What Is the 20 Percent Rule for Business Income?

The “20 percent rule” for business income refers to the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction. Established by the Tax Cuts and Jobs Act of 2017, this provision offers a tax benefit to owners of many small and medium-sized businesses. This is achieved by allowing eligible taxpayers to deduct up to 20 percent of their qualified business income from their taxable income. The deduction is temporary and is set to expire after the 2025 tax year.

Who Qualifies for the Deduction

The Qualified Business Income deduction is for pass-through businesses, where profits are “passed through” to the owner’s personal tax return and taxed at individual income tax rates. This includes sole proprietorships, partnerships, S corporations, and limited liability companies (LLCs). Income earned as an employee or from a C corporation does not qualify for this deduction.

Qualified Business Income is the net profit from a qualified trade or business conducted within the United States. It includes the basic income and loss from business operations but excludes certain types of income like capital gains, dividends, or interest. It also excludes any wages earned as an employee or reasonable compensation paid to S corporation owners.

The taxpayer’s taxable income before the QBI deduction is a determining factor. For the 2025 tax year, the deduction is fully available to individuals with taxable income at or below $197,300 for single filers and $394,600 for those married filing jointly. Taxpayers with income above these thresholds may find their deduction limited or phased out, depending on the nature of their business and other factors. The deduction is available whether a taxpayer chooses to itemize deductions or take the standard deduction.

Calculating the QBI Deduction

For those whose taxable income falls below the established thresholds, the deduction is the lesser of two amounts: 20% of the taxpayer’s qualified business income or 20% of their taxable income after subtracting any net capital gains. For instance, a single filer with $100,000 in QBI and $120,000 in taxable income (with no capital gains) would calculate 20% of QBI ($20,000) and 20% of taxable income ($24,000), taking the lesser amount of $20,000 as their deduction.

When a taxpayer’s income exceeds the thresholds, the deduction is subject to limitations based on two main factors: the amount of W-2 wages paid by the business and the unadjusted basis immediately after acquisition (UBIA) of qualified property. Qualified property includes tangible, depreciable assets like buildings and equipment used in the business. The UBIA is the original cost of the property when it was first placed in service. For these higher-income taxpayers, the deduction is limited to the greater of either 50% of the W-2 wages paid by the business, or 25% of the W-2 wages plus 2.5% of the UBIA of qualified property. The final deduction cannot exceed the overall limit of 20% of taxable income minus net capital gains.

Rules for Specified Service Trades or Businesses

Special rules apply to what the IRS defines as a Specified Service Trade or Business (SSTB). These are businesses in fields where the principal asset is the reputation or skill of its employees or owners. The list of SSTBs includes businesses in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Engineering and architecture are explicitly excluded from this category.

For owners of SSTBs, the QBI deduction is subject to a phase-out and potential elimination if their taxable income exceeds the annual thresholds. As income rises within the phase-out range, the amount of QBI, W-2 wages, and qualified property that can be considered for the deduction is reduced. Once taxable income surpasses the upper limit of the phase-out range, the QBI deduction is completely eliminated for an SSTB. For the 2025 tax year, this upper cap is $247,300 for single filers and $494,600 for joint filers.

Required Tax Forms and Reporting

Claiming the Qualified Business Income deduction requires specific reporting on a taxpayer’s annual income tax return. The IRS has created two distinct forms for this purpose: Form 8995, Qualified Business Income Deduction Simplified Computation, and Form 8995-A, Qualified Business Income Deduction.

Taxpayers generally use the simpler Form 8995 if their taxable income before the QBI deduction is at or below the annual thresholds. This form is for individuals who do not have income from agricultural or horticultural cooperatives and whose situation does not involve the more complex limitations.

Form 8995-A is required for taxpayers whose income exceeds the thresholds or who have more complex business situations, such as being a patron in a cooperative or having income from a publicly traded partnership. This form is more detailed, as it incorporates the calculations for the W-2 wage and qualified property limitations, as well as the phase-outs for SSTBs. After completing the appropriate form, the final QBI deduction amount is entered on line 13 of Form 1040.