Pass-Through Deduction Planning

Section 199A Qualified Business Income Deduction

The Tax Cuts and Jobs Act of 2017 created Section 199A, allowing owners of pass-through entities to deduct up to 20% of qualified business income (QBI). This deduction reduces taxable income for partners in partnerships, shareholders in S corporations, members of LLCs taxed as partnerships or S corporations, and sole proprietors.

The deduction is significant: a business owner with $300,000 in QBI potentially deducts $60,000, saving $22,200 at the 37% marginal rate. However, complex limitations based on income level, business type, W-2 wages paid, and property held require careful planning to maximize the benefit.

Section 199A is scheduled to expire after December 31, 2025, unless Congress extends it. Planning for 2024 and 2025 remains valuable; future availability depends on legislative action.

Basic 20% Deduction Calculation

The starting point is simple: deduct 20% of qualified business income. QBI includes the net amount of qualified income, gain, deduction, and loss from any qualified trade or business.

Qualified business income includes:

• Ordinary income from business operations
• Section 1231 gains from business property sales
• Guaranteed payments for services (for partnerships, with limitations)
• Net rental income (if rising to level of trade or business)

QBI excludes:

• W-2 wages received as an employee
• Capital gains or losses
• Interest income not allocable to a trade or business
• Dividend income
• Annuity income
• Investment income

Basic calculation example:

• Partnership distributes $250,000 K-1 income to partner
• Entire amount is ordinary business income
• Tentative QBI deduction: $250,000 x 20% = $50,000
• Deduction reduces taxable income by $50,000

The deduction is taken on the individual return, not at the entity level. Partners and S corporation shareholders claim it based on their share of QBI reported on Schedule K-1.

Income Thresholds and Phase-Outs

The deduction becomes limited once taxable income exceeds threshold amounts. For 2024:

Below threshold: Full 20% deduction with no limitations based on W-2 wages or business type.

Within phase-out range: Limitations phase in proportionally. Specified service trade or business (SSTB) limitations and W-2 wage/capital limitations apply partially.

Above threshold: Full limitations apply. SSTB income receives no deduction. Non-SSTB income is limited by the greater of the W-2 wage limitation or the W-2 wage plus capital limitation.

Specified Service Trade or Business (SSTB) Limitations

Specified service trades or businesses face severe restrictions. Once taxable income exceeds the phase-out range, SSTB income qualifies for zero deduction regardless of business profitability.

SSTB categories include:

• Health (physicians, dentists, nurses, physical therapists)
• Law (attorneys, paralegals, legal support)
• Accounting (CPAs, enrolled agents, bookkeepers)
• Actuarial science
• Performing arts
• Consulting (unless embedded in product/service sales)
• Athletics
• Financial services (wealth management, financial advising, investment management)
• Brokerage services
• Any business where principal asset is reputation or skill of employees/owners

Specifically excluded from SSTB (eligible for deduction):

• Architecture
• Engineering
• Real estate brokers (specifically carved out)
• Insurance agents (specifically carved out)

SSTB phase-out example:

Dr. Martinez operates a medical practice as an S corporation. Her 2024 taxable income is $433,900 (single filer), placing her 50% through the phase-out range ($191,950 to $241,950 is $50,000; she is $242,000 above threshold, so actually fully phased out).

Since her income exceeds $241,950, the SSTB limitation is complete. Her medical practice QBI qualifies for $0 deduction regardless of amount.

If Dr. Martinez had taxable income of $216,950 (50% through the phase-out), she could claim 50% of what would otherwise be her deduction. If QBI were $200,000, tentative deduction would be $40,000, but only $20,000 (50%) would be allowed.

W-2 Wage and Capital Limitations

For non-SSTB businesses (and SSTB businesses still in phase-out), the deduction above the threshold is limited to the greater of:

Limitation A: 50% of the W-2 wages paid by the business

Limitation B: 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property

Qualified property means depreciable tangible property used in the business and held at tax year end, within the longer of the depreciation period or 10 years from placed-in-service date.

W-2 wage limitation example:

Tech Consulting LLC (non-SSTB because it sells software, not pure consulting) has:

• QBI allocated to owner: $500,000
• W-2 wages paid to employees: $200,000
• UBIA of qualified property: $100,000
• Owner's taxable income: $600,000 (above MFJ threshold)

Tentative QBI deduction: $500,000 x 20% = $100,000

Limitation A (50% of W-2 wages): $200,000 x 50% = $100,000 Limitation B (25% wages + 2.5% UBIA): ($200,000 x 25%) + ($100,000 x 2.5%) = $50,000 + $2,500 = $52,500

Greater of Limitation A or B: $100,000

Since $100,000 (limitation) equals $100,000 (tentative deduction), full $100,000 deduction allowed.

W-2 wage planning opportunity:

The same business with $100,000 W-2 wages instead of $200,000:

Limitation A: $100,000 x 50% = $50,000 Limitation B: ($100,000 x 25%) + ($100,000 x 2.5%) = $27,500

Greater of A or B: $50,000

Deduction limited to $50,000 instead of $100,000. The $100,000 reduction in W-2 wages cost $50,000 in lost QBI deduction.

Aggregation of Businesses

Taxpayers may elect to aggregate multiple businesses if they share:

• Common ownership (50%+ common ownership by same people)
• Common management and centralized business functions
• Interdependency in operations

Aggregation allows W-2 wages and UBIA from one business to support QBI from another business within the same aggregated group. This helps when one business has high QBI but low wages, while another has wages but limited QBI.

Aggregation example:

Sarah owns:

• Business A: $400,000 QBI, $50,000 W-2 wages
• Business B: $50,000 QBI, $150,000 W-2 wages

Without aggregation:

• Business A: Tentative deduction $80,000, limited to $25,000 (50% of $50,000 wages)
• Business B: Tentative deduction $10,000, limited to $10,000 (50% of wages exceeds tentative)
• Total deduction: $35,000

With aggregation:

• Combined QBI: $450,000
• Combined W-2 wages: $200,000
• Tentative deduction: $90,000
• Wage limitation: $100,000 (50% of $200,000)
• Total deduction: $90,000 (full tentative amount)

Aggregation increases Sarah's deduction by $55,000.

Worked Example: Comprehensive Planning

Situation: Robert owns 100% of a manufacturing S corporation. His 2024 tax profile:

• S corporation QBI: $600,000
• S corporation W-2 wages paid: $180,000
• S corporation UBIA qualified property: $400,000
• Other income (wife's salary, investments): $200,000
• Total taxable income: $800,000 (MFJ, above threshold)

Determine SSTB status: Manufacturing is not an SSTB. Full deduction rules apply subject to W-2/UBIA limitations.

Calculate tentative deduction: $600,000 x 20% = $120,000

Calculate W-2 wage limitation: Limitation A: $180,000 x 50% = $90,000 Limitation B: ($180,000 x 25%) + ($400,000 x 2.5%) = $45,000 + $10,000 = $55,000

Greater of A or B: $90,000

Final deduction: $90,000 (limited from $120,000 tentative)

Tax savings: $90,000 x 37% = $33,300

Planning opportunity: If Robert increases W-2 wages to $240,000 (adding $60,000), his wage limitation becomes $120,000, allowing the full tentative deduction. The additional $60,000 in wages costs approximately $7,650 in payroll taxes (employer share of FICA/Medicare), but generates $30,000 additional deduction saving $11,100 in income tax. Net benefit: approximately $3,450.

Common Pitfalls

Pitfall #1: Assuming SSTB means no deduction

SSTB limitations only apply above the income threshold. A consultant with taxable income of $150,000 (single) receives the full 20% deduction on QBI regardless of SSTB classification.

Pitfall #2: Ignoring rental real estate QBI

Rental income may qualify as QBI if the activity rises to the level of a trade or business. The IRS provides a safe harbor: 250+ hours of rental services annually qualifies the rental as a trade or business eligible for the 20% deduction.

Pitfall #3: Miscounting W-2 wages

Only W-2 wages paid by the qualified business count toward the limitation. Wages the business owner receives as an S corporation employee count toward the business's W-2 wages, but guaranteed payments in partnerships do not.

Pitfall #4: Overlooking aggregation benefits

Businesses must be aggregated on the original return or first amended return. Missing the election in year one cannot be corrected later without IRS consent. Evaluate aggregation opportunities annually.

Pitfall #5: Forgetting the deduction reduces income tax only

The QBI deduction does not reduce self-employment tax or net investment income tax. It applies only to regular income tax calculation.

Planning Checklist

Before year-end:

• Calculate projected taxable income against thresholds
• Determine SSTB status for each business
• Evaluate W-2 wage and UBIA positions
• Consider income shifting strategies (retirement contributions, timing)

W-2 wage planning:

• Calculate current W-2 wages paid by business
• Determine if wage increase would enable larger deduction
• Compare payroll tax cost against additional deduction benefit
• Time wage adjustments before year-end

Aggregation review:

• List all businesses with common ownership
• Evaluate which combinations improve W-2/UBIA position
• Document common management and operations
• Make aggregation election on timely filed return

At tax filing:

• Complete Form 8995 (simplified) or Form 8995-A (detailed)
• Report aggregated businesses on Form 8995-A Schedule B
• Attach statements for SSTB determinations if complex
• Track carryforwards of excess QBI losses

Long-term planning:

• Monitor legislative changes to Section 199A sunset
• Consider entity structure changes to maximize deduction
• Plan large income events around threshold amounts
• Document rental activities for trade or business qualification

Section 199A provides substantial tax savings for pass-through business owners, but extracting maximum benefit requires understanding thresholds, SSTB limitations, and W-2 wage requirements. Annual planning before year-end ensures wages, aggregation elections, and income timing optimize the available deduction.