Tax Facts
806 / How are S corporations taxed under the 2017 tax reform legislation?
The 2017 Tax Act made substantial changes to the treatment of pass-through business income, which was previously simply “passed through” and taxed at the business owners’ individual ordinary income tax rates as discussed in Q 805. Partnerships (and entities that elect partnership taxation, such as certain LLCs), S corporations and sole proprietorships are subject to the post-reform pass-through taxation rules, which apply for tax years beginning after December 31, 2017. While these rules were set to expire after December 31, 2025, the 2025 OBBBA made them permanent.1 The rules are complicated, and the IRS and related agencies have released extensive interpretive materials explaining how the provisions will be applied.
Shareholders of S corporations may now generally deduct 20 percent of “qualified business income”2 (QBI, which largely excludes “specified service business” income (see below)).
S corporations that are categorized as service businesses and have income below the applicable threshold level plus $75,000 ($150,000 for joint returns) also qualify for the 20 percent deduction. Prior to 2026, the phase out range was $50,000 ($100,000 for joint returns).
The applicable threshold levels for 2025 increase to $394,600 for married taxpayers filing jointly ($383,900 for 2024, $364,200 in 2023, $340,100 in 2022, $329,800 in 2021, $326,000 in 2020) or $197,300 for single filers ($191,950 for 2024, $182,000 in 2023, $170,050 in 2022, $164,900 in 2021, $163,300 in 2020). 3 Service business owners in 2025 with income that exceeds $494,600 (married filing jointly) or $247,300 (single filers) will not receive the benefit of the deduction. The entirety of the taxpayer’s income must be taken into account (not only the business’ income).4
The deduction is available regardless of whether the S corporation shareholder itemizes, and is applied based on ownership interest (i.e., a shareholder who owns 25 percent of an S corporation is entitled to apply the deduction to 25 percent of his or her qualified business income). The calculation is made on an entity-specific basis, meaning that the deduction must be applied separately to each entity rather than based upon the cumulative income of all entities owned by the taxpayer.
Qualified business income is generally the net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer, excluding qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income (but see Q ).5 Income, gain, deduction and loss items are generally qualified if they are connected with a U.S. trade or business and are included or allowed in calculating taxable income. Amounts related to the following investment items are excluded: capital gains, qualified dividend income (or equivalent), non-business interest income, foreign base company income taken into account under IRC Section 954(c) and non-business annuity distributions.6
For alternative minimum tax purposes, qualified business income is calculated without regard to otherwise allowable adjustments.7
When the taxpayer’s income exceeds the applicable annual threshold, the deduction is capped at the greater of (1) 50 percent of W-2 wage income or (2) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all “qualified property” (but see Q for a discussion of the so-called “phase-in” for certain taxpayers whose income only exceeds the threshold by $75,000 ($150,000 for joint returns) Prior to 2026, the amounts were $50,000 ($100,000 for joint returns)).8
“Qualified property” generally includes depreciable property that is used in the taxpayer’s trade or business for the production of income as of the end of the tax year, as long as the depreciation period has not expired before the end of that year. The depreciation period is a period that begins on the first day that the taxpayer places the property in service and ends the later of (1) 10 years after that date or (2) the last day of the last full year in the applicable recovery period that would apply to the property under IRC Section 168 (without regard to Section 168(g)).9
A “specified service business” is a 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 the business is the reputation or skill of one or more employees or workers, or one which involves the performance of services consisting of investing and investment management trading or dealing in securities, partnership interests or commodities.
To determine the “qualified business income” with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages.10 With respect to S corporations, qualified business income does not include any amounts that are treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include guaranteed payments or amounts paid or incurred by a partnership to a partner, when the partner is providing services and is not acting in his or her capacity as a partner.11
If the qualified business income for the year is a loss, it is carried forward as a loss for the next tax year. Any deduction allowed for that subsequent tax year is reduced by 20 percent of any carried forward business loss from the previous year.12
The deduction is allowed in reducing taxable income (functioning more like an exclusion), rather than as a deduction in computing adjusted gross income (i.e., the deduction does not impact limitations based on adjusted gross income). Further, trusts and estates are also eligible for the 20 percent deduction.
For partnerships and S corporations, these rules apply at the partner or shareholder level (each shareholder is treated as having W-2 wages for the year equal to that shareholder’s allocable share of the S corporation).
Minimum QBI Deduction for Small Businessses.
Beginning in 2026, the OBBBA establishes a minimum QBI deduction, which will be inflation-adjusted, for active qualified business income for an applicable taxpayer.13 An "applicable taxpayer" is one who earns at least $1,000 in aggregate qualified business income from active qualified trades or businesses.14 Qualified trades or businesses are those in which the taxpayer materially participates in the business activity.15 The minimum deduction is $400 regardless of the otherwise required phase-out.16
See Q for a detailed discussion of how a pass-through entity’s deduction for qualified business income is determined.
1. Under IRC § 199A.
2. IRC § 199A(a).
3. Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34, Rev. Proc. 2024-40.
4. IRC §§ 199A(b)(3), 199A(d)(2).
5. IRC § 199A(c).
6. IRC §§ 199A(c)(3), 199A(d)(3).
7. IRC § 199A(f)(2).
8. IRC § 199A(b)(2). IRC § 199A(b)(5) directs the Secretary of Treasury to develop guidance on how these limitations apply in short tax years, or in the case of acquisitions or dispositions of other businesses.
9. IRC § 199A(b)(6). IRC Section 168 provides accelerated cost recovery system rules. IRC Section 168(g) provides an alternate depreciation system that may be used with respect to certain property, including tangible property used predominantly outside the U.S., tax-exempt use property and tax-exempt bond financed property.
10. As defined in IRC § 199A(b)(4).
11. IRC § 199A(c)(4).
12. IRC § 199A(c)(2).
13. OBBBA § 70105(b) amending IRC § 199A(i).
14. IRC § 199A(i)(2)(A).
15. IRC § 199A(i)(2)(B) referring to IRC § 469(h).
16. IRC § 199A(i)(1).
Shareholders of S corporations may now generally deduct 20 percent of “qualified business income”2 (QBI, which largely excludes “specified service business” income (see below)).
S corporations that are categorized as service businesses and have income below the applicable threshold level plus $75,000 ($150,000 for joint returns) also qualify for the 20 percent deduction. Prior to 2026, the phase out range was $50,000 ($100,000 for joint returns).
The applicable threshold levels for 2025 increase to $394,600 for married taxpayers filing jointly ($383,900 for 2024, $364,200 in 2023, $340,100 in 2022, $329,800 in 2021, $326,000 in 2020) or $197,300 for single filers ($191,950 for 2024, $182,000 in 2023, $170,050 in 2022, $164,900 in 2021, $163,300 in 2020). 3 Service business owners in 2025 with income that exceeds $494,600 (married filing jointly) or $247,300 (single filers) will not receive the benefit of the deduction. The entirety of the taxpayer’s income must be taken into account (not only the business’ income).4
The deduction is available regardless of whether the S corporation shareholder itemizes, and is applied based on ownership interest (i.e., a shareholder who owns 25 percent of an S corporation is entitled to apply the deduction to 25 percent of his or her qualified business income). The calculation is made on an entity-specific basis, meaning that the deduction must be applied separately to each entity rather than based upon the cumulative income of all entities owned by the taxpayer.
Qualified business income is generally the net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer, excluding qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income (but see Q ).5 Income, gain, deduction and loss items are generally qualified if they are connected with a U.S. trade or business and are included or allowed in calculating taxable income. Amounts related to the following investment items are excluded: capital gains, qualified dividend income (or equivalent), non-business interest income, foreign base company income taken into account under IRC Section 954(c) and non-business annuity distributions.6
For alternative minimum tax purposes, qualified business income is calculated without regard to otherwise allowable adjustments.7
When the taxpayer’s income exceeds the applicable annual threshold, the deduction is capped at the greater of (1) 50 percent of W-2 wage income or (2) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all “qualified property” (but see Q for a discussion of the so-called “phase-in” for certain taxpayers whose income only exceeds the threshold by $75,000 ($150,000 for joint returns) Prior to 2026, the amounts were $50,000 ($100,000 for joint returns)).8
“Qualified property” generally includes depreciable property that is used in the taxpayer’s trade or business for the production of income as of the end of the tax year, as long as the depreciation period has not expired before the end of that year. The depreciation period is a period that begins on the first day that the taxpayer places the property in service and ends the later of (1) 10 years after that date or (2) the last day of the last full year in the applicable recovery period that would apply to the property under IRC Section 168 (without regard to Section 168(g)).9
A “specified service business” is a 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 the business is the reputation or skill of one or more employees or workers, or one which involves the performance of services consisting of investing and investment management trading or dealing in securities, partnership interests or commodities.
To determine the “qualified business income” with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages.10 With respect to S corporations, qualified business income does not include any amounts that are treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include guaranteed payments or amounts paid or incurred by a partnership to a partner, when the partner is providing services and is not acting in his or her capacity as a partner.11
If the qualified business income for the year is a loss, it is carried forward as a loss for the next tax year. Any deduction allowed for that subsequent tax year is reduced by 20 percent of any carried forward business loss from the previous year.12
The deduction is allowed in reducing taxable income (functioning more like an exclusion), rather than as a deduction in computing adjusted gross income (i.e., the deduction does not impact limitations based on adjusted gross income). Further, trusts and estates are also eligible for the 20 percent deduction.
For partnerships and S corporations, these rules apply at the partner or shareholder level (each shareholder is treated as having W-2 wages for the year equal to that shareholder’s allocable share of the S corporation).
Minimum QBI Deduction for Small Businessses.
Beginning in 2026, the OBBBA establishes a minimum QBI deduction, which will be inflation-adjusted, for active qualified business income for an applicable taxpayer.13 An "applicable taxpayer" is one who earns at least $1,000 in aggregate qualified business income from active qualified trades or businesses.14 Qualified trades or businesses are those in which the taxpayer materially participates in the business activity.15 The minimum deduction is $400 regardless of the otherwise required phase-out.16
See Q for a detailed discussion of how a pass-through entity’s deduction for qualified business income is determined.
1. Under IRC § 199A.
2. IRC § 199A(a).
3. Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34, Rev. Proc. 2024-40.
4. IRC §§ 199A(b)(3), 199A(d)(2).
5. IRC § 199A(c).
6. IRC §§ 199A(c)(3), 199A(d)(3).
7. IRC § 199A(f)(2).
8. IRC § 199A(b)(2). IRC § 199A(b)(5) directs the Secretary of Treasury to develop guidance on how these limitations apply in short tax years, or in the case of acquisitions or dispositions of other businesses.
9. IRC § 199A(b)(6). IRC Section 168 provides accelerated cost recovery system rules. IRC Section 168(g) provides an alternate depreciation system that may be used with respect to certain property, including tangible property used predominantly outside the U.S., tax-exempt use property and tax-exempt bond financed property.
10. As defined in IRC § 199A(b)(4).
11. IRC § 199A(c)(4).
12. IRC § 199A(c)(2).
13. OBBBA § 70105(b) amending IRC § 199A(i).
14. IRC § 199A(i)(2)(A).
15. IRC § 199A(i)(2)(B) referring to IRC § 469(h).
16. IRC § 199A(i)(1).
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