One of the most important and complicated provisions of the Tax Cuts and Jobs Act provides a tax deduction to owners of a business that qualifies as a pass-through business. The deduction is currently scheduled to last through the end of 2025, although Congress has the authority to extend it to 2026 and beyond if it chooses. A pass-through business is any business that pays no taxes directly. Some common examples include sole proprietorships, partnerships, LLCs, LLPs, and S corporations. “Pass-through” means that any profits or losses from operating the business are passed to the individual owners, who pay taxes on their returns. Most small businesses are operated in this way.
A business owner must have positive taxable income to qualify for a pass-through deduction. Calculating the total taxable income for a year involves taking all of an individual’s taxable income from all sources, including sources other than the business, and then subtracting deductions. The pass-through deduction is capped at 20 percent of a business owner’s total taxable income.
Qualified Business Income
The deduction allows a business owner to deduct up to 20 percent of their qualified business income from each pass-through business. Qualified business income is defined as the net profit that the business receives during the year. This involves calculating the total income of the business and subtracting regular deductions. If your business involves a rental, a real estate investment trust, or a publicly traded partnership, income from any of these business counts as qualified business income. However, qualified business income does not cover any dividend income, interest income, income earned outside the U.S., the salaries of S corporation shareholders, or any guaranteed payments to partners in partnerships or members in LLCs. It also does not include any capital gain or loss.
If you own multiple businesses, and one of them loses money, you will subtract that amount from the qualified business income of any business that is profitable. If your total qualified business income from all of your businesses is zero or less, you will not receive a pass-through deduction. Moreover, your loss will be deducted from any qualified business income that you receive in the following year.
Deduction with Taxable Income Below $321,400/$160,700
As of 2019, if you have $321,400 or less in taxable income, or $160,700 or less if you are single, you will receive a deduction of 20 percent of your qualified business income.
Deduction for Service Providers with Taxable Income Above $321,400/$160,700
If you have more than $321,400 in taxable income, or more than $160,700 if you are single, you will receive a more limited deduction if your business can be classified as a service provider. This generally means that the business involves health, law, accounting, performing arts, athletics, consulting, financial or brokerage services, investment management, securities or commodities trading, or actuarial science. However, even if your business does not fit into one of these categories, it can qualify as a service provider if its principal asset consists of the reputation or skill of an owner or employee.
Owners of businesses that are service providers cannot claim a pass-through deduction if their income reaches $421,400, or $210,700 if they are single. If they have an income between $321,400 and $421,400 (or between $160,700 and $210,700 if they are single), they will receive a pass-through deduction that is less than 20 percent. The formula for calculating the deduction is the same as the formula below for non-service providers, which includes a wage-business property limitation. Once you have used the formula, your deduction will be reduced by 1 percent for every $1,000 that your income exceeds $321,400 (or by 1 percent for every $500 that your income exceeds $160,700 if you are single).
Deduction for Non-Service Providers with Taxable Income Above $321,400/$160,700
Owners of businesses that do not qualify as service providers must calculate their taxable income to determine the extent of their deduction. These business owners are divided into two groups. One group consists of business owners who have a taxable income between $321,400 and $421,400 ($160,700 to $210,700 if they are single), and the other group consists of business owners who have a taxable income greater than $421,400 (greater than $210,700 if they are single).
If you are in the former group, your deduction will be based in part on 20 percent of your qualified business income and in part on the wage-business property limitation. First, you would need to calculate your deduction as though the wage-business property limitation did not apply at all, and then you would need to calculate your deduction as though the wage-business property limitation applied fully. Finally, you would need to subtract the second number from the first number and multiply the result by your phase-in percentage. This is the percentage by which your qualified business income exceeds the $321,400 (or $160,700) threshold. If your qualified business income is $361,400, for example, your phase-in percentage is 40 percent. If your qualified business income is $391,400, your phase-in percentage is 70 percent.
If you are in the latter group, a wage-business property limitation will restrict the deduction. It will be limited to 50 percent of the W-2 employee wages that you paid to your employees, or to 25 percent of those wages plus 2.5 percent of the acquisition cost of your depreciable business property, whichever amount is greater. You will not receive any deduction if you do not have employees or depreciable business property. Depreciable business property means that the property was used to produce income for the business, rather than simply being inventory. The value of this property is calculated according to its original acquisition cost. You can take the 2.5 percent deduction throughout the time that the property depreciates, which must be at least 10 years.