Section 199A Deduction for Pass-Through Business Income: An Overview

Section 199A Deduction for Pass-Through Business Income: An Overview

Updated March 22, 2024
Section 199A Deduction for Pass-Through Business Income: An
Overview
The 2017 tax revision (P.L. 115-97, also known as the Tax
QBI does not include wage income, capital gains,
Cuts and Jobs Act or TCJA) created a temporary deduction
dividends, and interest and annuity income unrelated to a
for qualified pass-through business income (QBI) under
trade or business. It also does not apply to compensation
Section 199A of the federal tax code. The maximum
paid to S corporation shareholders and payments to partners
deduction is equal to the lesser of (1) 20% of a firm’s
for services they perform for their business.
qualified business income (QBI) in a tax year or (2) 20% of
its taxable income without the Section 199A deduction and
Use of the Deduction
any net capital gains. The deduction is scheduled to expire
Use of the deduction hinges on four considerations: (1) a
at the end of 2025.
pass-through business owner’s taxable income, (2) the
nature of the owner’s business, (3) the owner’s share of W-
The Section 199A deduction helps establish parity between
2 wages for the business, and (4) the owner’s share of the
the tax burden on corporate and noncorporate profits. The
unadjusted basis of tangible, depreciable property placed in
TCJA also reduced the corporate tax burden by replacing a
service in the past 10 years.
graduated rate structure with a top rate of 35% under prior
law with a single rate of 21%, a 40% decrease. By contrast,
Taxable income refers to a pass-through business owner’s
the maximum Section 199A deduction lowers the top
AGI less all deductions, except for the Section 199A
effective tax rate on pass-through business profits from
deduction. Owners whose taxable income is at or below the
39.6% to 29.6%, a 25% decrease.
deduction’s lower income threshold ($383,900 for joint
filers and $191,950 for other filers in 2024) may claim the
Pass-through businesses fall into three categories: sole
maximum deduction for any kind of business.
proprietorships, subchapter S corporations, and partnerships
(including limited liability companies electing to be taxed
For owners with taxable income above that threshold, the
as partnerships). In each category, the items of income,
deduction they may claim is subject to two limitations.
loss, gain, and deduction for a business are attributed (or
passed through) to the owners, and any profits are taxed as
One limitation is based on a business’s W-2 wage base and
part of their individual taxable income, regardless of how
stock of tangible capital assets and can be labeled the wage-
the profits are distributed.
and-qualified-property (WQP) limit. A business’s W-2
wage base is the sum total of its wages subject to
By contrast, subchapter C corporation profits are taxed
withholding, elective deferrals, and deferred compensation.
twice: once at the entity level, and a second time at the
A business’s capital stock refers to the unadjusted basis of
owners’ individual level when the profits are distributed to
tangible, depreciable assets it placed in service in the
them as dividends and realized long-term capital gains.
previous 10 years.
Most U.S. businesses are organized as a pass-through
The other limitation is based on whether or not a business
entity. According to Internal Revenue Service (IRS) data,
qualifies as a “specified service trade or business” (SSTB).
pass-through firms accounted for 96% of the 38 million
A SSTB is any trade or business involved in health care,
business tax returns filed for the 2019 tax year; sole
law, accounting, actuarial science, the performing arts,
proprietorships filed 76% of pass-through business returns.
consulting, athletics, financial services, brokerage services,
investing and investment management, trading or dealing in
Current Law
securities, commodities, or partnership interests. A SSTB is
Section 199A allows individuals, estates, and trusts with
also any business whose principal asset is the reputation or
pass-through business income to deduct up to 20% of their
skills of one or more of its employees and/or owners.
QBI in determining their taxable income. Owners of
agricultural and horticultural cooperatives may also claim
The two limitations on the Section 199A deduction phase in
the deduction. Taxpayers may claim the deduction after
if an owner’s taxable income lies between the deduction’s
computing their adjusted gross income (AGI).
lower income threshold and its upper income threshold
($483,900 for joint filers and $241,950 of other filers in
A pass-through business owner’s QBI is the net amount of
2024). Both thresholds are indexed for inflation. Separate
income, loss, gain, and deduction for each qualified
formulas determine the deduction an owner may claim
domestic trade or business he or she owns. Taxpayers who
under each limitation. Owners with taxable income above
own more than one pass-through business are required to
the upper income threshold may claim no deduction for
determine the QBI for each one and combine them to
SSTB QBI; in the case of non-SSTB QBI, an owner may
determine the taxpayer’s total QBI in a tax year.
claim a deduction equal to the larger of 50% of an owner’s
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Section 199A Deduction for Pass-Through Business Income: An Overview
share of a business’s W-2 wage base or 25% of that base
business income outside the United States, which is
plus 2.5% of an owner’s share of the business’s capital
ineligible for the deduction; and (4) they chose not to claim
stock.
the deduction because they did not understand how to
calculate it. The IRS promised to invest more to increase
Three Basic Outcomes
awareness of the deduction among small business owners.
The rules for the use of the Section 199A deduction for QBI
mean that eligible taxpayers face three basic outcomes,
Among the continuing challenges in claiming the deduction
depending on their taxable income.
is determining whether certain business activities qualify
for the deduction. The final regulations (T.D. 9847) for
Outcome 1
Section 199A, issued by the IRS in January 2019, provided
Pass-through business owners with taxable income at or
guidelines for identifying qualifying business income. In
below the 2024 lower income threshold may take the
many cases, a business’s eligibility is likely to hinge on
maximum Section 199A deduction.
relevant “facts and circumstances.”
Outcome 2
Policy Issues
Pass-through business owners with taxable income between
Congress may consider whether to extend and modify the
the 2024 lower and upper income thresholds may take a
Section 199A deduction before it expires at the end of
reduced deduction because they are subject to the SSTB
2025. Analysts point out that there are reasons to retain the
and WQP limits. In the case of taxpayers with SSTB or
deduction (though not necessarily in its current form) and
non-SSTB income only, the allowable deduction depends
reasons to let it expire.
on a pass-through business owner’s “applicable
percentage,” which is the ratio of an owner’s taxable
Proponents of extending the deduction argue that it
income minus the applicable lower income threshold to
provides pass-through firms with a powerful incentive to
$100,000 for joint filers and $50,000 for other filers. This
invest more than they otherwise would by reducing their
percentage is used to calculate a reduction amount, which is
cost of capital for investment in a wide range of tangible
subtracted from a taxpayer’s deduction with no limits to
and intangible assets and increasing their short-term cash
determine the Section 199A deduction an owner may claim.
flow. It is unclear to what extent any rise in pass-through
This calculation is more complicated if an owner has both
business investment since 2018 can be attributed to the
SSTB and non-SSTB income.
Section 199A deduction. It is difficult to disentangle its
investment effects from the pass-through business
Outcome 3
investment effects of the TCJA’s temporary individual
Pass-through business owners with taxable income above
income tax rate cuts and 100% expensing allowance for
the 2024 upper income threshold may claim no deduction
certain capital certain assets placed in service between 2018
for SSTB income. They may claim a deduction for non-
and 2022.
SSTB income that cannot exceed the larger of (1) 50% of
an owner’s share of a business’s W-2 wage base or (2) 25%
Critics of the deduction acknowledge the Section 199A
of those wages plus 2.5% of an owner’s share of the
deduction’s potential for boosting pass-through business
business’s unadjusted basis of qualified property placed in
investment, but they say there are several reasons why it
service in the previous 10 years.
should not be extended beyond 2025. In their view, the
deduction is an inefficient investment incentive because a
Initial Filing Concerns
business can benefit from it without undertaking new
It is estimated that over 90% of pass-through business
investments. Critics also note that the deduction is non-
owners might have qualified for a full or partial Section
neutral in its impact on pass-through business income,
199A deduction in 2018, the first year the deduction was
encouraging investment and growth in some industries but
available. However, data from the 2019 filing season
not all industries. In addition, critics says the deduction
indicated that many eligible owners did not claim it. In a
reduces horizontal equity in the federal income tax, creates
2020 report, the Treasury Inspector General for Tax
new opportunities for small business owners to underreport
Administration (TIGTA) found that nearly 880,000 of the
their income to the IRS, and deters many eligible taxpayers
federal tax returns processed as of May 2, 2019, that
from claiming it because of its complexity.
appeared to be eligible for the deduction did not claim it.
Eligibility was determined according to the net income they
Some call for replacing the deduction with a more efficient
reported on Schedule C (for sole proprietors) or Schedule E
system for taxing business income. Options include
(for partners or S corporation shareholders). The taxable
progressively taxing the profits of all pass-through
income of each filer did not exceed the deduction’s lower
businesses and privately held corporations at the same rate
income threshold for 2018.
while keeping the current corporate income tax for publicly
held corporations and implementing new measures to
It is unclear from the TIGTA report why so many pass-
reduce income underreporting by pass-through businesses.
through business owners failed to take the deduction. The
report mentioned four likely explanations: (1) the owners
Gary Guenther, Analyst in Public Finance
were unaware of the deduction; (2) the software used to
prepare their returns lacked clear guidelines about the
IF11122
determination of QBI; (3) the taxpayers earned substantial

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Section 199A Deduction for Pass-Through Business Income: An Overview

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https://crsreports.congress.gov | IF11122 · VERSION 4 · UPDATED