What is this new 20% business deduction?
The new 20% business deduction (also called the pass-through deduction, qualified business income deduction, or section 199A deduction) was created by the 2017 Tax Cuts and Jobs Act (TCJA) and is in effect for tax years 2018 through 2025.
This new deduction means that most self-employed taxpayers and small business owners can exclude up to 20% of their qualified business income from federal income tax (but not self-employment tax), whether they itemize or not.
At higher income levels, the deduction may be reduced or eliminated, depending on the nature of the business.
For the purposes of the new deduction, QBI is defined as net business income, excluding:
- Income generated outside the United States
- Investment income
- W-2 compensation paid to an S corporation owner
- Guaranteed payments to a partner
- Income from REITs, publicly traded partnerships, and qualified cooperatives*
*These 3 entities can qualify for the 20% deduction under a different set of rules, the explanation of which is beyond the scope of this article.
This new deduction applies to Schedule C filers (sole proprietorships and other self-employed businesses), LLCs, partnerships, S corporations, and trusts. Corporations are not eligible because they received their own tax breaks under the TCJA.
That said, not every eligible business automatically qualifies for the deduction. In particular, some types of service businesses (SSTBs) are disqualified once their owners' taxable incomes exceed a certain threshold.
The specified service trade or business (SSTB) classification doesn’t come into play as long as total taxable income is under $157,500 ($315,000 if filing jointly). At higher income levels, the deduction for SSTBs is reduced and in some cases, eliminated.
For the purposes of the new 20% deduction, an SSTB is defined as any trade or business that performs services in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Brokerage services (including investment management and investing, trading, or dealing in securities, commodities, or partnership interests)
Engineering and architecture were specifically excluded from the SSTB definition as it relates to this new deduction.
That will depend on the business owner’s total taxable income, which includes nonbusiness income (such as wages, interest, capital gains) as well as business income.
Under $157,500 ($315,000 if filing jointly): The calculation is straightforward — 20% is applied to QBI or taxable income minus capital gains and dividends (whichever is less) to come up with the deduction.
For instance, a taxpayer with $30,000 of QBI, $100,000 in total taxable income, and $5,000 in capital gains would simply apply 20% to their QBI because it’s the lesser of the two amounts ($30,000 vs. $95,000). In this case, they’d get 20% of $30,000 for a $6,000 deduction.
$157,500 to $207,500 ($315,000 to $415,000 if filing jointly): Here’s where things start getting complicated. We’ll explain it below, but rest assured that TurboTax will handle this calculation with ease. Let’s start with a fictitious example so you can follow along.
Jack and Jill are joint filers, and here’s the info they’ll need to calculate their deduction:
- Total taxable income = $400,000
- QBI = $300,000
- 20% of QBI = $60,000
- W-2 wages paid = $50,000
- Unadjusted basis of qualified property = $800,000
- Their business is not classified as an SSTB
They first need to figure their reduction ratio. The formula is:
- (Taxable income – $315,000) ÷ $100,000 for joint filers
- (Taxable income – $157,500) ÷ $50,000 for all others
Jack and Jill’s reduction ratio = ($400,000 – $315,000) ÷ $100,000 = 0.85.
Next, they need to figure their excess amount. It starts with the greater of these 2 amounts:
- 50% of W-2 wages paid, or
- 25% of W-2 wages paid plus 2.5% of the unadjusted basis of qualified property.
For Jack and Jill, these 2 amounts work out to $25,000 and $32,500 respectively. To figure their excess amount, they subtract the greater amount ($32,500) from 20% of their QBI ($60,000) to come up with $27,500.
Now, they plug their numbers into this formula to calculate their deduction:
20% of QBI – (excess amount x reduction ratio)
The deduction for Jack and Jill’s non-SSTB business = $60,000 – ($27,500 x 0.85) = $36,625.
If their business was an SSTB, they would simply apply a special factor (1 minus their reduction ratio, or 0.15) to the above result to calculate their deduction (in this case, 0.15 x $36,625 for a deduction of $5,493.75).
Over $207,500 (over $415,000 if filing jointly)
SSTBs don’t qualify for the deduction. For non-SSTBs, the deduction is the lesser of:
- 50% of the business's W-2 wages paid (or 25% of the W-2 wages paid plus 2.5% of the business's unadjusted basis in all qualified property), whichever is the greater amount
- 20% of QBI.
For illustration purposes, if we reuse the numbers from Jack and Jill’s business, the deduction would be the lesser of:
- $25,000 or $32,500 (whichever is greater)
This works out to a $32,500 deduction.
If all of this sounds complicated, it is, at least at the higher income levels. TurboTax will take care of the calculations and let you know if you qualified and how much of a deduction you’re entitled to.