As I understand it, your original assumption was correct. The 20% only applies to distribution income, not to W-2 income. But the 20% deduction is limited to 50% of the W-2 income. So to maximize the deduction and minimize payroll taxes, the business owner will try to set his W-2 wages at 40% of the pass-through income, or two sevenths (~28.57%) of the business income before owner wages.