Formally known as the Section 199A deduction, the “pass-through” deduction allows many sole proprietorships, partnerships, S corporations, trusts, or estates to deduct up to 20 percent of their qualified business income. Taxpayers who are eligible can also deduct up to 20 percent of their qualified real estate investment trust (REIT) dividends and publicly traded partnership income. Though this is a great opportunity for eligible taxpayers, it is important to understand the various nuances of this deduction so you avoid future impacts to your business.
Determine whether you are a “pass-through” entity
As the name implies, the passthrough deduction is for individuals that report their business income on their personal returns. These entities include:
- Sole proprietorships
- S corporations.
- Limited liability companies (LLCs)
- Any S-corporation, trust, or partnership that owns interest in a “pass-through” entity
Determine whether you’re involved in a Qualified Trade or Business
The qualification for claiming the “pass-through” deduction is being involved in a qualified trade or business. According to Section 199A, any business or trade is eligible for the “pass-through” deduction, except for trades or businesses in which you perform services as an employee or any trades or businesses specified as excepted by the IRS.
Specified service trades or businesses (SSTB) are defined as any “trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owner (IRS.gov).” It’s important to note that this SSTB exception only applies if your taxable income exceeds the taxable income thresholds of $315,000 (for married taxpayers filing jointly) or $157,500 (for all other taxpayers).
Review your Qualified Business Income
After establishing whether or not you are involved in a qualified trade or business (and beneath the appropriate income threshold), you then need to determine your qualified business income (QBI). Qualified business income is basically the net income from any qualified business or service trade. Caveats to QBI are that the qualified items must be accounted for within the tax year and that the net income and its associated items (gains, losses, etc.) must be connected with the operation of a business or trade within the United States.
Items that are excluded from qualified business income are:
- Capital gains or losses
- Dividends or dividend-equivalent amounts
- Interest income that isn’t properly allocable to a trade or business
- Net income from transactions involving foreign currency or commodities
- Income from notional principal contracts
- Amounts from annuities that aren’t received in connection with a trade or business
- Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered in connection to the trade or business
- Payments, as described in Section 707(a) or – for guaranteed payments – Section 707(c), that are made to a partner for services rendered with respect to the trade or business.
- Any deductions or losses able to be allocated to any of the previous items in this list
Figure out whether your deduction is limited
After verifying the qualification of your business and income, there are two limitations that may affect your deduction amount: the W-2 Wage limitation and the Qualified Property limitation. These limitations only apply to individuals with taxable income (before the QBI deduction) that is within the thresholds mentioned earlier ($315,000 for married taxpayers filing jointly or $157,500 for all other taxpayers).
If your income is above these thresholds, after determining your qualified business income, you are to take the lesser amount between 20% of your QBI and the higher amount of either:
- 50% of the W-2 wages related to the qualified trade or business OR
- 25% of the W-2 wages related to the qualified trade or business plus 2.5% of the unadjusted basis following the acquisition of all qualified property connected to the qualified trade or business
To be clear, the Qualified Property limitation pertains to all tangible and depreciable property that meets the following criteria:
- It’s owned and usable by the qualified trade or business at the end of the tax year
- It was used to produced QBI during the tax year
- Its depreciable period on or following the end of the tax year
Determine your final Qualified Business Income & deduction amounts
After calculating the QBI for each qualified business or trade, you are to consider your final QBI deduction amount as the lesser amount between (a) 20% of your net taxable income amount before the QBI deduction and (b) your combined QBI income from all qualified trades and businesses.