Updated February 25, 2020
Section 199A Deduction for Pass-through Business Income: An
The 2017 tax revision (P.L. 115-97) added, under Section
QBI does not include capital gains, dividends, and interest
199A of the federal tax code, a new deduction for pass-
and annuity income unrelated to a trade or business. It also
through business income. In its simplest form, the
does not apply to compensation paid to S corporation
deduction is equal to 20% of a firm’s qualified business
shareholders or partners for services they perform for their
income (QBI) in a tax year. However, the calculation
business, or to their employees.
becomes more complicated when an owner’s income
exceeds certain amounts and a business has employees and
In general, the deduction for QBI in a tax year for taxpayers
depreciable, tangible assets.
with relatively low taxable income is equal to the smaller of
Congress created the deduction, in part, to establish parity
20% of a taxpayer’s QBI, or
between the taxation of corporate and noncorporate
20% of their taxable income computed without the
business income from 2018 to 2025; the deduction is set to
Section 199A deduction and reduced by any net capital
expire on December 31, 2025. P.L. 115-97 reduced the
gain and qualified cooperative dividends.
corporate income tax from a graduated rate structure with a
top rate of 35% to a single rate of 21%, a 40% decrease. By
Taxpayers with qualified cooperative dividends make a
contrast, the Section 199A deduction lowers the effective
similar computation. Any deduction they claim is added to
tax rate on pass-through business profits by 20% at all
any deduction they may claim if they have QBI.
individual tax rates.
For pass-through business owners with relatively high
Pass-through businesses fall into one of three categories: a
taxable income, the deduction is either unavailable because
sole proprietorship, a subchapter S corporation, or a
of the kind of business they own, or is the smaller of
partnership (including a limited liability company electing
20% of a taxpayer’s QBI from all businesses, or
to be taxed as a partnership). In each case, the items of
income, loss, gain, and deduction for the business are
a W-2 wages/qualified property (WQP) limit, which is
attributed (or passed through) to the owners, and any profits
the larger of
are taxed as part of their individual taxable income. By
contrast, the profits of a subchapter C corporation are taxed
50% of a taxpayer’s share of total W-2 wages
twice: once at the entity level, and a second time at the
for a business, or
owners’ level when the profits are distributed to them as
dividends and realized long-term capital gains.
the sum of 25% of those wages plus 2.5% of
their share of the unadjusted basis of all
Most U.S. businesses are organized as a pass-through
qualified property used in the business.
business. According to data from the Internal Revenue
Service (IRS), pass-through firms accounted for 94% of the
Use of the Deduction
36.2 million business tax returns filed for the 2016 tax year.
Use of the deduction hinges on four considerations: (1) the
Sole proprietorships filed 75% of pass-through business
taxable income of a taxpayer with QBI, (2) the nature of the
returns and 70% of all returns.
trade or business generating the QBI, (3) the taxpayer’s
share of W-2 wages for the QBI, and (4) the taxpayer’s
Summary of Current Law
share of the unadjusted basis of tangible, depreciable
Section 199A allows individuals, estates, and trusts with
property used to generate the QBI. (See below for a few
pass-through business income to deduct up to 20% of their
examples of how these criteria interact in determining a
QBI in determining their taxable income through 2025.
taxpayer’s Section 199A deduction.)
Owners of agricultural and horticultural cooperatives may
also claim the deduction. Taxpayers claim the deduction
Taxable income denotes a pass-through business owner’s
after computing their adjusted gross income (AGI).
AGI less all deductions, except the Section 199A deduction.
All trades and businesses are eligible for the deduction
A pass-through business owner’s QBI is the net amount of
when a taxpayer’s taxable income is less than or equal to a
items of income, loss, gain, and deduction for each
specified level. Above that amount, the deduction is subject
qualified domestic trade or business he or she owns. If a
to two limits. One is the WQP limit, and the other is a limit
taxpayer owns more than one business, then QBI must be
based on whether or not a business is considered a
determined separately for each one and added together to
“specified service trade or business” (SSTB).
determine the taxpayer’s total QBI in a tax year.
Section 199A Deduction for Pass-through Business Income: An Overview
In the case of the WQP limit, W-2 wages are the total
lower income threshold, to $50,000 for single and HOH
wages attributable to a taxpayer’s QBI during a tax year
filers or $100,000 for joint filers. This percentage is used to
subject to withholding, elective deferrals, and deferred
adjust a taxpayer’s QBI for SSTB income, and then to
compensation. The unadjusted basis of tangible, depreciable
calculate a reduction amount, which is subtracted from a
assets used in a business refers to the acquisition cost of
taxpayer’s deduction with no WQP limit to determine the
such property attributable to a taxpayer’s QBI.
Section 199A deduction.
A SSTB is any trade or business involved in the
Selected Filing Issues
performance of services in health care, law, accounting,
According to one estimate, over 90% of pass-through
actuarial science, the performing arts, consulting, athletics,
business owners were likely to have qualified for a full or
financial services, brokerage services, investing and
partial Section 199A deduction in the 2018 tax year. But
investment management, trading or dealing in securities,
data from the 2019 filing season indicate that many owners
commodities, or partnership interests. Businesses whose
who were eligible for the deduction did not claim it.
principal asset is the reputation or skills of one or more of
According to a 2020 report on the 2019 filing season by the
their employees and/or owners are also regarded as SSTBs.
Treasury Inspector General for Tax Administration
(TIGTA), nearly 880,000 tax returns processed as of May 2,
Section 1202, which provides a capital gains tax exclusion
2019, did not claim the deduction, even though the
for qualified small business stock, has a similar list of
taxpayers appeared to be eligible for it, based on profits
ineligible businesses. Among those lines of business are
they reported on Schedule C (for sole proprietors) or
architecture and engineering firms. By contrast, those
Schedule E (for partners or S corporation shareholders). In
businesses qualify for the Section 199A deduction.
each case, taxable income did not exceed the applicable
lower income threshold for 2018.
The limitations on the use of the deduction are phased in for
joint filers when their taxable income in 2020 falls between
It is unclear why so many pass-through business owners did
$326,600 and $426,600, and for all other filers when their
not claim the deduction when they qualified for it. TIGTA
taxable income is between $163,300 and $213,300. Beyond
cited these possible explanations: (1) the taxpayers were
the upper income limit, no SSTB income qualifies for the
unaware they could claim the deduction; (2) the software
deduction, and the deduction for other firms cannot exceed
used to prepare their returns was unclear about what
the WQP limit. These income thresholds are indexed for
constituted QBI; (3) the taxpayers earned substantial
business income outside the United States; or (4) they chose
not to claim the deduction because it seemed too
There are three basic outcomes for using the Section 199A
complicated to calculate.
Among the challenges in claiming the deduction is
determining whether business activities qualify for the
Taxpayers with QBI who have taxable income in 2020 at or
deduction. The final regulations (T.D. 9847) for Section
below the lower income threshold of $163,300 for single
199A, issued by the IRS in January 2019, provided
and head-of-household (HOH) filers, and $326,600 for joint
guidelines for identifying qualifying businesses. In many
filers, may be able to take the maximum Section 199A
cases, the question of a firm’s eligibility is likely to hinge
deduction, which is equal to 20% of their QBI.
on relevant “facts and circumstances.”
The second outcome happens when a taxpayer’s taxable
There are benefits and costs associated with the Section
income exceeds $213,300 for single and HOH filers, and
199A deduction. Proponents argue that it encourages
$426,600 for joint filers in 2020. In this case, no deduction
increased business investment in a wide range of assets by
is available for SSTB income. For other QBI, the deduction
reducing the cost of capital for that purpose and increasing
is subject to the WQP limit. In this case, the deduction is
the cash flow of firms that can claim the deduction. Owing
the smaller of 20% of a taxpayer’s QBI for such a business,
to the deduction and the temporary cut in individual income
or an amount equal to the larger of (1) 50% of a taxpayer’s
tax rates, the 2017 tax revision strengthened the incentive to
share of W-2 wages for a qualified business or (2) 25% of
invest arising from the tax code.
those wages plus 2.5% of their share of the unadjusted basis
of qualified property used in the business.
Critics of the deduction recognize its potential benefits for
business investment, but they point to several other effects
as reasons to revise or repeal it. In their view, the deduction
This is arguably the most complicated of the three
is not neutral in its impact on the taxation of pass-through
outcomes, as it involves a phase-in of the SSTB and WQP
firms; reduces the progressivity of the federal income tax;
limits. It applies to taxpayers with QBI from SSTBs and
creates new opportunities for gaming the tax code; and
non-SSTBs, and taxable income in 2020 between the
imposes significant compliance costs on taxpayers.
income thresholds of $163,300 and $213,300 for single and
HOH filers, and $326,600 and $426,600 for joint filers. For
, Analyst in Public Finance
these taxpayers, the calculation of the deduction takes into
account an owner’s “applicable percentage,” which is the
ratio of a taxpayer’s taxable income less the applicable
Section 199A Deduction for Pass-through Business Income: An Overview
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