The Tax Cuts and Jobs Act created a deduction for households with income from sole proprietorships, partnerships, and S corporations, which allows taxpayers to exclude up to 20 percent of their pass-through business income from federal income tax. For upper-income taxpayers, the deduction is subject to several limits.
How Does the Sec. 199A Deduction Work?
To determine a household’s pass-through deduction, the following two amounts are compared:
- 20 percent of the household’s eligible business income
- 20 percent of the household’s taxable ordinary income (calculated before taking the pass-through deduction into account)
A household’s pass-through deduction is equal to whichever of these two amounts is smaller. In practice, the calculation of the pass-through deduction can be much more complicated than simply multiplying business income by 20 percent due to rules about what qualifies as business income and other tests.
|Sample Calculations for a Single Filer with $40,000 of Pass-Through Business Income in 2018|
|Without the Pass-Through Deduction||With the Pass-Through Deduction|
|Note: Calculations assume that the filer has no dependents, takes the standard deduction, and has no sources of income other than pass-through business income|
|Business income||$40,000||Business income||$40,000|
|Standard deduction||-$12,000||Standard deduction||-$12,000|
|Taxable ordinary income, computed without regard to the pass-through deduction||$28,000|
|Taxable income||$28,000||Taxable income||$22,400|
|Income subject to the 10% bracket||$9,525||Income subject to the 10% bracket||$9,525|
|Income subject to the 12% bracket||$18,475||Income subject to the 12% bracket||$12,875|
|Tax from the 10% bracket||$952.50||Tax from the 10% bracket||$952.50|
|Tax from the 12% bracket||$2,217.00||Tax from the 12% bracket||$1,545.00|
|Total income taxes owed||$3,169.50||Total income taxes owed||$2,497.50|
|Total Tax Savings from the Pass-Through Deduction:||$672.00|
What Are the Limits?
There are a number of rules that define what income counts as business income. For instance, taxpayers’ income from pass-through businesses is eligible for the deduction, while their income from employment and capital gains is not. In addition, two categories of payments by businesses to owners (reasonable compensation and guaranteed payments) are not allowed to count toward owners’ “business income” for the purposes of calculating the pass-through deduction.
Upper-income households are subject to two additional limits on the pass-through deduction. These thresholds are $163,300 of qualified business income for single taxpayers and $326,600 for married taxpayers filing jointly for tax year 2020.
First, these households are disallowed from counting income from “specified service trades or businesses” (SSTB) in their calculation of the deduction, which includes the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, and dealing in certain assets where the principal asset is the reputation or skill of one or more of its employees or owners, etc.
The second limit (known as the “wage or wage/capital limit”) focuses on whether households receive income from businesses that have engaged in substantial real economic activities—specifically, paying wages and investing in tangible property. Upper-income households may see their pass-through deduction limited if the businesses that they own pay relatively little in wages and have relatively little property.Share