§199A Qualified Business Income Deduction: A Quick Primer

By Fred Sroka, Dean of the GGU School of Accounting & Bruce F. Braden School of Taxation

The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. It dramatically reduced corporate tax rates, from 35% to 21%. The small business lobby fought this change because it shifted the competitive balance from local businesses (that tend to be sole proprietorships, partnerships or limited liability companies) to big corporations.

To address this, new §199A reduces the tax rate for individuals or trusts on “qualified business income” (QBI). The law was drafted hastily without the usual public hearings. As a result, we all need guidance from IRS or technical corrections from Congress before we can be confident in how this new law will be applied.

  1. §199A Tax Benefit: The new law is designed to reduce tax rates on business income. Rather than create a different tax rate chart, Congress instead created a 20% “QBI deduction.” This approach gives a very favorable result, since it reduces tax at the highest tax bracket. For individuals in the top tax bracket of 37%, a full QBI deduction will reduce tax on business income to 37% * 80% = 29.6%!


As pointed out in the above slide, tax deductions generally impact many tax attributes other than tax calculations. To avoid this, the law specifies that the QBI deduction does NOT affect other tax attributes like the net operating loss (NOL), tax basis or Adjusted Gross Income (AGI). The law also specifies that the QBI deduction can be claimed regardless of whether the taxpayer itemizes deductions, claims the standard deduction, or is subject to the Alternative Minimum Tax (AMT). In short, the deduction just lowers your tax!

  1. How does the QBI deduction work? Calculating the QBI deduction is complex. Let’s begin with a “road map” of the calculation.


  • Business Activity: The first step is to determine whether income comes from a business activity, as opposed to an investment activity. The law also excludes foreign business income from the calculation.
  • Compensation for Services: The second step is to determine whether the income represents compensation for the taxpayer’s services.
  • Taxable Income Test: If your taxable income (before any QBI deduction) is under $315,000 (for a joint tax return) or $157,500 (for an individual tax return), you’re done! Simply deduct 20% of the QBI that isn’t treated as compensation. If your taxable income is above these amounts, you must pass through two more hurdles.
  • Specified Service Business Income: The new law denies some or all of the QBI deduction for doctors, lawyers, accountants, and many other professional service providers if their income is above the taxable income test.
  • Wage Limit: The new law limits the QBI deduction for all businesses if the business doesn’t employ enough people (or, as we’ll see, buy enough depreciable property). Again, this limit only applies if you exceed the taxable income test.
  • QBI Deduction: If you make it through the above tests and limits, you are entitled to deduct 20% of your QBI in computing your federal tax!
  1. Business Income: Let’s begin with an exploration of the business income test. Happily, QBI can come from a sole proprietorship, a partnership, LLC or even S corporation. The only business entity which prevents this flow-through is a corporation which pays its own tax under Subchapter C (fittingly called a C corporation).

QBI has some immediate limits on the types of income that qualify. First, the income must come from a domestic business. If a business has operations in a foreign country, the income attributable to foreign operations must be separated and disallowed. Second, the income must be ordinary business income. This means that capital gain, dividend income, interest income (except for business interest paid by customers), and a few other exotic types of income (net of related expense) are disallowed.


Perhaps the greatest challenge in defining QBI is determining whether income constitutes a business. For many years, taxpayers have been afraid of calling an activity a business. Business income is subject to self-employment tax and it generally exposes us to tax in other states or even other countries. TCJA has shifted this balance dramatically. First, investment expenses incurred by individuals (previously deductible under §212) will no longer be deductible starting in 2018. Second, only business income qualifies for the 20% QBI deduction.

What does it take to be a business? In general, the amount of income isn’t important. Instead, the Courts tend to focus on the level of involvement of the owner. If the activity is substantial, systematic and continuous, Courts have considered the activity to be a business. Under this standard, merely renting your house to a relative, or renting a warehouse to an unrelated tenant under a triple-net lease do not rise to the level of a business.

Do we want all our activities to be treated as businesses? Maybe not. First, TCJA has also introduced very liberal cost recovery rules, allowing for immediate write-offs of many purchases of new and used property. If you expect your activity to run at a loss, you might prefer to limit your activities to prevent the loss from offsetting other business income in the computation of the QBI deduction.

  1. Compensation: Compensation for services is also ineligible for the QBI deduction. Thus, any wages that are reported to you on a form W-2 do not qualify. A number of blogs have suggested that employees should simply quit their jobs and ask their boss for a form 1099. Please beware of any advice that sounds too good to be true. To be in your own business, you must control the “manner and mode” in which you do your work. The IRS applies 20 common law factors to decide whether the taxpayer’s classification as an independent contractor makes sense.


Even if you are in your own business, a portion of your income may be treated as compensation for services. §199A(c)(4) excludes any W-2 wages paid to the owner by an S corporation. The statute also disallows QBI deductions for compensation paid by a partnership to a partner if the amount is determined without regard to partnership income. The law does NOT specify other types of income that will be treated as “reasonable compensation”, raising significant questions about the choice of entity in running our businesses.

  • Sole Proprietorships: Curiously, the statute does not explicitly include any portion of income from a sole proprietorship as compensation for services. This seems odd, particularly where the business is itself a service business. Absent future technical corrections or guidance from IRS, most sole proprietors will qualify for the QBI deduction.
  • Partnerships: Partnerships can pay partners a “guaranteed payment” under §707(c), or make very similar payments under §707(a). Both of these are ineligible for QBI. As a result, many partnerships may change their economic terms, reducing any partner’s right to fixed compensation, instead increasing the partners’ share of “bottom line” income. Like sole proprietorships, the statute does not state that these allocations of net profit will be treated as compensation, even if the partnership provides services.
  • S Corporations: Prior law has firmly established that S corporations must pay “reasonable compensation” to shareholders, or else any distributions to the shareholder will be recharacterized as salary. This salary is not eligible for the QBI deduction. As a result, many S corporations may feel that they are at a disadvantage compared to other forms of business entities. Before precipitously changing away from S corp status, taxpayers should consider other factors:
    • IRS only forces S corp shareholders to recognize compensation income if they actually take money out of the business. As a result, if the profits of an S corp are retained within the business for growth, the statute appears to allow for full QBI deduction.
    • Before changing from an S corporation to any non-corporate form of business entity, owners should be VERY concerned about the tax impact of liquidating the corporation. Liquidation of any corporation (C or S) triggers gain on the appreciation in all corporate assets. Even a small service business likely has substantial value in its trade name and goodwill. The tax cost of liquidating a small service S corporation can be devastating.
    • Finally, shareholders in an S corporation benefit from a glitch in the “Net Investment Income” (NII) rules of §1411. If the shareholder “materially participates” in the business (meaning works over 500 hours per year) and receives reasonable compensation for services, then any residual income allocated to the shareholder on the form K-1 likely escapes both the 3.8% SE tax and the 3.8% NII tax. TCJA failed to close this obvious gap between the SE and NII taxes. As a result, S corp shareholders may prefer to give up the 7% QBI benefit on their salary if the 3.8% benefit on distributions is substantially larger.
  1. Taxable Income Test: We now know what income meets the definition of QBI. The next step is to determine whether any limits apply to the QBI deduction. This is based on the taxable income (including income from all sources, not merely the one business) excluding only the QBI deduction itself.


If your taxable income (before the QBI deduction) does not exceed $157,500 on a single return, or $315,000 on a joint return, then you are not subject to any further limits. You simply multiply your QBI by 20%, and that’s your QBI deduction.

Conversely, if your taxable income is over $207,500 on a single return, or $415,000 on a joint return, you are fully subject to the “Specified Service” and “Wages” limitations. As explained below, this wipes out any QBI benefit for Specified Services, and limits the benefit if the business does not pay sufficient W-2 wages.

The taxable income limits phase in gradually between the above floor and ceiling. For a joint return, every $1,000 of taxable income over the $315,000 floor results in an additional 1% of the limits being applied, so that fully 100% of the limits apply once your income hits $415,000. Single taxpayers increasingly are limited by 1% for every $500 their income exceeds the $157,500 floor.

  1. Specified Service Business Test: If your taxable income is below the above limits, then it doesn’t matter what business or profession you are in. However, if you are over the limit, then a portion of your QBI from certain service businesses will be limited.


Which businesses are specified? To begin with, most licensed professionals (doctors, lawyers, accountants, etc.) are specified. Curiously engineers and architects were removed from the list of specified businesses shortly before enactment. In addition to licensed professionals, artists, consultants, and athletes are considered “specified.”

A separate category of specified business involves financial services. Bankers, stock brokers, investment advisers, and dealers are all treated as specified.

One final category of specified service is any business where “the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” This category comes from the “Qualified Small Business Stock” rules contained in §1202. Sadly, there is little case law to interpret how reputation or skill of an individual is measured as an asset of the business.

  1. Wages Test: If your taxable income is below the taxable income limits discussed above, then it doesn’t matter how much you pay in W-2 wages. However, if you are over the limit, then your QBI deduction may be limited. The purpose of the limit is to restrict the §199A benefit to those businesses who create jobs. However, pressure from the real estate industry created a secondary test, which measures a combination of wages paid and depreciable property used in the business.


  • Wages: The basic limit is 50% of the amount of wages paid and reported on form W-2 for the current tax year. The statute does not exclude wages paid to the owner, though as explained above these wages will not themselves be eligible for the QBI deduction.
  • Wages and Property: The alternate test includes 25% of wages, plus 2.5% of the “unadjusted basis” of tangible depreciable property used in the business. The property must be held in the business at the end of the year, must have been used in the business during the year, and cannot be fully depreciated AND more than 10 years old. The term “unadjusted basis” is unclear. IRS Pub 946 states that unadjusted basis of property is the purchase price reduced by any “bonus depreciation” under §168(k) or expensed under §179. §199A(b)(2)(B)(ii) uses the term “unadjusted basis immediately after the acquisition of all qualified property.” It is possible (but not certain) that the QBI deduction will face greater limits if §168(k) bonus depreciation or §179 expensing is elected.

The impact of the wages limit is complex. Let’s assume that Ann’s QBI is $100,000, but she only paid $10,000 in W-2 wages and doesn’t have depreciable property.  If her taxable income is under $315,000 (mfj), Ann escapes any limit and her QBI deduction is 20% * $100,000 = $20,000. If Ann’s taxable income is over $415,000, then her QBI deduction is limited to the LESSER of 20% of $100,000 QBI or the $10,000 wages. As a result, Ann’s QBI deduction is only $10,000. Finally, if Ann’s taxable income is $365,000, then she is subject to half the limit—so she gets $15,000 of QBI deduction.

Finally, it is worth noting that a specified business may be subject to a second limitation if taxable income falls between the floor and ceiling amounts. The calculation first disallows a percentage of the specified QBI, and then separately applies the wage limit to QBI and wages reduced by the same percentage.

  1. Special Rules for Losses: What if Ann makes money in one business but loses money in another business? The law requires that she reduce the income from the first business by the amount of loss in the second. If the result is an overall business loss, that loss carries forward to reduce Ann’s QBI deduction in the following year.

Two additional special rules regarding losses have been introduced. First, if a taxpayer has an overall business loss that exceeds $250,000 on a single return ($500,000 on a joint return), that loss is disallowed and carried forward to future years. This prevents large business losses from being offset by large investment income.  Finally, the passive loss limitations of §469 are applied before the computation of QBI, so any net passive losses do not offset income from active businesses.

CONCLUSION: §199A provides a substantial tax benefit for non-corporate businesses and businesses operating through S corporations. However, uncertainty remains on the definitions of business, compensation, and specified businesses. Along with this uncertainty, the new law imposes a complex series of limitations which may reduce the benefit. Finally, taxpayers will not know how to compute their benefit until their taxable income is finally determined, which may not occur until after the end of the tax year.

About Fred Sroka

Fred Sroka, JD is the Dean of the GGU School of Accounting & Bruce F. Braden School of Taxation. Fred Sroka received his JD from UCLA, practiced as a tax lawyer for 18 years, worked as a tax accountant for 18 years, and managed a couple of years as a management consultant! He has been a member of the GGU adjunct tax faculty since 1983, and a member of the tax advisory board. Fred retired from PricewaterhouseCoopers (PwC) in 2014 and has served as the Dean of the Bruce F. Braden School of Tax since October 2014.

He holds an active CPA license in California and Colorado and is an inactive member of the California State Bar. Fred and his wife Ronda have two kids (both off in grad school), who provide constant coaching on the world from a millennial student’s perspective. Fred loves to play tennis and golf and is constantly puttering around the house with his tools.

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