Utilizing the New 20% Pass-Through Tax Deduction

By Richard Bloom, Faye Tannenbaum and Nate Pliskin

The Tax Cuts and Jobs Act (“TCJA”) includes a provision allowing certain taxpayers a 20 percent deduction for qualified business income of pass-through entities. The new 20 percent pass-through deduction may provide a substantial amount of tax relief for sole proprietors, the owners of S Corporations and partnerships, and trusts and estates and their beneficiaries. This provision is effective for tax years beginning after December 31, 2017. It is critical that taxpayers review their business arrangements to ensure that they will be able to benefit from the new deduction to the maximum extent allowable.

The deduction is equal to the sum of:

  • The lesser of the (A) combined qualified business income amount of the taxpayer or (B) an amount equal to 20% of the excess of the taxpayer’s taxable income over the sum of the net capital gain plus the aggregate amount of the qualified cooperative dividends, plus
  • The lesser of (A) 20% of the aggregate amount of qualified cooperative dividends of the taxpayer for the taxable year or (B) taxable income reduced by the net capital gains of the taxpayer for the taxable year.

A taxpayer’s combined qualified business income amount means, with respect to any taxable year, an amount equal to the sum of:

  1. 20% of the taxpayer’s qualified business income (discussed in (ii) below) with respect to each qualified trade or business (discussed in (i) below) plus
  2. 20%of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the taxable year.

The amount of a taxpayer’s qualified business income is subject to a wage or wage and basis limitation which is discussed in sections (iii) and (iv), respectively, below.

Consider a sole proprietorship which earns $100,000 of qualified business income. Assuming the taxpayer’s overall taxable income is in excess of $100,000, the taxpayer has no capital gains and subject to the restrictions discussed below, such qualified business income from the sole proprietorship will provide its owner with a corresponding $20,000 deduction.

Four of the issues that need to be addressed when determining the availability of the pass-through deduction are as follows:

  • Whether or not any part of a Taxpayer’s business constitutes a qualified trade or business;
  • Whether the income generated is qualified business income;
  • To what extent the business pays allocable W-2 wages; and
  • To what extent the business owns qualified property.

Each of these items is discussed in detail in parts (i) – (iv), below. Additional issues are also addressed in parts (v) – (vii). Taxpayers may want to take steps to ensure the availability of the deduction for their business. Additionally, pass-through entities may need to report a substantial amount of new information to their owners, who may be eligible to claim this deduction.

(i) Qualified Trade or Business

The first step in determining the availability of the deduction is determining whether the business itself is a qualified trade or business. The law defines this as any trade or business other than (1) a specified service trade or business or (2) the trade or business of performing services as an employee. The latter provision is clearly intended to prevent individual taxpayers from forming a LLC to receive payments that were formerly salary payments and converting such payments to pass-through income. The former provision excludes numerous professional service businesses from the definition of a qualified trade or business.

The new category of specified service trade or business is a listing of excluded industries that generally cannot take advantage of the deduction. A specified service trade or business is generally one (A) involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners or (B) involving the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Until Treasury issues regulations or guidance interpreting what is meant by specified service trade or business, there remains a large amount of grey area in these definitions. Even businesses that are not specifically listed could potentially fall under the catchall provision that excludes businesses if the principal asset of the business is the reputation or skill of 1 or more of its employees or owners. This could theoretically apply quite broadly and it is an open question how the IRS will interpret this provision.

Mazars Insight: The term “trade or business” is not clearly defined and is based on the facts and circumstances of each situation. Businesses that are engaged in multiple business lines will need to closely consider how to proceed with their affairs in light of the new law. At this juncture, it is unclear to what extent performing any of the excluded services would wholly taint a business that is engaged in the conduct of a separate permitted business. It is also unclear if a single entity will be permitted to engage in mixture of both qualified and nonqualified trades and businesses. In light of this uncertainty, it would be prudent for taxpayers to track income and deductions on an activity by activity basis in case “trade or business” is defined on an activity basis for purposes of this pass-through deduction.

 Businesses may consider spinning off an existing business line to prevent the possibility of qualified trade or business being tainted by specified service business activities. However, any spun off business may need to pay wages or hold tangible depreciable property to comply with the limitations discussed in parts (iii) and (iv), below. Even entities that are clearly specified service businesses may be able to spin off a portion of their activity into a new entity. For example, an entity that owns the building housing its offices should consider creating a separate rental real estate partnership. Another example would be a law firm, accounting firm, or medical practice segregating many of its business functions into a different entity. For example, could IT services, HR services, financial management services and secretarial support be spun off into a separate entity (Newco LLC). This separate entity would charge the law firm, accounting firm or medical practice a market rate fee to provide these services. The profit that Newco LLC generates may be considered qualified business income and eligible for the 20 percent pass-through deduction. Consideration needs to be given to where wages are paid, health insurance, qualified retirement plans as well as many other issues before determining if the structure is economically feasible assuming it would generate a pass-through deduction under the pass-through deduction rules.

 It is noted that the Secretary is instructed to issue regulations as are necessary to carry out the purposes of this new law. It is unclear whether Secretary will issue anti-abuse regulations forbidding the use of certain related-entity structures.

The law also provides an exception that allows owners of specified service trades or businesses to enjoy the pass-through deduction if the owner’s taxable income is below a threshold amount. The deduction will still be available where a taxpayer’s taxable income does not exceed the threshold amount of $315,000 ($157,500 for unmarried individuals), with a phase out for income up to $415,000 ($207,500 for unmarried individuals).

Mazars Insight: Even “specified service” businesses, such as law firms and medical practices, must be cognizant of the rules governing this provision because these businesses may have owners that will fall into this exception in some tax years.

Returning to our initial example of a sole proprietorship that earns $100,000 of qualified business income in the tax year, the availability of the $20,000 deduction is dependent on the type of business. If it is a solo law firm, the business will provide no deduction if the owner files a joint return and has taxable income over $415,000. However, if this owner’s taxable income is under $315,000 (the threshold amount), he will receive a full $20,000 deduction.

The amount of the deduction is phased out between $315,000 and $415,000 of taxable income. For example, if the owner has $365,000 of taxable income (the mid-point of the phase-out) he can take a $10,000 deduction, reducing his actual taxable income to $355,000.

If the business is not a specified service business, the owner is entitled to the full 20% deduction (subject to additional limitations discussed below) regardless of taxable income. Thus, the owner of an engineering firm (explicitly excluded from the definition of specified service business) with a taxable income of $10,000,000 will receive a $20,000 deduction based upon the qualified business income of $100,000 from his engineering firm.

(ii) Qualified Business Income

As indicated above, the new deduction is available for up to 20% of the “qualified business income of a trade or business. Qualified business income is, initially, defined broadly as non-investment ordinary income that is effectively connected with a U.S. trade or business if such income is includable in taxable income for the tax year. Generally, most business income earned domestically, other than investment income, will be qualified business income.

Mazars Insight: Businesses with foreign sourced income must be able to identify what portion of their income is foreign or domestic because foreign sourced income will not be eligible for any deduction.


Returning to our example of a sole proprietorship with $100,000 of qualified business income: If $40,000 of such net income is foreign source, only $60,000 will be qualified business income and the business will only provide a $12,000 deduction.

Qualified business income does not include certain items of investment income: capital gains, dividends (or dividend equivalents), interest (if not allocable to a trade or business), commodities transactions income (other than transactions entered into in the normal course of business), foreign currency gains (other than from transactions entered into in the normal course of business), income from notional principal contracts (other than ordinary hedging transactions), or annuity income (not used in the trade or business activity).

Business income also does not include reasonable compensation paid to the individual taxpayer by the business. Thus, individual taxpayers will not receive a deduction based upon guaranteed payments from a partnership to a partner, wages paid by an S Corporation to a shareholder, or transactions between a partner and partnership where the partner is acting other than in his capacity as a partner.

Mazars Insight: Clearly, the guaranteed payments restriction could serve to severely limit the availability of the deduction for some partners. As partners negotiate (or renegotiate) partnership agreements, they should be aware of this potential downside of guaranteed payments. S Corporations may also want to reconsider the structure of their compensation (although this could impact the W-2 wage limitation, discussed below).

Finally, the law requires taxpayers to offset their qualifying business income from one business with losses from other businesses. Thus, individuals with qualifying business losses from one partnership must reduce the qualifying business income (and the corresponding deduction) received from another partnership. Moreover, if qualifying business losses exceed qualifying business income, this qualifying business loss is carried over to subsequent tax years. This prevents taxpayers from bunching income and losses in specific years to minimize the impact of losses.


A taxpayer is a partner in Partnership A and Partnership B. In Year 1, Partnership A allocates qualifying business income of $100,000 to the taxpayer. This would normally provide a $20,000 deduction. However, Partnership B allocates a qualifying business loss of $120,000 to the taxpayer. This will reduce the taxpayer’s qualifying business income to ($20,000). Therefore the taxpayer will receive no pass-through deduction (although he does have a $20,000 loss). Moreover, the taxpayer must carryforward the $20,000 qualifying business loss. In Year 2, both Partnerships A and B allocate qualifying business income of $50,000 to the taxpayer. The taxpayer receives $100,000 of qualifying business income in Year 2, reduced by the $20,000 qualifying business loss carryforward, for total Year 2 qualifying business income of $80,000. The taxpayer is entitled to a $16,000 deduction in Year 2.

(iii) W-2 Wage Limitation

The law limits the availability of the pass-through deduction to the greater of (i) 50% of “W-2 wages with respect to the qualified trade or business,” or (ii) 25% of “W-2 wages” plus 2.5% of “the unadjusted basis immediately after acquisition of all qualified property.” The 25% of wages plus basis test is discussed in part (iv) below. The 50% “W-2 wages” limitation generally prevents taxpayers from taking the deduction if the business’s wage expense is not high enough relative to its business income.

Example: Returning to our example of a sole proprietorship that earns $100,000 of qualifying business income. The $20,000 deduction provided by this income is limited to 50% of wages paid by the business. Thus, if the business only pays $30,000 of wages during the year, the deduction is limited to $15,000.

However, individuals with taxable income under the $315,000 ($157,500 for unmarried individuals) threshold are not subject to the W-2 wage limitation, with a phase in of the limit for income up to $415,000 ($207,500 for unmarried individuals). These are the same threshold amounts, discussed in part (i) above, which allow owners of specified service trades or businesses to take advantage of the pass-through deduction if their taxable income is low enough.

Generally, gross wages paid to employees will be treated as “W-2 wages”, except to the extent wages are not properly allocable to qualified business income. Thus, to the extent a business has foreign income or investment income (capital gain, interest, dividends, etc.), a portion of the wages would not be allocable to qualified business income, resulting in a lower wage limitation. The statute does not provide any further guidance on how wages should be allocated between types of income, however it explicitly instructs Treasury to issue regulations requiring or restricting the allocation of wages.

Mazars Insight: If the W-2 wage limitation will be a limiting factor for taxpayers, they should consider disposing of investment assets. They may also need to justify any position they take that allocates specific wages to qualified business income.

Taxpayers should also consider how their labor arrangements will impact the availability of the deduction. Firms who utilize the services of independent contractors may consider hiring such individuals as employees. Also, firms that utilize a professional employer organization or that have a separate entity to pay employees may need to reconsider this arrangement. The statute refers to wages paid with respect to a trade or business, not a specific entity. Consequently, payment of wages from a separate entity may be allowed: however, it is currently unclear to what extent these arrangements will be problematic under any forthcoming regulatory or administrative guidance.

 The law prevents employers from including “W-2 wages” in the calculation if the wages are not reported to the Social Security Administration (SSA) before the 60th day after the due date for such returns. Thus, a failure to timely file Forms W-2 with the SSA could result in a complete loss of the pass-through deduction.

(iv) Wages Plus Basis Limitation

As noted above, the pass-through deduction is allowable in an amount equal to the greater of (i) 50% of W-2 wages, or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The second prong of the limitation test makes the deduction available for capital-intensive businesses that pay relatively low total wages.

Businesses relying on this test will benefit from owning enough qualified property to permit a pass-through deduction. The law defines qualified property as tangible property that is depreciable under IRC Section 167. To qualify, the property must be held by and available for use in the qualified trade or business at the close of the tax year and be used at any point during the tax year in the production of qualified business income. Additionally, the property must either have been placed into service within the past 10 years or its basis must still be recoverable under the applicable tax recovery period. Thus, property that is depreciable for tax purposes over 5 years is still qualifying property for 10 years after it is placed in service. And property depreciable for over 10 years will remain qualifying property until its basis has been fully recovered.

Mazars Insight: Businesses may want to consider owning, rather than leasing, business property in order to increase the amount of qualifying property held, thereby increasing the amount of deduction available under the wages plus basis limitation.


Assume the same facts as our previous example: a sole proprietorship generates$100,000 of qualifying business income and pays $30,000 of wages. The $20,000 deduction provided by this loss would be limited to $15,000 (i.e., 50% of wages paid) under the W-2 wages test. However, the law provides for a limitation equal to the greater of the W-2 wage limitation or wages plus basis limitation. Assume that this business purchased a piece of equipment 8 years ago for $400,000. The equipment is 5-year property that has been fully depreciated for tax purposes. However, the business can still count the cost basis of qualifying property for up to 10 years for purposes of the 25% wages plus 2.5% basis limitation. Here, 25% of wages is $7,500 and 2.5% of basis is $10,000. Thus, the total wages plus basis limitation is $17,500. The taxpayer is allowed a deduction that is equal to the greater of the wage limitation ($15,000) or the wages plus basis limitation ($17,500). Therefore, the taxpayer is allowed a deduction in the amount of $17,500.

As noted above, the limitation is not applicable to individuals with taxable income under the $315,000 ($157,500 for unmarried individuals) threshold, with a phase in of the limit for income up to $415,000 ($207,500 for unmarried individuals). Such taxpayers may enjoy the benefit of the deduction regardless of the property basis or wages paid by the underlying business.

(v) Overall Limitation

The availability of the pass-through deduction is still subject to one final overall limitation at the individual level. This limitation first requires that a taxpayer calculates his/her total tentative deduction available under the provision. To reach this number, the taxpayer sums (i) all pass-through deductions received from the taxpayer’s different businesses (subject to the limitations discussed above), (ii) plus a deduction equal to 20% of qualified REIT income, and (iii) 20% of qualified publicly traded partnership income.

Next, the taxpayer calculates his taxable income less net capital gains. Lastly, the taxpayer takes 20% of this modified taxable income amount. The total deduction allowable is limited to this 20% of modified taxable income amount.[1]


A taxpayer receives $100,000 of combined qualified business income (not subject to any other limitations), $100,000 of qualified REIT dividends, and $100,000 of publicly traded partnership income. These income items all provide a 20% deduction, thus the taxpayer’s tentative total pass-through deduction is $60,000.

However, this deduction is still subject to the overall limitation. Assume the taxpayer’s taxable income is $350,000 including net capital gains of $150,000. The taxpayer reduces taxable income by net capital gains, arriving at $200,000 and then takes 20% of this amount, arriving at an overall limitation of $40,000. In this scenario, the taxpayer cannot take the full $60,000 deduction and is instead limited to a $40,000 deduction.

Mazars Insight: The overall limitation reduces the total deduction available in a tax year if a taxpayer’s taxable income is largely composed of capital gain income or has already been offset by large losses. Thus, it prevents taxpayers from taking a deduction against income that is already taxed at a favorable rate.

(vi) Type of Deduction

The pass-through deduction has three additional important features:

  • it is not allowed in computing adjusted gross income;
  • it is allowed to non-itemizers; and
  • it is allowed for purposes of computing Alternative Minimum Tax.

Mazars Insight: The allowance for non-itemizers is important as the new tax regime will greatly reduce the number of taxpayers who itemize deductions. Also, because the deduction is not allowed in computing adjusted gross income, it may not provide a deduction on state returns that use federal adjusted gross income as a starting point unless such states incorporate the deduction into their tax regime.

(vii) Sunset Provision

This deduction expires for tax years beginning after December 31, 2025.


The pass-through deduction is a completely new element of the tax code and can potentially be extremely valuable for business owners. Taxpayers need to analyze how the provision’s rules will apply to their business arrangements to ensure they are able to take advantage of the new deduction.

Please contact your Mazars USA LLP professional for additional information.