This article is an up to date summary of all the information you need to know about the 20% pass-through deduction.

What Is A Pass-Through?

A pass-through entity is an entity that passes its income through to its owners or partners so they can deduct those earnings on their individual tax returns (i.e., not subject them to income tax on that money). Pass-through owners are not taxed at the entity level. Instead, they are taxed on their share of the business's income or loss on their individual tax returns. Depending on the industry, pass-through entities include partnerships, S corporations, sole proprietorships and limited liability companies (LLCs), among others. Pass-through businesses can use the 20% deduction against up to $315,000 of net business income (or $157,500 for those married filing separately). The deduction is scheduled to expire in 2025.

What Is The 20% Pass-through Deduction?

The IRS was given the authority by congress to create a 20% pass-through deduction for small businesses. This means that owners of certain businesses (with income under $157,500) can deduct up to 20% of their net business income on their individual tax return. This is actually a significant benefit for small businesses, as most sole proprietorships and partnerships are taxed at the maximum individual tax rate of 37%. Small business owners usually pay more in income taxes than corporations do because of the way their business income is taxed. For example, a business owner with $100,000 of net business income will pay $37,650 of federal income taxes at the individual rate. If 20% of that net income is deducted as a pass-through deduction, then the owners would only pay $32,850 in federal income taxes on that same net business income. This amounts to a tax savings of nearly forty-thousand dollars ($40,000).

Who Qualifies For The 20% Pass-through Deduction?

Only owners whose businesses generate less than $157,500 in taxable net business income (i.e., cash profits) are eligible to claim this deduction on their tax return. There are three types of pass-through business that qualify for the deduction: corporations (S corporations, LLCs, C corporations) partnerships (partnerships, LLCs) sole proprietorships. These rules apply to all businesses except: Federally-recognized Indian tribal governments not treated as a state or U.S. possession 1 , and Tax exempt organizations 2 . In addition, the 20% deduction is available only to owners of businesses that have been in existence for at least two years before the end of the tax year for which they claim this deduction.

What Are The Pass-Through Deduction Rules?

The pass-through deduction rules were set up by the United States Internal Revenue Code. They allow businesses to deduct the entire cost of a capital investment property, including both land and capital improvements, from their tax return. This has allowed many companies to benefit from more favorable tax rates than would be available under a traditional depreciation schedule.

In order to qualify for this type of deduction, a business must be in one of the following three industries: agriculture, mining operations or drilling. These are the only industries that can benefit from the pass-through deduction.

In order to qualify, the property must:

In addition to this qualification, the business must also have a "qualified business interest". This means that the business' primary income from which it derives income is from an activity listed in one of these three industries. The only other exception to these rules is for businesses involved in commercial fishermen who meet certain qualifications (such as being part of a group and all members of the group having valid commercial fishing licenses.) These also have very limited applicability. The amount that can be deducted depends on several different factors including changes in fair market value and improvements made during a given year.

How Much Is The 20% Pass-Through Tax Deduction?

The amount that you can deduct each year depends upon how much taxable net business income your business has, and whether or not you choose to itemize deductions in your taxes.

If your business has less than $157,500 in taxable net business income and you choose to itemize deductions on your tax return, you can deduct up to 20% of the lesser of (1) your total qualified business income or (2) the total of your taxable income plus any net capital gains.

So for example: If your taxable income is $90,000 and if you have a $100,000 sole proprietorship with a single partner. You would be able to deduct up to $20,000 ($90,000-$69,500). If your taxable income was $90,000 and your sole proprietorship generated $100,000 in net income, then you would be able to deduct the entire amount.

You can choose to itemize deductions on your tax return or take the 20% deduction no matter which state you live in. Some states may have limitations on this deduction, so please check with a professional tax advisor who is licensed in your state.

What Are The Benefits Of Taking The 20% Pass-through Deduction?

The 20% pass-through tax deduction provides almost two million small business owners with significant tax relief. For example, if your business has taxable income of $100,000 and you have a single partner. The remaining balance after taking the deduction would be $80,000. You would pay $37,650 in federal income taxes on that income.

In this example, the cost of doing business is essentially $37,650 larger. If you were to add this cost to your hourly wage of $40 per hour or your total monthly compensation of $6,250 ($40 x 40 hours/week + 6 months / 12 weeks per month), then you can see where a significant cost burden could be placed on a small business owner who claimed the 20% pass-through deduction.

What Is The 20% Pass-through Tax Deduction Vs. The 20% Corporate Tax Deduction?

For the 2018 tax year, corporations are allowed to take a 20% tax deduction on their qualified business income. For some small businesses, this comparison will be helpful in deciding whether to take the 20% pass-through deduction or the corporate 20% tax break. The following table provides a side-by-side comparison of these two different types of tax breaks:

How Can The 20% Pass-through Tax Deduction Be Lowered Or Eliminated?

In 2025, the 20% pass-through deduction is scheduled to phase out once the regular corporate tax rate falls to just 21%. The table below outlines how much of a deduction small business owners can expect in each year when these two tax breaks will begin to phase in and out:

1 Federal level. For example, Wyoming permits pass-throughs to deduct up to 40% of their total income. This is in addition to state level deductions that are allowed by all states. In Michigan, small businesses with less than $150,000 net income may take a 50% deduction. 2 Tax exempt organizations include:

A religious organization. A company that does not pay taxes under Section 280G of the Internal Revenue Code (deduction for certain tax-exempt organizations). An international organization described in section 501(c)(3) of the Internal Revenue Code. A tax exempt organization exempt from federal income taxes under Section 511(a)(1) of the IRC (deduction for certain tax-exempt organizations) if it is not a private foundation or a public charity. In addition, some states are also beginning to phase out their pass-throughs. These state restrictions will apply going forward even after the individual phase-out begins in 2025.

The 20% pass-through tax deduction is equal to 20% of a sole proprietorship's qualified business income or 20% of a partnership's qualified business income. Because this deduction provides small business owners with more money in their pockets, it is referred to as a "pass-through deduction."

This deduction was created by the Tax Cuts and Jobs Act of 2017 and will be effective for tax years beginning after December 31, 2017.

This tax provision is effective for tax years beginning after Dec. 31, 2017 for a taxpayer who files a separate return under the cash method of accounting, or who does not file an income tax return at all.

The deduction is available for:

• The amount of the qualified business income allocable to each trade or business by the taxpayer,
• Each pass-through partner's share of such partner's qualified business income if the partner has more than one trade or business, and
• Qualified REIT dividends to a pass-through REIT.
• For this purpose, qualified REIT dividends are not treated as dividend income by any person other than the recipient of such dividends.
• For purposes of this section, if a taxpayer is treated as conducting two or more trades or businesses with substantially similar trade or business activities under Regulations section 1.469-4 (d), the taxpayer will not be treated as conducting more than one trade or business.
• Special rules for more than one trade or business. The deduction is available to the extent qualified business income does not exceed 20 times the taxable income of the taxpayer and that taxpayer's spouse (reduced by net capital gains).

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