The pass-through deduction, formally the Section 199A or QBI deduction, can reduce the taxable income on that flow-through profit. Eligibility, limits and the deduction percentage depend on the tax year. It has been permanent since the One Big Beautiful Bill Act was signed on 4 July 2025.
This guide covers eligible entities, qualified business income (QBI), the limits, three worked examples, and what Australian readers with U.S. business interests should check.
Key Takeaways
- Pass-through taxation moves income onto the owner's return without making it tax-free.
- The QBI deduction is separate from ordinary expenses and capped by taxable income, wages, property and business type.
- A deduction reduces taxable income; a credit reduces tax owed.
- Australian owners should confirm current U.S. rules and Australian reporting consequences first.
What Is a Pass-Through Deduction?
Under Section 199A, eligible non-corporate owners can deduct generally up to 20% of qualified business income (QBI) from a pass-through business on their personal return.
What is a pass-through entity?
A pass-through entity reports its taxable results through its owners. A partnership, for example, generally doesn't pay tax on its income but passes profits or losses to its partners. A C corporation pays its own tax, and shareholders may be taxed again on dividends.
State and foreign treatment can differ from the federal picture, so check each layer.
Common pass-through business structures
- Sole proprietorships: one individual owns an unincorporated business.
- Partnerships: income and losses are allocated to partners.
- S corporations: shareholders report income and losses on personal returns.
- LLCs: a state-law form, not a federal tax class; multi-member defaults to partnership, single-member to disregarded status, and can elect corporate or S corporation treatment
Each owner's result depends on the entity's election, ownership percentage, allocations and the nature of the income. Partners receive this detail on Schedule K-1 (Form 1065), which reports their share of income, deductions and credits.
The Section 199A or QBI deduction
Section 199A lets eligible non-corporate owners deduct generally up to 20% of qualified business income. That 20% is a deduction percentage, not a tax rate. Owners claim it on their own return, either with standard or itemised deductions. It isn't a business expense deducted from operating profit.
Pass-through income versus qualified business income
Not everything a pass-through reports counts as QBI. The income must be effectively connected with a U.S. trade or business. Excluded items include:
- Capital gains and losses
- Dividends and most interest income
- W-2 wages earned as an employee
- S corporation reasonable compensation received by the owner
- Guaranteed payments to partners for services
QBI is net eligible income, not turnover or cash distributions.
Who Qualifies and What Limits Apply?
Taxable-income thresholds and phase-in rules
Eligibility turns on the taxpayer, the type of business, the character of the income, and taxable income before the deduction. Below the threshold, the limits don't apply. Above it, they phase in.
Thresholds by tax year (USD, taxable income before the QBI deduction):
| Tax year | Filing status | Threshold | Phase-in width |
|---|---|---|---|
| 2024 | Married filing jointly | $383,900 | $100,000 |
| 2024 | All other returns | $191,950 | $50,000 |
| 2025 | Married filing jointly | $394,600 | $100,000 |
| 2025 | All other returns | $197,300 | $50,000 |
| 2026 | Married filing jointly | $403,500 | $150,000 |
| 2026 | Married filing separately | $201,775 | $75,000 |
| 2026 | Other returns | $201,750 | $75,000 |
The figures come from IRS Rev. Proc. 2025-32 and earlier procedures. Don't substitute the 2026 "other returns" figure for married filing separately.
Specified service trades or businesses
A specified service trade or business (SSTB) includes health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investment management and trading. Architecture and engineering are excluded from the consulting category.
For an SSTB, the deduction phases down within the range and disappears above the endpoint. Not every professional-services business is an SSTB, so classify carefully.
W-2 wage and qualified property limitations
Once fully applicable, the business component is the lesser of:
- 20% of QBI, or
- the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
Payroll records, fixed-asset schedules and accurate allocation between related businesses all affect this number.
Other restrictions and documentation
- Business losses offset positive QBI proportionately. A net loss carries forward.
- Related businesses can be aggregated if they meet ownership and operational tests, and none is an SSTB.
- Qualified REIT dividends and publicly traded partnership income get a separate 20% component.
- The overall cap is generally 20% of taxable income less net capital gain.
- From 2026, owners with at least $1,000 of active QBI may claim a minimum $400 deduction.
Keep financial statements, payroll data, depreciation records and K-1 information. Taxpayers use Form 8995 for the simplified calculation and Form 8995-A above the threshold.
How Is the Deduction Calculated? Examples of the Benefit
Step 1: Determine the owner's qualified business income
Calculate QBI separately for each business: ordinary income less deductible expenses, excluding the items above. If one business has a loss, it is allocated against the others' positive QBI proportionately. A net negative total carries forward rather than creating a current deduction.
Step 2: Apply the relevant deduction formula
Start with 20% of QBI. That is the preliminary figure. The final deduction is the lesser of the combined business components and 20% of taxable income less net capital gain, after the wage, property and SSTB rules.
The three examples below use 2018 figures from Treasury regulations. They illustrate the mechanics, not current thresholds or anyone's actual result.
Example 1: A non-SSTB below the threshold
An unmarried computer-repair sole proprietor has QBI of $100,000 and taxable income of $81,000, with no capital gains.
- 20% of QBI: $20,000
- 20% of taxable income: $16,200
- Deduction: $16,200
The taxable-income cap, not QBI, set the result.
Example 2: A business affected by wages
An unmarried owner has three businesses. X and Y each earn $1,000,000 of QBI. Z loses $600,000.
- The loss is shared equally, so X and Y each have adjusted QBI of $700,000.
- X paid $500,000 in W-2 wages. Y paid none.
- X's amount is the lesser of $140,000 (20% of QBI) and $250,000 (50% of wages), so $140,000. Y has no wages, so its amount is $0.
- Deduction: $140,000
Supporting this calculation takes payroll records, depreciation schedules and ownership documents.
Example 3: An SSTB at higher taxable income
A married couple filing jointly has taxable income of $375,000. B's share of an SSTB's QBI is $300,000, with $40,000 of wages and no qualified property. The 2018 threshold was $315,000 with a $100,000 range.
- Applicable percentage: 40%, so counted QBI is $120,000 and wages $16,000
- Preliminary amount: $24,000. Wage amount: $8,000
- Excess over wage limit: $16,000; reduction $16,000 × 60% = $9,600
- Final deduction: $14,400
| Stage | Amount |
|---|---|
| Preliminary | $24,000 |
| After limitation | $14,400 |
Benefits, Planning Considerations, and Compliance
Why the deduction may be valuable
An eligible deduction lowers the income subject to U.S. federal tax, though that income still appears on the U.S. return. The value depends on your marginal rate, QBI, taxable income, entity structure and the rest of your return.
For context, JCT data shows 25.6 million tax units claimed about $216 billion of deductions in 2022. Those are deductions, not tax savings.
Avoid choosing a business structure for the deduction alone
Entity choice also affects:
- Liability protection
- Self-employment and payroll taxes (the QBI deduction doesn't reduce self-employment earnings)
- State taxes and annual report or franchise tax
- Administrative cost and retirement planning
- Cross-border reporting
S corporation owners must pay reasonable compensation before taking distributions, and that pay isn't QBI. Model the full tax and compliance picture before restructuring.
Records and professional review
A short compliance checklist:
- Keep reconciled books and financial statements.
- Maintain payroll records and W-2 filings.
- Track fixed assets and depreciation.
- Document ownership and allocations.
- Retain K-1 data and track suspended losses.
- Record business classifications and any aggregation elections.
- Prepare the owner's return on time.
Australian owners with U.S. pass-through interests
Australian tax residents must declare foreign income in Australia. A foreign income tax offset may apply, subject to limits. A U.S. LLC's treatment in Australia depends on the foreign-hybrid conditions, separate from the U.S. election. ATO ID 2010/77 confirms a single-member U.S. LLC can qualify, though it is not published advice.
Australians who are nonresident aliens for U.S. tax may claim the QBI deduction through Form 1040-NR, subject to effectively connected income rules. S corporations cannot have nonresident-alien shareholders.
VJM Global's CPAs and Chartered Accountants prepare U.S. federal and state returns, including Form 1040 and 1040-NR, and have served 250+ Australian businesses. They can help organise records and coordinate cross-border documentation for your situation.
Frequently Asked Questions
What are pass-through deductions?
Pass-through deductions refer to the owner-level Section 199A deduction for eligible QBI and certain REIT and PTP amounts. Eligibility and limits depend on current U.S. tax law.
What is the 199A deduction for qualified business income?
Section 199A, enacted in 2017 and now permanent, allows a deduction of generally up to 20% of eligible QBI. It is neither a business expense nor a tax credit.
What is the income limit for the 199A deduction?
Thresholds vary by tax year and filing status. SSTBs phase out, while non-SSTBs can remain eligible subject to wage and property limits. Check current IRS guidance.
Is pass-through income taxable?
Yes. Owners report it on their own returns and pay tax at individual rates, even when a deduction applies.
What is a pass-through entity?
It is a business structure where profits and losses flow through to owners' personal tax returns. Examples include sole proprietorships, partnerships, S corporations and LLCs taxed as partnerships or S corporations.
What is the QBI deduction?
It's the common name for the Section 199A deduction. Not all pass-through income qualifies, since wages, capital gains and most interest are excluded.
