The Pros and Cons of the New Section 199A Pass-Through Deduction

Apr 29, 2021

The Tax Cuts and Jobs Act provides a significant benefit for many business owners in the form of a 20 percent deduction of their qualifying business income from a pass-through entity. Unfortunately, there is a high level of complexity, ambiguity, and lack of official guidance in trying to determine what type of income qualifies and how much. Taxpayers and their advisers need answers.


Pass-through businesses (sole proprietorships, S corporations, partnerships, and LLCs) represent about half the workforce, over 60 percent of the reported business taxable income, and over 95 percent of all business tax return filings, according to the Tax Foundation.1

Pass-through income prior to the Tax Cuts and Jobs Act (and ignoring state taxes) was subject to a federal marginal income tax rate as high as 39.6 percent plus, in many cases, an additional 3.8 percent Medicare surtax, for a potential federal income tax obligation of about 43.4 percent. C corporations, before tax reform, had a double tax burden of about 50.5 percent (i.e., a 35 percent C corporation rate plus 20 percent preferential rate on after-tax earnings disbursed as dividends or otherwise reflected in a greater value of a later sale of the stock or assets, plus the 3.8 percent Medicare surtax). This seven-point tax rate difference demonstrates the popularity of pass-through vehicles.

After the Tax Cuts and Jobs Act, and again ignoring state taxes, the top federal personal marginal income tax rate has dropped to 37 percent, bringing the regular pass-through total for federal income tax down to about 40.8 percent after possible Medicare surtax. The new C corporation double tax burden is now 39.8 percent (21 percent C corporation rate plus 20 percent preferential rate on the after-tax earnings disbursed as dividends or otherwise reflected in a greater value of a later sale of the stock, plus the 3.8 percent Medicare surtax). In short, pass-throughs appeared to have lost their seven point tax rate advantage.

As a result, Congress provided partial relief for pass-throughs in the form of Section 199A.

Effective for tax years beginning after Dec. 31, 2017, through 2025, individuals, trusts, and estates are eligible for a 20 percent deduction from their allocable domestic qualified business income (QBI) from each partnership, LLC, S corporation, sole proprietorship, disregarded entity, real estate investment trust (REIT), qualifying cooperative, and qualifying publicly traded partnership. However, there are several limitations:

  • There are limitations on the amount of the deduction based on the level of W-2 wages and tangible depreciable property in the business, although this is not applicable below certain adjusted gross income (AGI) thresholds, above which the limitation is phased in.
  • Income from most service businesses may not qualify (known as “specified service businesses”), although there is an AGI threshold below which the taxpayer can be exempted from this. Above which, the exemption phases out.
  • The deduction is to be taken as a reduction of the taxpayer’s overall taxable income, not against AGI, and is therefore not affected by whether or not the taxpayer itemizes. This means the deduction does not actually reduce the business net income, which could still be subject to self-employment tax and the Medicare surtax.
  • Several provisions apply to the impact of cooperatives, REITS, publicly traded partnerships, and their related dividends and distributions, but these cause even more complexity and will not be covered here as they are beyond the scope of this summary.

Section 199A Definitions and Provisions

QBI – This is the net amount of qualified items of income, gain, deduction, and loss with respect to the qualifying business. If such net item is a loss, then that loss apparently first offsets any QBI from other businesses that year, and any net loss remaining is treated as a deduction in the next year. Any QBI deduction that next year must be reduced by 20 percent of such qualified business loss carryover.

QBI deduction – The taxpayer’s QBI deduction will generally be equal to the lesser of the taxpayer’s combined QBI for the taxable year, or an amount equal to 20 percent of the excess of the taxpayer’s taxable income for the year over the sum of any net capital gain plus qualified cooperative dividends; plus, the lesser of 20 percent of the qualifying cooperative dividends, or the taxpayer’s taxable income minus any net capital gain. In no event can the deduction exceed the taxpayer’s taxable income for the year as reduced for any net capital gain. And the term taxable income for this purpose is determined without regard to the Section 199A deduction.

Combined QBI – This is a confusing term, as it is defined as the sum of the deductible amounts, maxed at 20 percent of QBI, for each qualified trade or business carried on by the taxpayer.

Qualified items – These will not include investment-related items such as short-term or long-term capital gains or losses; dividends; nonbusiness-related interest income; or gains and losses from commodities, foreign currency, notional contracts, or annuities. It will also not include reasonable compensation or guaranteed payments paid to the taxpayer for services rendered in connection with that trade or business.

Deductible amount – For purposes of computing the combined QBI, this is generally the lesser of the following:

  • 20 percent of the taxpayer’s QBI with respect to each qualified business, or
  • A W-2 wage/qualifying property limitation defined as the greater of 50 percent of the W-2 wages with respect to the qualifying business, or the sum of 25 percent of the W-2 wages with respect to the qualifying business, plus 2.5 percent of the “unadjusted basis immediately after acquisition” of all qualified property.
Exception: The above wage/asset limitation in determining the deductible amount will not apply to taxpayers with less than $315,000 (married filing jointly) or $157,500 (all other) of taxable income before deduction, and the limitation is phased in under a complex calculation over the next $100,000 (married filing jointly) or $50,000 (all others) of taxable income before limitation.

Additionally, it appears that a taxpayer may be able to claim the deduction even if they are above the AGI thresholds, and even though they may not have any W-2 wages in the business (such as a sole proprietorship), as long as they have tangible assets in the business.

Qualified property – This is tangible depreciable property, still being depreciated as of the close of the tax year, and within its first 10 years of depreciable life.

Qualifying trade or business – Generally, any type of business except specified service trades or businesses or a trade or business of performing services as an employee.

Specified service trade or business – Subject to deduction limitation, these are “any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.” For guidance as to what constitutes a specified service, the Conference Report to Accompany H.R. 1 – Tax Cuts and Jobs Act refers to established law for defining personal service corporations in Internal Revenue Code Section 448. Also note, the statute exempts architectural and engineering services from being disqualified services.

Exception: Even if a taxpayer has a “specified service trade or business” subject to the deduction limitation, the deduction will still be available to taxpayers with income less than $315,000 (married filing jointly) and $157,500 (single). This is phased out under some complex calculations over the next $100,000/$50,000 respectively, including the interaction of the general wage and asset limitations discussed earlier.


Here is an example from the above referenced Conference Report: Assume that a taxpayer who is subject to the AGI limitation does business as a sole proprietorship conducting a widget-making business that is not a “specified service business.” The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of 50 percent of W-2 wages (or $0) or the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition ($100,000 x .025 = $2,500). The amount of the limitation on the taxpayer’s deduction therefore is $2,500.

Here is an expanded example I put together.

Assume a taxpayer does business as a qualifying S corporation conducting a widget-making business that has qualifying business income of $3 million in 2018. The taxpayer is the sole shareholder. Therefore, prior to any AGI limitation that would trigger the wages/property limitation, the deductible amount would normally be 20 percent, or $600,000.

Now, assume the taxpayer is well above the AGI threshold amounts and is therefore subject to the previously discussed wage/property limitations. The business has 25 employees in 2018 with W-2 wages of $1 million, and has unadjusted basis in depreciable property (immediately after their acquisition) of $8 million.

The taxpayer’s limitation in 2018 would be the greater of 50 percent of W-2 wages ($500,000), or the sum of 25 percent of W-2 wages ($250,000) plus 2.5 percent of the unadjusted basis of qualifying property (2.5 percent x $8 million = $200,000), which totals $450,000.

The amount of the limitation on the taxpayer’s deduction is therefore $500,000.

Other Provisions

For partnerships and S corporations, the deduction is applied at the partner or shareholder level, generally by taking into account the allocable share of the entity’s separately stated items, and uses the same allocable share in determining the applicable wage and asset limitation.

If the taxpayer has a substantial understatement of income tax as a result of an improper Section 199A deduction, the taxpayer will be subject to the 20 percent accuracy-related penalty if the understatement is more than the greater of 5 percent (not 10 percent) of the tax required to be shown on the tax return, or $5,000.

Unanswered Questions

In their haste to enact this legislation, the tax writers created lots of ambiguity and omitted numerous clarifications. On Feb. 21, 2018, the AICPA sent a formal letter to the Treasury Department and the IRS outlining more than 50 concerns arising from the ambiguity of the statutory language of Section 199A.2 The AICPA stressed the importance for quick guidance regarding the concerns due to the fact that the law is already in effect and will impact estimated payments coming up this spring, it will affect how entities should be structured, and it will affect tax planning and compliance situations.

The sidebar at the bottom of this article is a list of many of AICPA's concerns as well as several others originating from PICPA's Federal Taxation Committee. (There are others that are too technical for the scope of this article, but could nevertheless be significant under specific taxpayer facts and circumstances.)

Effects on Choice of Entity

Congress appears to have intended that Section 199A effectively would exempt up to 20 percent of qualifying income in a pass-through business, thus lowering the highest federal individual marginal rate on such income to a maximum effective rate of 29.6 percent (i.e., 80 percent of the new highest federal individual statutory rate of 37 percent), plus a possible 3.8 percent Medicare surtax for a total pass-through maximum federal tax obligation of 33.4 percent. This compares to 40.8 percent for pass-through owners who are not eligible for this new qualifying deduction (as calculated in the beginning of this article).

Therefore, this new deduction would give pass-through owners, if they qualify, a continued federal income tax rate advantage of about seven points over the new C corporation double tax burden rate of about 39.8 percent.

Of course, as explained in the beginning of this feature, even the lower federal maximum effective federal tax burden of 33.4 percent on pass-through income (if the owner qualifies) is not as attractive as the new 21 percent rate of C corporations (i.e., without taking distributions or intent to sell, and hope to avoid the accumulated earnings tax until such stock could pass to the next generation with a step up in basis at death).

However, businesses in Pennsylvania must also consider how choice of entity will impact state income taxes. After tax reform, assuming the taxpayer is a Pennsylvania resident and the business is entirely in state, the comparative analysis changes a bit. Specifically, if a business is held in C corporation form, with the intent to take distributions or exit via a sale, the total maximum federal and state tax burden becomes 48 percent (i.e., about eight points more than previously calculated due to the additional 9.99 percent Pennsylvania corporate tax rate less a 21 percent federal benefit). A qualifying pass-through’s total federal and Pennsylvania rate would be 36.5 percent (i.e., about three points more than previously calculated due to the 3.07 percent state individual rate assumed to be effectively nondeductible after tax reform). The advantage of operating in qualifying pass-through form in Pennsylvania is about 11.5 tax-rate points over being in C corporation form.

But if an owner believes he or she does not need the distributions or has an intent to sell, and feels that if the business were held in C corporation form he or she could defend against an accumulated tax problem until the business can pass to the next generation, then the new combined federal and state C corporation rate of 28.9 percent (i.e., 21 percent federal plus an effective 8 percent Pennsylvania corporate rate) is attractive compared with the new qualifying pass-through maximum federal and state rate of 36.5 percent.

Planning Considerations

You may have already begun to imagine the planning possibilities Section 199A opens up. Here are 10 to consider3:

  • Consider using the 20 percent deduction in calculating 2018 estimated tax payments if you are comfortable with your facts and circumstances allowing you, or your client, eligibility.
  • Reconsider your form of doing business. Consider what restructuring may be needed to fit qualifying activities into a pass-through entity if you are not presently into one.
  • Perhaps the tax-rate differentials make you wonder if the best path is to take advantage of the new 21 percent C corporation rate (assuming no need for distributions and no intent to sell the company in the near future; can defend against accumulated earnings tax exposure; and are waiting for shareholders to pass and get a step up in basis).
  • Review organization agreements and tax elections to avoid missteps to protect the choice of having a pass-through entity.
  • To optimize the deduction, what activities or businesses could be restructured among a group of companies, or establish new companies within your control, to maximize eligible activities and businesses?
  • Consider what wages or guaranteed payments are taken out or not taken out to optimize the W-2 wage portion of the limitation calculation. If you are a sole proprietorship or LLC, you would not have W-2 wages to yourself, so does that mean you should consider becoming an S corporation to optimize that calculation?
  • Should wages be reallocated within the businesses if presently centralizing them into one large W-2 pool in one company and charging the affiliates their share?
  • If you have kept tangible depreciable property outside certain businesses and charged them rent, should some be moved into the businesses that could use more of that for the tangible property portion of the limitation calculation?
  • Reconsider making some independent contractors more like employees to boost the W-2 calculation.
  • If you believe a business qualifies for the Section 199A deduction, then review carefully what business activity codes and descriptions you are already providing the IRS, or plan to in the future, to increase the chances going forward they accept the Section 199A deduction.


For those who want to be aggressive in applying Section 199A provisions, I suppose this could be an opportunity. For those who are more risk averse, the lack of clarity is problematic. Hopefully this article has enlightened you about this significant opportunity; and if you were already aware of it, you may now realize there are numerous unresolved questions about how to apply it. I strongly recommend you read through the Conference Report and search for ongoing guidance from the AICPA and U.S. Treasury over the next few months before you advise on it or commit to an approach in order to stay up to date with any answers regarding the many pitfalls and planning opportunities.


AICPA and PICPA Concerns Regarding Section 199A

In relation to the definition of QBI:

How is QBI determined: at the activity level within an entity or at an aggregate-entity level by looking at the principal business only?

Can there be a de minimus rule to exempt a small amount of nonqualifying income mixed into the business, say 5 percent?

What is meant by the language in the Conference Report that QBI will not include reasonable compensation or guaranteed payments paid to the taxpayer for services rendered in connection with that trade or business? Does this mean the related expense is not deducted in determining QBI; not included as additional QBI; or is a reduction of QBI?

Clarification is needed on whether a taxpayer must offset ordinary income from the business with any related deductible business interest expense.

Guidance is needed on whether a taxpayer can aggregate the relevant metrics from various pass-through businesses if they are managed as one business in determining the wage/asset limitations, especially when the taxpayer has businesses integrated in a vertical or horizontal entity structure under common control.

Examples are needed for how current qualifying business losses are treated. For example, confirmation that they offset QBI from other qualifying businesses in the same year before the 20 percent deduction is calculated, and how the carryover of excess losses will work.

How will losses from other sections, such as 469 passive losses, originating in a current year or prior year, be treated in determining current year QBI? Do such prior passive losses offset passive income from that same business in the current year, and does the remaining prior passive loss offset current year QBI from that same business?

Confirmation is needed that a passive owner or shareholder is also eligible for the deduction, and that a rental real estate activity also qualifies.

Examples are needed of what is meant by disqualifying income if it is dependent on the “reputation or skill of one or more of its employees or owners.”

Specific and additional examples are needed of disqualifying income from “specified service businesses.”

Guidance is needed as to how to include the items of income flowing through to the owner/shareholder from a fiscal year K-1, especially one that ends in 2018 and began prior to the new law.

Clarification is needed as to exactly what types of business-related items make up QBI. For example, what about unrecaptured Section 1250 gain, Section 1245 recapture income when the asset or the business is sold, Section 1231 gains, and gain on sale of business intangibles?

How is the character of QBI affected, if at all, when it passes up through multiple other pass-throughs that may have other types of businesses, some of which may have QBI and some may not? How will REIT income, or other types of QBI, be treated when passed through other entities? In other words, how will these provisions work when there are multiple tiers of entities?

How does this all interact with alternative minimum tax, which still exists for individuals?

With regard to the W-2 wage limitation calculations once the applicable AGI thresholds are exceeded in order to determine the allowable deduction:

How are taxpayer wages or guaranteed payments treated in determining the wage limitations: fully included or excluded?

What if a business uses independent contractors vs. employees? Could there be a substance-over-form standard used to allow those payments in the overall W-2 limitation?

Clarification is needed as to how to compute the available deduction when a taxpayer is subject to the “double phaseouts” of being in a disqualified service business, and also to the wage and asset limitations.

With respect to the 2.5 percent of the “unadjusted basis immediately after acquisition” calculation:
How is unadjusted basis determined in the case of a tax-free acquisition, such as a like-kind exchange of real estate, a statutory merger, or a gift or inheritance?

Will improvements be allowed to be added to the original unadjusted basis?

How does one factor in property acquired midyear or sold midyear?

What if the business was not held all year?

What if property is recorded as a capitalized lease?

Will assets placed in service before 2018 be allowed to be included or only new additions?

Will unadjusted basis be considered before applying bonus expensing and Section 179 expensing?


1 Scott Greenberg, “Pass-Through Businesses: Data and Policy,” Tax Foundation, Jan. 17, 2017.
2 “Request for Immediate Guidance Regarding IRC Section 199A – Deduction for Qualified Business Income of Pass-Through Entities (Pub. L. No. 115-97, Sec. 11011),” American Institute of Certified Public Accountants, Feb. 21, 2018.
3 Jason Watson, “Taxpayer’s Comprehensive Guide to LLCs and S Corps: 2018 Edition,” Watson CPA Group. (Special thanks for the early publishing of guidance on this topic.)

Robert E. Duquette, CPA, is a retired EY senior tax partner who is a professor of practice in the College of Business and Economics at Lehigh University in Bethlehem, and a member of the Stevens & Lee/Griffin Tax and Consulting Network. He is on the PICPA Federal Taxation Committee, and can be reached at

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