What Is the 20% Pass-Through Deduction for Business Owners?

The 20% pass-through deduction, introduced by the Tax Cuts and Jobs Act of 2017, offers a significant tax break for business owners. This provision allows eligible taxpayers to deduct up to 20% of their qualified business income (QBI) from certain businesses, potentially reducing taxable income. Its purpose is to lower the effective tax rate for small business owners, increasing cash flow and encouraging reinvestment.

Qualified Business Income Rules

The Qualified Business Income (QBI) deduction, under Section 199A of the Internal Revenue Code, applies to income from domestic businesses structured as pass-through entities, including partnerships, S corporations, and sole proprietorships. The deduction equals the lesser of 20% of the taxpayer’s QBI or 20% of taxable income minus net capital gains. Capital gains, dividends, and non-business interest income are excluded from QBI. Limitations based on W-2 wages paid by the business and the unadjusted basis immediately after acquisition (UBIA) of qualified property also apply. These factors are especially relevant for businesses with significant capital investments or large workforces.

Eligible Structures

The deduction is specifically designed for pass-through entities, where income is taxed at individual rates on owners’ personal tax returns.

Partnerships

Partnerships, under Subchapter K of the Internal Revenue Code, pass income, deductions, and credits to partners, who report these items on their tax returns. The QBI deduction is calculated at the partner level, with each partner’s share of QBI subject to limitations. Guaranteed payments to partners do not qualify as QBI. Partnerships must also consider the impact of W-2 wage limitations and UBIA of qualified property.

S Corporations

S Corporations pass income to shareholders, who report it on their personal tax returns. The QBI deduction is calculated at the shareholder level. S Corporations are required to pay reasonable compensation to shareholder-employees, reported as W-2 wages, which are excluded from QBI. Structuring compensation and distributions strategically can optimize tax benefits.

Sole Proprietorships

Sole proprietorships report business income directly on the owner’s tax return, typically on Schedule C of Form 1040. The QBI deduction is based on net business income and is subject to the same W-2 wage and UBIA limitations as other pass-through entities. Sole proprietors must carefully distinguish between business and personal expenses to ensure compliance.

Specified Service Trades

Specified Service Trades or Businesses (SSTBs) face additional limitations under the QBI deduction. SSTBs include fields like health, law, and accounting, where the primary asset is the reputation or skill of employees or owners. For SSTBs, the deduction phases out for taxpayers whose taxable income exceeds $364,200 for joint filers and $182,100 for single filers in 2024. Businesses providing a mix of services may explore ways to segment operations to reduce the impact of these limitations. Effective management of taxable income through strategies like income deferral and retirement plan contributions can help mitigate phase-out effects.

Income Threshold Details

Income thresholds play a significant role in determining eligibility for the deduction. For 2024, the threshold begins at $364,200 for married couples filing jointly and $182,100 for single filers, with a phase-out range extending $75,000 and $37,500 beyond these amounts, respectively. Taxpayers below these thresholds qualify for the full deduction without needing to account for W-2 wages or UBIA of qualified property. Those near the threshold may benefit from careful tax planning, including deferring income and maximizing deductible expenses.

Filing Considerations

Claiming the 20% pass-through deduction requires precise attention to tax filing. It is reported on Form 1040, specifically on line 13 of Schedule 1, and involves completing Form 8995 or Form 8995-A, depending on the taxpayer’s situation. Accurate documentation of QBI, W-2 wages, and UBIA of qualified property is essential. Taxpayers with multiple businesses must correctly aggregate or separate income; improper aggregation can result in disallowed deductions or penalties. Consulting a tax professional or using advanced tax software can help ensure compliance and maximize benefits.