Hamill: Understanding the 20% business income deduction

The 2018 Tax Act created a new deduction for qualified business income earned by an individual. The basic deduction is 20% of the income earned from the business.

This deduction is available whether you itemize deductions or not. It is broadly subject to two limits (there are, of course, nitpicky details also).

First, the deduction may be limited if the individual’s taxable income exceeds a threshold.

Second, the income threshold is applied in a different manner if the business is classified as a “specified service trade or business,” or SSTB.

The 2018 legislation said that the deduction would expire at the end of 2025. The deduction proved to be extremely popular.

It is difficult to eliminate popular tax breaks. So, the most recent tax legislation made the deduction permanent.

The 2025 legislation also raised the range of income that a high-income person could earn before the deduction was phased out.

Let’s cover the basic rules that apply to 2025. The higher phase-out range applies to 2025, so my examples will be applying the new law.

If your taxable income does not exceed the income threshold, your deduction is 20% of the business income (again, with a few quirky exceptions).

For 2025, the lower range of the phase-out is taxable income of $394,600 for married filing jointly and $197,300 for a single filer.

Most income phase-out provisions in the tax law are based on adjusted gross income or AGI as modified.

Taxable income is after all deductions have been claimed, including the standard deduction or itemized deductions.

I will use a married taxpayer for my examples. If taxable income for 2025 — before the business deduction — is $394,600 or less, there is no limit to the 20% deduction.

If income exceeds $394,600, the deduction is lowered. It can drop to zero when taxable income hits $544,600 ($150,000 above the lower income phase-out).

Let’s say qualified business income is $100,000. In general, the deduction is $20,000. If taxable income reaches $544,600, the deduction can be zero.

What if taxable income is $469,600, which is exactly halfway between the start and the end of the income phase-out range?

Then the general rule is that the deduction drops from $20,000 to $10,000. The reduction is proportionately applied throughout the phase-out range.

There is a way to get a larger deduction. That is to pay W-2 wages in the business or to use depreciable capital in the business.

The deduction cannot drop below the greater of 50% of W-2 wages paid or 2% of the initial cost of depreciable assets.

Let’s say that the taxpayer’s taxable income is $544,600, but that he pays $20,000 of W-2 wages to employees of the business.

Now his deduction is $10,000 rather than the zero shown before. This is 50% of the W-2 wages paid.

The taxable income for the year could be $5 million, and the deduction would still be $10,000 based on the W-2 wages paid.

If the business is an SSTB, there is a two-step limitation. The taxable income limit applies like what is shown above.

When the taxable income exceeds the lower phase-out number ($394,600), the SSTB deduction is further reduced by something called the “applicable percentage.”

The applicable percentage is 100 when taxable income is $394,600 or below. This means the SSTB is treated the same as any other business.

The applicable percentage gradually drops to zero as taxable income goes to the upper end of the phase-out, $544,600 in my example.

This applicable percentage is applied to the business income, the W-2 wages, and the depreciable capital.

When the applicable percentage drops to zero ($544,600 taxable income or higher), the allowed deduction also becomes zero.

This is because the business income, W-2 wages, and capital are all treated as being zero (because they were multiplied by the applicable percentage).

An SSTB with $100,000 of income, $20,000 of W-2 wages, and taxable income of $469,600 — halfway through the phase-out — is $5,000.

This $5,000 is exactly half of the allowed deduction for the non-SSTB (see above). The applicable percentage is 50%.

SSTBs include things like accounting, law, health care, consulting and so on. High-income people in those businesses lose out on the deduction.

The latest tax law improved things a bit for this deduction. There was a hard lobby effort to eliminate the SSTB distinction, but that failed.

Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.