Who Can Use the 20% Pass-Through Deduction: Learn About the New Treasury Regulations

IRS regulations try to clarify questions about the extremely complex 20% pass-through deduction.

By , J.D.

One of the most significant elements of the Tax Cuts and Jobs Act (TCJA) was a brand new tax deduction for pass-through businesses. Starting in 2018 and continuing through 2025, qualifying business owners can deduct from their income taxes up to 20% of their net business income. (IRC Sec. 199A.) Unfortunately, this is an extremely complex deduction and the TCJA left many questions unanswered about how it was supposed to work. The IRS has issued 246 pages of final regulations that help answer these questions.

Here are some of the main takeaways from these complex regulations.

  1. The Pass-Through Deduction is Only for Legitimate Pass-Through Businesses

To benefit from the pass-through deduction, you must have a legitimate pass-through business. A pass-through business is 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). 

Certain other entities can also qualify for the deduction: publicly traded partnerships, real estate investment trusts (REITs), estates and trusts, and agricultural cooperatives.

Employees do not qualify for the pass-through deduction. The final regulations make it clear that employees cannot get the deduction simply by having their employers reclassify them as independent contractors. The regulations provide that if a worker is reclassified as an employee, but continues to perform the same work directly or indirectly for the hiring firm that they did as an employee, the IRS will presume that the worker doesn't qualify for the pass-through deduction for the next three years. This presumption can be overcome only by convincing the IRS that the worker qualifies as an independent contractor.

For any former employee to get this deduction, the person must be operating a legitimate business, separate from that of the former employer. The IRS common law test is used to determine whether a former employee is a legitimate independent contractor who can qualify for the pass-through deduction. Under this test, a worker is an employee if the hiring firm has the right to control the worker on the job.

  1. The Deduction is Phased Out for Certain Service Businesses

If your business is a "specified service trade or business," (SSTB) and your taxable income is over a threshold amount, your pass-through deduction is gradually phased out. At the top of the of the income range, you get no deduction at all. For 2018, the phase-out range begins at $315,000 in taxable income for marrieds filing jointly and $157,500 for single filers. The phase-out range ends at $415,000 in taxable income for married joint filers and $207,500 for single filers. That is, if your total taxable income is $415,000 (married) or $207,500 (single), you get no deduction. These numbers are adjusted each year for inflation.

There are several specific types of business activities that are SSTBs, and one "catch-all" category. The final regulations help make it clear which business activities are and are not SSTBs. These are shown in the following chart:

Specified Service Trades or Businesses ("SSTB")

Business Activity




Doctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar healthcare professionals (it is not necessary to provide medical services directly to patients)

People who provide services not directly related to medicine, even though they may improve health, such as the operators of health clubs or spas, or people engaged in research, testing, and sale of pharmaceuticals or medical devices


Lawyers, paralegals, legal arbitrators, and mediators

People who provide non-legal services such as printing, delivery, or stenography


Accountants, enrolled agents, return preparers, financial auditors, bookkeepers, and similar professionals

Payment processing and billing analysis

Actuarial Science

Actuaries and similar professionals

Analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events

Performing Arts

Actors, singers, musicians, entertainers, directors, and other professionals who participate in the creation of performing art, including songwriters and screenplay writers

People who broadcast or disseminate video or audio to the public, or maintain or operate equipment or facilities used for performing arts


People who provide professional advice and counsel to clients to assist in achieving goals and solving problems, including government lobbyists

Salespeople and those who provide training or educational courses


Athletes, coaches, team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing

Broadcasters and people who maintain or operate equipment used in athletic events

Financial Services

People providing financial services to clients, including managing wealth, developing retirement or transition plans, merger and acquisition advice, and valuation work--for example, financial advisors, investment bankers, wealth planners, and retirement advisors.


Brokerage Services

Stock brokers

Real estate brokers, insurance brokers

Investment Management

People who receive fees for providing investing, asset management, or investment management services

Real property managers


Traders in securities, commodities, or partnership interests

Farmers or manufacturers who engage in hedging transactions as part of their trade or business

The final regulations are a big win for real estate brokers and agents, insurance brokers and agents, and real property managers who many feared might be covered by the SSTB limitations.

The TCJA includes a final "catch-all" category of SSTB: any business where the principal asset is the reputation or skill of one or more of its owners. Tax experts feared that many people whose business didn't fall within one of the specific categories in the above chart come within the catch-all category—for example, an author, real estate broker, or even an auto mechanic. However, the final regulations very narrowly define the catch-all 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.

This eliminates most people from falling within the catch-all category.

If the same business sells products or merchandise and also provides services that fall within one of the SSTB categories, the business will not be treated as an SSTB so long as less than 10% of the gross receipts of the business come from providing the service. For example, if a business earns $1 million selling computers, and $90,000 providing computer consulting services, it will not be treated as an SSTB. If the business has gross receipts over $25 million, the 10% limit is reduced to 5%. If the 10%/5% thresholds are exceeded, the entire business is treated as an SSTB.

  1. Multiple Businesses Can be Combined for the Pass-Through Deduction

The pass-through deduction is ordinarily determined separately for each pass-through business you own. However, if you own multiple businesses, you have the option of combining them for purposes of this deduction.

At higher income levels (more than $157,500 for singles and $315,000 for married joint filers), the pass-through deduction is based wholly or partly on how much you pay your employees and how much business property you own. Thus, combining multiple businesses can result in a larger pass-through deduction than computing the deduction separately for each business. For example, if one business has lots of profit and few employees and/or property, and another has little profit and many employees and/or property, combining them can result in a larger deduction.

You can combine (aggregate) multiple business only if the same person or group of people own 50% or more of each business for a majority of the year, which must include the last day of the year. None of the businesses may be SSTBs and they must share the same tax year. In addition, at least two of the following requirements must be satisfied:

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

The same people do not need to own an interest in each business that is being combined.

  1. Service Businesses Can't Separate Non-Service Functions

Specified service trade or business owners with taxable income over $207,500 (single) or $415,000 (married filing jointly) get no pass-through deduction. Such service business owners could attempt to separate out business functions that don't involve providing services and establish them as separate pass-through businesses—a process called "cracking." The income earned from the non-service business could then qualify for the pass-through deduction.

For example, the owners of a law firm could purchase a building in a separate LLC and rent it to their law firm. However, the final regulations largely prohibit this strategy. They provide that if a business rents property or provides services to a commonly controlled SSTB, the income received is treated as SSTB income not eligible for the pass-through deduction. Common control exists where the same person or group of people own 50% or more of both businesses. Thus, for example, law firm partners who create a separate business to rent a building to their firm could not apply the pass-through deduction to the rental income received.

  1. Leased Employees Count When Computing the Pass-Through Deduction

At higher income levels, the pass-through deduction is based wholly or partly on how much a pass-through pays its W-2 employees. The proposed regulations provide that a business that leases employees from professional employer organizations (PEOs) may include the W-2 wages paid by the PEO to those employees when calculating the deduction.

  1. Rentals Can Qualify for the Pass-Through Deduction

Real estate rental activities can qualify for the pass-through deduction. To do so, however, they must qualify as a business for tax purposes of the deduction. The final regulations provide that determining whether an activity qualifies as a business for purposes of the pass-through deduction is done under the general rules applicable to all businesses for all tax purposes (IRC Section 162.) Under these rules, an activity is a business if the owner engages in it regularly, continuously, and systematically to make a profit.

The final regulations provide only general guidance on how to determine if a rental activity is a business. Relevant factors include:

  • the type of rented property (commercial real property versus residential property)
  • the number of properties rented
  • the owner's or the owner's agents day-to-day involvement
  • the types and significance of any ancillary services provided under the lease, and
  • the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

Most real estate rental activities qualify as a business, but there are some exceptions. The regulations indicate that real estate rented or leased under a triple net lease is likely not a business. Triple net leases require the tenant to pay for maintenance and insurance as well as rent. They are usually used only for commercial real estate.

Some tax experts question whether a landlord who owns only a few rental units, or only one unit, is in business. The IRS did not answer this question in the final regulations. But previous tax court cases have held that ownership of a single rental property can be a business. And the IRS has agreed with these rulings. However, the IRS has also said that ownership of a single rental property doesn't always constitute a business; it depends on the circumstances.

To help alleviate this uncertainty, the IRS has created a special safe harbor rule for owners of real estate rentals. If the owner and his or her employees, agents, and independent contractors put in at least 250 hours per year providing rental services, the activity will be deemed a business for purposes of the pass-through deduction. (IRS Notice 2019-7.) For details, see "Landlords Must Be In Business to Claim 20% Pass-Through Tax Deduction."

The final regulations provide one exception to the trade or business requirement for rentals: The rental of property to a commonly controlled trade or business is always treated as a business for purposes of the pass-through deduction. To be "commonly controlled," the property must be rented to an individual or pass-through (no C corporation), and the same owner must own 50% or more of both the property and business.

The pass-through deduction is set forth in Internal Revenue Code Sec. 199A. You can access a copy of the IRS final Section 199A regulations at the IRS website. The IRS has also created a FAQ on the pass-through deduction.

  1. Landlords With Suspended Passive Losses Get Relief

Many landlords don't earn a profit from their property every year because of high expenses and the many deductions available, such as depreciation. Complex passive activity loss rules prohibit many landlords from deducting such losses from their nonrental income. Such losses become suspended losses that are carried forward to future years to be deducted from rental income. Landlords with substantial suspended losses from prior years could end up with no net rental income during 2018-2025 when the pass-through deduction is in effect. With no net rental income, they get no deduction. The final regulations give landlords with suspended losses relief by providing that only suspended losses from 2018 and later are taken into account for purposes of the pass-through deduction.

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