A Guide to the Small Business Deduction (2020)

What is the 2017 Tax Cuts and Jobs Act?

Signed in December of 2017, the Tax Cuts and Jobs Act (TCJA) reduced the tax rate for individuals and businesses, changed the way deductions are calculated, altered the rules about estate tax, and enacted other significant changes. Could it help your business this year?

The 2017 Tax Cuts and Jobs Act included a new deduction for some small business owners. This new provision allows a deduction of up to 20% of qualified business income, depending on income levels and business type. Only individuals with income from pass-through entities are eligible. 

This new small business deduction is referred to as the qualified business income (QBI) deduction, the pass-through deduction, or the Section 199A deduction. It is currently in place until 2025, when lawmakers will have to decide if they wish to extend the deduction.

What is Qualified Business Income?

Qualified Business Income (QBI) refers to the net profits of your business. According to the IRS, it’s the net amount of qualified items of income, gain, loss, and deduction with respect to any trade or business. QBI does not include any capital gains or losses, interest income, dividends, foreign income, or other shareholder related payments.

What is a Pass-Through Entity?

A pass-through entity is basically any company other than a corporation. Most businesses are pass-through entities with profits passed through to the owners, shareholders, and partners. These owners, shareholders, and partners pay taxes on that income on their personal returns at ordinary tax rates. Sole proprietorships, S corporations, LLCs, and partnerships are pass-through entities.

How Many People Claim this Deduction?

According to the Tax Foundation, around 17 million households can take advantage of this deduction.

How to Calculate the Pass-Through Deduction

The pass-through deduction is calculated by determining the smallest amount based on 1 of 2 factors:

  • 20% of a household’s eligible business income or…

  • 20% of a household’s taxable ordinary income

Whichever number is smaller after calculating is the eligible deduction amount.

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Other Considerations Regarding the Pass-Through Deduction

There are certain limits pertaining to application of the pass-through deduction based on the economic sector, the amount of wages paid, and property costs. Higher income households have a number of limitations and should work with a tax professional.

Be sure to talk to your tax professional about the pass-through deduction for your small business. For additional information and frequently asked questions, refer to resources from the IRS about this deduction.