By Claudia Fendian
The Tax Cuts and Jobs Act (“TCJA”) offers no shortage of changes to U.S. tax law, but perhaps most notable is the Section 199A Deduction (commonly referred to as the “20% Deduction” or the “Pass-Through Deduction”). Understanding the requirements and implications of the 199A Deduction can be challenging. Thus, this article seeks to guide entrepreneurs and business owners, particularly at the entity formation stage, as to how to best take advantage of the 20% Deduction.
Ideally, business owners will form entities to maximize 199A Deduction eligibility not only for themselves, but also ultimately for anyone who works for the business in the future. It is important for business owners and entrepreneurs to realize that certain entities will receive more favorable tax treatment because of both the pass-through taxation structure and the relative ease of hiring and paying workers.
Choosing an Entity
A. Pass-Through Tax Advantage
The 199A Deduction is commonly referred to as the Pass-Through Deduction because it favors business owners of pass-through entities, notably sole proprietorships, S corporations, and partnerships. It allows these entities to reduce the taxable income of the business by up to 20 percent. A pass-through entity refers to an entity whose profits “pass through” directly to the business owners, in contrast to C corporations which experience “double taxation” (being taxed first on the entity’s tax returns and then a second time on the individual owners’ returns). In fact, avoiding double taxation is a motivation for entrepreneurs to incorporate pass-through entities. Pass-through entities include sole proprietorships, partnerships, limited liability companies (“LLCs”), and S corporations.
At the entity formation stage, business owners will prefer pass through entity structures. These entities create the greatest opportunity for business owners to capitalize on the 199A Deduction as they are relatively easy to form (in terms of paperwork, necessary steps, and overall framework of the entity type itself) and allow owners to benefit from the deduction. Within pass-through entities, S corporations and partnerships are not generally considered taxpayers, but are still within the scope of the 199A Deduction. These entity structures create opportunities for shareholders or partners to capitalize on the 20% Deduction based on their respective shares in the entity, individual income, and other factors.
While pass-through entities have favorable tax structure, they can be unfavorable in their ability to hire workers. For example, choosing a sole proprietorship as an entity structure can create barriers and complicated steps for the expansion of the business to many employees or a traditional corporate structure. Alternatively, there may be parameters on what kind of members or employees a pass-through entity has. For example, limited partnerships must have at least two members: one general partner and one limited partner.
B. Employees and Independent Contractors: Why Flexibility May Matter
The deduction includes pass-through entity business owners yet has a defined scope that specifically excludes employees and business owners in certain industries, namely health, law, accounting, and others. Notably, employees are excluded, but independent contractors are not. Employees and independent contractors are differentiated in part by: the frequency of the service provided, whether income comes from one business or multiple sources, and the location of the primary place of business. For example, workers classified as employees provide consistent and regular services while independent contractors work “as needed.” For those already working as independent contractors, this is great news. But for employees who are eligible to work as independent contractors, an employee’s decision to switch to independent contractor status requires careful consideration of other factors (some of which may outweigh taxation benefits). For example, independent contractors are often not eligible for certain employer-provided benefits and may not have defined working hours set by an employer, resulting in an inconsistent schedule and increased out-of-pocket costs.
“Qualified Business Income” and How it Works
Before selecting a pass-through entity, entrepreneurs should consider the complicated nature of “qualified business income” (“QBI”), a term emphasized throughout Section 199A. The TCJA defines QBI as business income minus business expenses, with several caveats. QBI does not include salary paid to an individual in their capacity as a shareholder or partner of the pass-through entity, dividends or interest paid, and long-term or short-term capital gains. In addition, QBI is calculated for every business individually, even if the same individual will be paying taxes on behalf of multiple businesses.
By default, those entitled to the deduction would be allowed to deduct as much as 20 percent from QBI. However, Section 199A lays out several different income thresholds and exceptions that can render the deduction calculations challenging and infinitely more complex. For example, the TCJA sets upper and lower income thresholds for qualifying for the deduction. For individuals, the lower income threshold is $157,500 and the upper threshold is $200,000. For married couples filing jointly, the lower income threshold is $315,000 and the upper threshold is $400,000. Furthermore, there are limitations based on the type of services the business offers as well as restrictions based on wages of business employees. Additionally, whether the business has depreciable property under its name is factored into the deduction and eligibility. To best understand the nuances of 199A and apply it to one’s own business planning, the graphic at the end of this article should prove helpful.
Taxation is one of many significant factors for entrepreneurs to consider at the entity formation stage and throughout the business incorporation process as a whole. Thorough research and a careful assessment of the many benefits and drawbacks of any type of entity, paired with a consideration of the taxation benefits and applicability of the 199A Deduction, is the key to incorporating an entity that best fits the owners’ business needs and goals while simultaneously minimizing taxation impact.
 While this article gives minimal background information and analysis related to the 199A Deduction as a whole, the information not included in this article can still be beneficial to entrepreneurs throughout the business incorporation process. See generally Craig W. Benson, Section 199A: A Magic Dance Through the Labyrinth, 58 WASHBURN L. J. 187 (2019) (providing a helpful, detailed, and in-depth analysis of Section 199A and how it functions).
 A simplified example of the application of the 199A Deduction is as follows: A sole proprietorship has qualified business income of $100,000; if the personal income of the owner of the sole proprietorship falls below the lower threshold, he or she will be able to reduce the business’s taxable income by 20 percent, from $100,000 to $80,000. Tax Cuts and Jobs Act, H.R. 1, 10, 115th Cong. (2017) (enacted) [hereinafter “TCJA”].
 Tony Nitti, The 20% Pass-Through Deduction: Where Do We Stand Now?, FORBES (June 20, 2018), https://www.forbes.com/sites/anthonynitti/2018/06/20/the-20-pass-through-deduction-where-do-we-stand-now/#14edb08d4392.
 While the S corporation structure is included in this list, there is some debate as to whether or not it is a preferable entity structure. The benefit of S corporations is that it minimizes self-employment taxes and generally maximizes flexibility within the income threshold of the 199A Deduction. Benson, supra note 1, at 210. By contrast, the S corporation structure has more specific and narrower requirements, including strict limitations on the number and type of shareholders. S Corporations, IRS, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations (last updated May 3, 2018).
 Tax Cuts and Jobs Act, Provision 11011 Section 199A – Qualified Business Income Deduction FAQs, IRS, https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs (last updated Nov. 5, 2018). See id. for a complete list of what partnerships and S corporations report, including shareholders’/partners’ wages, share of qualified business income, etc.
 See Christine Hurt, Partnership Lost, 53 U. RICH. L. REV. 491, 550 (2019) (defining the role of a limited partner as opposed to a general partner).
 Nitti, supra note 3.
 5 Things to Consider if the New Tax Law Has You Thinking About Becoming an Independent Contractor, DON’T MESS WITH TAXES (June 7, 2017), https://www.dontmesswithtaxes.com/2018/06/tax-cuts-jobs-act-effect-on-independent-contractors.html. See Hurt, supra note 10, at 524 (noting that the 20 percent deduction is available to independent contractors or sole proprietors, or via a pass-through entity).
 Becoming an Independent Contractor, supra note 12.
 While this article’s primary focus is not to analyze the advantages and disadvantages of working under “independent contractor” status, it is helpful for entrepreneurs to have a general understanding of the distinctions between employees and independent contractors. For guidance, see Charles F. Hickman, Employee v. Independent Contractor, 7 COMPLEAT L. 48 (1990) and F. J. Canty, Independent Contractor or Employee, 17 INS. COUNS. J. 253 (1950).
 Becoming an Independent Contractor, supra note 12. There are further financial and business differences between independent contractor status and employee status, explored in detail in Hickman, supra note 16 and Canty, supra note 16.
 TCJA, supra note 2, at 10.
 Id. at 12.
 Nitti, supra note 3.
 E.g., id. See generally Tax Cuts and Jobs Act: Planning for the New Qualified Business Income Deduction, KEY PRIV. BANK (May 2018), https://www.key.com/kpb/our-insights/tax-perspectives/new-qualified-business-income-deduction.jsp (detailing specific income thresholds and limitations, and other considerations).
 TCJA, supra note 2, at 14.
 See id. (defining “threshold amount” as the lower limit for single individuals as outlined on page 2).
 Id. at 2.
 See id. (outlining the income brackets for married couples filing jointly).
 Id. at 13–14 (defining a qualified trade or business and giving examples of ineligible service types).
 Id. at 11–12 (discussing wages and their incorporation into the 199A calculations).
 Id. at 12 (defining qualified property).