where the principal asset is the reputation or skill of its employees or owners. If the business is an SSTB and the owner’s taxable income exceeds the threshold plus a phase-out range ($191,950 to $241,950 for single filers; $383,900 to $483,900 for joint filers), the QBI deduction is phased out and eventually eliminated.

Wage and Property Limitation

For taxpayers with non-SSTB businesses above the income threshold, the QBI deduction becomes subject to a second limitation. The deduction is capped at the greater of two amounts: 50% of the W-2 wages paid by the business, or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property. This limitation ensures that the deduction is tied to businesses that create jobs or make capital investments. Qualified property includes tangible, depreciable property like buildings and equipment used in the business.

Reporting and Claiming Special Deductions

C corporations report the Dividends Received Deduction and the Net Operating Loss deduction on Schedule C of Form 1120, the U.S. Corporation Income Tax Return. On Schedule C, the corporation calculates the DRD and enters any available NOL carryforward. The total from Schedule C is then carried to the main Form 1120 to reduce the corporation’s income.

Owners of pass-through entities claim the Qualified Business Income deduction on their personal income tax return, Form 1040. The calculation of this amount must be supported by an additional form. Taxpayers with taxable income below the statutory thresholds can typically use the simpler Form 8995, Qualified Business Income Deduction Simplified Computation.

Taxpayers with income above the thresholds, or those with more complex situations involving SSTBs, must use Form 8995-A, Qualified Business Income Deduction. This form is more detailed and guides the taxpayer through the wage and property limitations and the SSTB phase-out calculations. The result from either form provides the final QBI deduction figure that is then transferred to the taxpayer’s Form 1040.