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The passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 was a massive reform of the tax code that had a significant impact on the taxation of business income. However, the manner in which taxes on business income were reduced by the legislation differed depending on the legal form of the business.
For businesses taxed on their income at the entity level, most commonly organized as C corporations, the TCJA dramatically reduced the corporate income tax rate from a graduated rate topping out at 35% to a flat rate of 21%. Businesses organized as “pass-throughs,” such as partnerships (including LLCs taxed as partnerships), S corporations and sole proprietorships, do not pay an entity-level tax. Instead, the income of pass-through businesses is taxed at the business-owner level, which remains a graduated tax rate system with a current maximum rate of 37%.
In order to address this income tax rate disparity, Congress also extended tax relief in the TCJA to businesses that operate as pass-through entities. Through the enactment of a new Internal Revenue Code law, section 199A, Congress created a deduction for pass-through business owners who are individuals or certain types of trusts and estates.
Section 199A provides a deduction of up to 20% of “qualified business income” (QBI). A simplified explanation of QBI is that it represents the income of the business, less certain exclusions such as compensation income, capital gains or losses, dividends or interest income unconnected to the business. QBI must also be derived from an eligible business. To be considered eligible, the business must be conducting a regular and continuous “qualified business.” This is defined as a trade or business engaged in a regular and continuous profit-seeking activity.
The regulations under section 199A also provide high-income business owners who operate multiple pass-through businesses with the opportunity to aggregate those businesses to claim a larger QBI deduction than otherwise might be available if the deduction was calculated on an entity-by-entity basis. This is because high-income business owners are subject to two types of limitations when claiming the full deduction.
The first limitation, known as the SSTB limit, applies to the type of trade or business they own. Certain types of businesses, known as specified service trades or businesses, are subject to income limitations. SSTBs are businesses that are engaged in the performance of services that rely on the reputation or skills of their employees or owners. SSTBs include businesses in fields such as health, law, accounting, consulting, finance, investing or brokerage services (along with other types of excluded businesses). Owners of SSTBs do not qualify for the section 199A deduction above certain income thresholds. The income thresholds at which the deduction begins to phase out start at $383,900 for joint filers and $191,950 for all other filers in 2024. Under the SSTB limit, the deduction is lost completely at income of $483,900 for joint filers and $241,950 for other filers.
The second limitation, known as the WQP limit, is based on the W-2 wages the business pays its employees and the unadjusted basis immediately after acquisition (UBIA) of qualified depreciable property held by the business that was placed in service in the past 10 years. Owners of non-SSTB businesses can still claim at least a portion of the QBI deduction even when their income is above the $483,900/$241,950 income limit. However, the deduction amount they can claim is reduced to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the UBIA.
High-income owners subject to the WQP limit can often benefit from aggregation of their business activities, assuming they meet certain technical requirements to do so. For example, a business that has a large number of W-2 employees and/or significant UBIA but loses money receives no QBI deduction (since it has no income to offset). But if the money-losing business is aggregated with a profitable business entity, the additional W-2 wages and UBIA that are included in the aggregated group may mitigate the effect this limitation may otherwise have on the QBI deduction available to the profitable business.
Business owners whose taxable income is no greater than the deduction’s lower income threshold ($383,900 for joint filers and $191,950 for other filers in 2024) may claim the maximum QBI deduction for any kind of business without restriction.
It is important to note that, unlike the permanently enacted change to the corporate income tax rate, the section 199A deduction is scheduled to expire in December. Without congressional intervention this year to extend the expiring provisions of the 2017 legislation, this deduction will no longer be available to taxpayers in 2026. Despite an incoming administration that appears inclined to extend the expiring provisions of the TCJA, it is unclear in the age of exploding deficits whether Congress will act to preserve this deduction. The congressional Joint Committee on Taxation recently estimated that a permanent extension of the section 199A deduction would reduce federal tax revenues by $684.2 billion between 2025 and 2034. The exorbitant cost of keeping this deduction will likely be a key consideration by Congress in deciding whether to extend it.
Thus far, few details have been released regarding the future of the section 199A deduction. Businesses that have relied on this deduction in previous years should proactively consult with an experienced tax professional to assess tax planning strategies. Meanwhile, owners of newly formed businesses may want to reexamine the choice-of-entity question. Although the vast majority of businesses are operated as pass-throughs, the reduction in the corporate tax rate to a flat 21% may present a more tax-efficient structure in some cases, particularly if section 199A expires after this year.
Tax professionals can help taxpayers understand the specific impact of the expiration of this deduction and help them navigate other tax savings options. One such impact a tax professional may have is through the identification of deductions that can be “bunched” into a single tax year. Because the section 199A deduction is applied to a taxpayer’s income only after the itemized deductions or the standard deduction has been applied, a taxpayer who successfully utilizes deductions to reduce taxable income may become eligible for the section 199A deduction in a year where income threshold limitations may otherwise have resulted in a reduced or nonexistent deduction. Given that the future of the section 199A deduction is uncertain, it is especially vital that taxpayers maximize their ability to use this deduction while it remains available.
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Reprinted with permission from the January 17, 2025, edition of The Legal Intelligencer © 2025 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.