Easy Guide: The 20% Pass-Through Deduction for Small Business Owners
For the 2018 tax year, there’s a new tax law in place which offers a 20 percent pass-through deduction for qualifying small business owners and those who are self-employed. Officially called Section 199A of the Tax Cuts and Jobs Act, this deduction can allow you to deduct up to 20 percent of your business income that you report on your personal tax return.
Who qualifies for pass-through deduction?
The qualifications are both simple and complicated at the same time. First, you must have a pass-through entity, which is pretty straight-forward. Second, you must have qualified business income, which is your business’ net profit with certain exclusions. Lastly, it’s also dependent on your income level. If it’s under the limit, it’s considered pass-through income. But, if you’re over the limit, it’s dependent on if your business is classified as a specified service business or not.
You’ll notice the term “pass-through” used often here. Think of it as being able to pass through a door for each qualification you meet. With each door you enter, you’re heading toward being able to claim this 20 percent deduction, which we now call the pass-through tax deduction.
Keep reading below for a breakdown to help you determine if you if qualify under this new, money-saving tax law.
What are the qualified pass-through deduction business types?
Any small business owner who operates a pass-through business can qualify for the pass-through tax deduction. The good news is that the majority of smaller businesses are pass-through entities, which include:
- Sole proprietorship
- S corporations
- Limited liability companies (LLCs)
Therefore, if you work as an employee or your businesses is operated as a regular C corporation, you don't qualify. Also, if you have a “specified service trade or business” that earns over the limit, that will disqualify you, which we’ll get into more detail below.
What is qualified business income?
Qualified business income (QBI) is defined as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” That’s your business’s net profit, but not all business income qualifies. QBI exclusions are:
- Income earned outside the U.S
- Capital gains or losses
- Interest income
- Certain wages and guaranteed payments made to partners and shareholders
If you’re two for two on meeting the above requirements, don’t get too excited yet, because your income level is a huge deciding factor on if you’re entitled to claim this pass-through tax deduction.
What is pass-through income and what are the limits?
If your total taxable income, taking into account your business income plus other income earned in 2018, is at or below $157,500 for single filers or $315,000 for joint married filers, and your business also meets the criteria for pass-through entities and QBR, then you can open the door to the 20% deduction on your taxable business income.
However, if your income is above the limit, then this is where the door gets stuck.
If you’re above the limit for pass-through income tax reform, you may still qualify, but first need to determine if your business classifies as a specified trade or business, which is defined by the IRS as businesses in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Investment management
The full list of professions with detailed inclusions and exclusions can be found here. These specified trades and businesses tend to produce high earnings. Therefore, most individuals who operate businesses in these fields won’t qualify for the tax break, because it disappears once you hit $207,500 total taxable income if you’re single, and $415,000 if you’re married filing jointly.
What pass-through income is eligible for a 199A deduction?
If your income is between $157,500 and $207,500 (single filers) or between $315,000 to $415,000 (joint filers) and you have a specified trade or business, you might be able to claim a reduced pass-through tax deduction.
It’s the same if you own a business with pass-through income that’s not a specified trade or business, and your taxable income tops $157,500 (single filers) or $315,000 (joint filers).
In these cases, the amount of your deduction is based on a calculation taking into account the amount of wages you paid to employees (including yourself), as well as the value of property the business owns. The higher those figures, you’re more likely to qualify for the deduction.
But this is where things can get complicated, so it's best to consult with a tax professional or refer to the IRS regulations if your pass-through status falls into these areas.
If you have no employees or own business property, you get no deduction. The rule is intended to encourage business owners to hire employees and/or buy resources for their business.
What is the Section 199A deduction?
This is the official name for the 20 percent pass-through deduction. If you qualify for the pass-through tax deduction, you can deduct 20 percent of your business profit from your income taxes. To calculate, first determine your taxable income, which is your total income minus all deductions.
How to calculate your Section 199A for pass-through deduction
Let’s say you operate your business as a sole proprietorship, and your company earned $100,000 in QBI, and your total taxable income was $125,000.
Your pass-through tax deduction is 20 percent x $100,000 QBI = $20,000. Therefore, you can deduct $20,000 from your income taxes, and you can pass through the door to owing less money to Uncle Sam.
To assure that you’re not leaving any money on the table when preparing and filing your taxes, make sure you’re claiming all the deductions you’re entitled to by automatically and accurately tracking your business mileage and expenses.
Remember, the more deductions you’re able to take, the less your taxable income will be, and you’ll get to hold onto more of your hard-earned money for yourself or your company.