The 20% Pass-Through Tax Deduction for Business Owners

The Tax Cuts and Jobs Act created a qualified business income (QBI) deduction for pass-through business entity owners to deduct up to 20% of their business income.

By , J.D. · USC Gould School of Law
Updated by Amy Loftsgordon, Attorney · University of Denver Sturm College of Law

The Tax Cuts and Jobs Act (TCJA), the massive tax reform law that took effect in 2018, established a new tax deduction for owners of pass-through businesses, such as sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and limited liability partnerships (LLPs). The "qualified business income" (QBI) deduction allows certain business owners to deduct up to 20% of their QBI.

This deduction began in 2018 and is scheduled to last through 2025. So, it will end on January 1, 2026, unless Congress extends it.

What Is the 20% Qualified Business Income (QBI) Deduction?

Pass-through owners who qualify can deduct up to 20% of their net business income from their income taxes, reducing their effective income tax rate by 20%. This deduction is commonly known as the "qualified business income deduction" or "QBI deduction."

This deduction can really add up. For example, if you have $100,000 in pass-through income, you could qualify to deduct $20,000, reducing your income taxes by a whopping $4,400 if you're in the 22% income tax bracket.

Clearly, all small business owners need to understand this complex deduction.

What Businesses Qualify for the QBI Deduction?

You must have a pass-through business to qualify for this deduction. A "pass-through business" is any business that is owned and operated through a pass-through business entity, which includes any business that is:

  • a sole proprietorship
 (a one-owner business in which the owner personally owns all the business assets)
  • a partnership
  • an S corporation
  • a limited liability company (LLC), or
  • a limited liability partnership (LLP).

What Is a Pass-Through Business?

For tax purposes, what distinguishes these types of businesses is that they pay no taxes themselves. Instead, the profits (or losses) from such businesses are passed through the business, and the owners pay tax on the money on their individual tax returns at their individual tax rates.

The vast majority of smaller businesses are pass-through entities. Indeed, over 86% of businesses without employees are sole proprietorships.

What About C Corporations?

Regular "C" corporations don't qualify for this deduction. However, they do qualify for a low 21% corporate tax rate on all their income. Unlike the pass-through deduction, the 21% rate for C corporations is permanent under the TCJA.

You Must Have Qualified Business Income

Again, individuals who earn income through pass-through businesses may qualify to deduct from their income tax an amount equal to up to 20% of their "qualified business income" (QBI) from each pass-through business they own. (IRC Sec. 199A).

What Is QBI?

QBI is the net income (profit) your pass-through business earns during the year. You determine this by subtracting all your regular business deductions from your total business income. QBI includes rental income so long as your rental activity qualifies as a business (as most do).

It also includes income from publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.

What Is Not Considered QBI?

QBI doesn't include:

  • short-term or long-term capital gain or loss—for example, a landlord would not include capital gain earned from selling a rental property
  • dividend income
  • interest income
  • wages paid to S corporation shareholders
  • guaranteed payments to partners in partnerships or LLC members, or
  • business income earned outside the United States.

How to Determine Your QBI

QBI is determined separately for each separate business you own. If you own multiple businesses that aren't service businesses listed below, you have the option of combining them into one for the deduction, but only if at least two of the following requirements are satisfied:

  • the businesses provide products or services that are the same or customarily offered together or

  • the businesses share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources or

  • the businesses are operated in coordination with, or reliance upon, one or more of the businesses in the combined group.

If one or more of your separate businesses lose money, you deduct the loss from the QBI of your profitable businesses. If you have a qualified business loss—that is, your net QBI is zero or less—you get no pass-through deduction for the year. Any loss is carried forward to the next year and is deducted against your QBI for that year.

Example. This year, George earned $20,000 in QBI from his Bitcoin mining business and had a $50,000 loss from his separate bakery business. He had a $30,000 qualified business loss, so he gets no pass-through deduction for the year. The $30,000 loss must be carried forward and deducted from his QBI in the following year or years.

How Do I Calculate My QBI Deduction?

To determine your pass-through deduction, you must first figure your total taxable income for the year (not counting the pass-through deduction). This is your total taxable income from all sources (business, investment, and job income) minus deductions, including the standard deduction ($13,850 for singles; $27,700 for marrieds in 2023).

You Must Have Taxable Income

You must have positive taxable income to take the pass-through deduction. Moreover, the deduction can never exceed 20% of your taxable income.

Example. Larson earned $100,000 in profit from his consulting business in 2023. He had no other income and took the standard deduction. His taxable income is $86,150 ($100,000 – $13,850 standard deduction = $86,150). Even though Larson had $100,000 in QBI, his pass-through deduction can't exceed 20% of $86,150, or $17,230. If Larson had $13,850 in additional nonbusiness income, he would have had $100,000 in taxable income and qualified for the full 20% of QBI deduction, or $20,000.

20% Deduction for Taxable Income Below Annual Threshold

How the pass-through deduction is calculated depends on whether your taxable income (QBI income plus other taxable income) exceeds an annual threshold that is adjusted for inflation each year.

Deduction for Taxable Income Up to $182,100 ($364,200 if Married)

For 2023, the threshold is taxable income up to $364,200 if married filing jointly, or up to $182,100 if single. If your income is within this threshold, your pass-through deduction is equal to 20% of your qualified business income (QBI). This is the maximum possible pass-through deduction.

Example. Tommy is single and operates his public relations business as a sole proprietorship. His business earns $100,000 in qualified business income during 2023. He also earned $33,850 in investment income and took the $13,850 standard deduction. His total taxable income for the year is $120,000 (($100,000 + $33,850) – $13,850 = $120,000). His pass-through deduction is 20% x $100,000 = $20,000. He may deduct $20,000 from his income taxes.

If your taxable income is within the thresholds, that's all there is to the pass-through deduction. You can stop reading.

Deduction for Income Above the Annual Threshold

If your taxable income exceeds the annual threshold ($364,200 if married filing jointly; $182,100 if single for 2023), calculating your deduction is much more complicated and depends on your total income and the type of work you do.

Are You a Specified Service Business?

First, you need to determine whether your business falls within one of the following service provider categories:

  • health (doctors, dentists, and other health fields)
  • law
  • accounting
  • actuarial science
  • performing arts
  • consulting
  • athletics
  • financial services
  • brokerage services (not including real estate or insurance brokers)
  • investing and investment management (not including property managers), or
  • trading and dealing in securities or commodities.

A final catchall category includes any business where the principal asset is the reputation or skill of one or more of its owners or employees. IRS regulations narrowly define this catchall category to include only cases where a person:

  • receives fees or other income for endorsing products or services

  • licenses his or her image, likeness, name, signature, voice, or trademark, or

  • receives fees or other income for appearing at an event or on radio, television, or another media format.

Architecture and engineering services are expressly not included in the list of personal services.

Pass-through owners who provide personal services aren't favored under the pass-through deduction. Indeed, they lose the deduction entirely at certain income levels. No such limitations apply to pass-through owners who don't provide personal services.

Deduction for Non-Service Providers with Income Over Annual Threshold

If your business isn't included in the list of service providers, how you calculate your deduction depends on how much your taxable income exceeds the annual taxable income threshold ($364,200 if married filing jointly; $182,100 if single for 2023).

Taxable Income $100,000/$50,000 Above Threshold

If you're a non-service provider and your taxable income is $100,000 or more above the income threshold if married filing jointly, or $50,000 if single, your pass-through deduction is fully subject to a W-2 wage/business property limitation. So, if you're married filing jointly, this limitation applies if your taxable income is over $464,200 ($232,100 if you're single). Your maximum possible pass-through deduction is 20% of your QBI, just like at the lower income levels.

However, when your income is this high, your deduction is further limited to the greater of:

  • 50% of your share W-2 employee wages paid by the business, or
  • 25% of W-2 wages plus 2.5% of the acquisition cost of your depreciable business property.

So, you get no deduction if you have neither employees nor depreciable property. This limitation is intended to encourage pass-through owners to hire employees and/or buy property for their business.

The business property must be depreciable long-term property used in the production of income—for example, the real property or equipment used in the business (not inventory). The cost is its unadjusted basis—the original acquisition cost minus the cost of land, if any. The 2.5% deduction can be taken during the entire depreciation period for the property; however, it can be no shorter than ten years.

Example. Hal and Wanda are married and file jointly. Their taxable income this year is $500,000, including $400,000 in QBI they earned from the bar business they own through an LLC. They employed four bartenders during the year to whom they paid $150,000 in W2 wages. They own their bar building. They bought it four years ago for $600,000, and the land is worth $100,000, so its unadjusted acquisition basis is $500,000. Their maximum possible pass-through deduction is 20% of their $400,000 QBI, which equals $80,000. However, because their taxable income was over the $464,200 threshold, their pass-through deduction is limited to the greater of (1) 50% of the W2 wages they paid their employees or (2) 25% of W2 wages plus 2.5% of their bar building's $500,000 basis. Item (1) is $75,000 (50% x $150,000 = $75,000); Item (2) is $50,000 (2.5% x $500,000) + (25% x $150,000) = $50,000. Item (1) is greater, so their pass-through deduction is $75,000.

Many owners of pass-through businesses, especially landlords, have no employees. So, the 25% plus 2.5% deduction is of most benefit to them.

Example. Alex, a single taxpayer, owns a 5-unit apartment building. She earned $250,000 in total taxable income during the year, well over the $232,100 threshold for singles. She has no employees in her rental business. Thus, her pass-through deduction is limited to 2.5% of the unadjusted basis of the long-term property she uses in her rental business. This consists of her building, which she purchased five years ago. Her unadjusted basis in the building (purchase price minus the value of the land) is $500,000. Her pass-through deduction is 2.5% x $500,000 = $12,500.

Taxable Income Less Than $100,000/$50,000 Over Threshold

If your taxable income is less than $100,000 over the threshold if you're married filing jointly, or $50,000 if you're single, the W2 wages/property limitation is phased in. For 2023, this applies if your taxable income is $364,201 to $464,200 if married filing jointly or $182,101 to $232,100 if single. In this event, only part of your deduction is subject to the W2 wage/property limit, and the rest is based on 20% of your QBI.

The phase-in range is $100,000 for marrieds, and $50,000 for singles. At the top of the range ($464,200 for marrieds, $232,100 for singles), your entire deduction is subject to the W2 wages/business property limit. If you have no W2 wages or business property, you get no deduction.

To calculate the phase-in, first, determine what the amount of your deduction would be if the W2 wages/property limit didn't apply at all—this is 20% x your QBI. Next, calculate your deduction as if the W2 wages/property limit applied in full. Your phase-in amount is based on the difference between these two calculations multiplied by your phase-in percentage.

Example. Sid and Nancy are married and operate an equipment rental business as an LLC. Their QBI this year is $394,200, and the business pays $100,000 in W-2 wages and owns no property. Their phase-in percentage is 30% because their $394,200 QBI is $30,000 over the $364,200 limit ($30,000 ÷ $100,000 phase-in range = 30%). Their deduction if the W-2 wages/property limit didn't apply would be 20% of their $394,200 QBI, which equals $78,840. Their fully limited deduction based on W-2 wages is $50,000 (50% of $100,000 W-2 wages = $50,000). They should lose 30% of the difference between the full deduction of $78,840 and the fully limited deduction of $50,000. The difference amounts to $8,652 (30% x ($78,840 – $50,000) = $8,652). Thus, they should lose $8,652 from the full $78,840 deduction. Sid and Nancy can take a $70,188 pass-through deduction on their return. Had their QBI been $464,200, their phase-in percentage would have been 100%, and their total deduction limited to 50% of their W-2 wages, or $50,000.

Deduction for Service Business Owners with Income Over Threshold

If your business involves providing personal services, and your taxable income is over the $364,200/$182,100 thresholds, your pass-through deduction is gradually phased out up to $464,200/$232,100 of QBI.

At the top of the income range, you get no deduction at all. That is, if your total income is more than $464,200 if you're married, or $232,100 if you're single, you get no deduction. This was intended to prevent highly compensated employees who provide personal services—lawyers, for example—from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction. There is no such phase-out of the entire deduction for nonservice providers.

To calculate your deduction, you start by using the same formula as for non-service providers discussed above. Your maximum possible deduction is 20% of your QBI. However, your deduction may not exceed the greater of:

  • 50% of your share of W-2 employee wages paid by the business, or
  • 25% W-2 wages plus 2.5% of the acquisition cost of depreciable property used in the business.

Thus, if you have no employees or depreciable business property, you get no deduction.

Next, you calculate the phase-out of the deduction. If you have employees or property, your deduction is phased out by 1% for every $1,000 your income exceeds the $364,200 threshold. When your income reaches $464,201, you get no deduction. If you're single, your deduction is reduced by 2% for every $1,000 your income exceeds the $184,100 threshold, and you get no deduction if your income reaches $232,101.

Example. Mark is married and files jointly. He earned $394,200 in taxable income in 2023. His sole proprietorship consulting business earned $494,200 and paid $100,000 to employees. Consulting is one of the specified service businesses, so his pass-through deduction is subject to the phase-out. His $394,200 taxable income is $30,000, or 30%, over the $364,200 threshold. Before the phase-out, his deduction is limited to 50% of the W-2 wages he paid, which was $50,000 (50% x $100,000 W-2 wages = $50,000). Because his phase-out percentage is 30%, he gets 70% of the full deduction, or $35,000 (70% x $50,000 = $35,000).

Taking the QBI Deduction

The pass-through QBI deduction is a personal deduction you may take on your Form 1040 whether or not you itemize. It is not an "above the line" deduction on the first page of Form 1040 that reduces your adjusted gross income (AGI). Moreover, the deduction only reduces income taxes, not Social Security or Medicare taxes.

Get More Information

For more information on this and other tax issues for small businesses, get Deduct It! Lower Your Small Business Taxes, by Stephen Fishman (Nolo).

If you need more help, talk to a tax professional, such as a certified public accountant or a tax attorney. A tax professional can prepare tax returns or provide tax information, guidance, or representation before the IRS.

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