What Small Businesses Need to Know About Tax Reform

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Updated on Tuesday, February 6, 2018

If a portion of your income comes to you via a side project, freelance work or start-up business, you’re likely to see a tax cut in 2018. The new tax bill went into effect Jan. 1. And it offers an attractive 20% deduction for small-business owners, independent contract workers and entrepreneurs.

“Anybody who owns a business should be happy to see this [deduction] because it’s going to likely reduce their taxes,” said St. Louis-based financial planner David Zaegel.

Over 90% of U.S. businesses are “pass-through” companies like LLCs, sole proprietorships and S-corporations, the Tax Foundation reported. They are called pass-through entities because they are taxed differently than normal businesses. Instead of being subject to corporate income tax, business income is “passed through” to the owner’s individual tax return and taxed at the owner’s individual tax rate.

Corporations, on the other hand — which make up 8.1% of U.S. businesses — are technically taxed at the corporate rate, which fell from a maximum rate of 35% to 21% under the new tax plan. Then, when profits are paid out to shareholders as dividends, the income is taxed on the shareholder’s individual tax return, too.

“They were lowering the corporate tax rate and they had to do something for the small-business owners or else everyone would run and organize themselves as a C-corp,” said Zaegel. Under the act, the deduction is set to expire Dec. 31, 2025.

Who is eligible for the new small-business tax deduction?

A business must first operate as a pass-through entity to qualify for the deduction, but that still doesn’t guarantee the deduction. In order to qualify for at least some of the deduction, the business must also:

  1. Operate a qualified trade or business AND
  2. Fall under the maximum income threshold amount — $207,000 for single filers and at $415,000 for those filing jointly.

C-corporations don’t count. Of course, new rules accompany the pass-through deduction to limit abuse, so not all pass-throughs count, either.

To understand the rules, one must first understand the following tax jargon:

Any trade or business conducted by a pass-through entity that is not a specified service trade or business.

The taxpayer’s share of the qualified trade or business’s net income excluding any amount paid to the taxpayer that is treated as reasonable compensation or guaranteed payment for services rendered.

Tangible property — anything you can touch — used to produce qualified business income, that depreciates over time and will still be available for use at the end of the tax year.

Any business that involves performing services in the fields of health, law, consulting, athletics, financial services, brokerage services or “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.”

When a taxpayer reaches the income threshold — $157,500 for single filers and $315,000 for those filing jointly— restrictions on service businesses and wage limits apply. The benefit is phased out as income rises. Eligibility caps out at incomes of $207,000 for single filers and at $415,000 for joint filers.

How to calculate the deduction:

As long as pass-through business owners fall under the income threshold amount — $157,500 for single filers and $315,000 for those filing jointly— they are in the clear to deduct 20% from the company’s qualified business income and the remaining amount of taxable income would be taxed at the individual’s tax rate.

If they exceed the income threshold but fall under the limit, then new limits start to apply. The deduction would then be limited to the lesser of :

  1. 20% of qualified business income, or

    The greater of:

  2. 50% of the total W-2 wages paid by the business
  3. 25% of the total W-2 wages + 2.5% of unadjusted basis of all qualified property

Plus

  • 20% of qualified REIT dividends
  • Qualified publicly-traded partnership income

For the sake of length, time and complexity, we will focus on the part before “plus.”

What if there’s more than one business owner?

Business owners who have business partners sometimes mistakenly believe the income threshold refers to all owners collectively. But it doesn’t.

“One thing to be clear on in this situation is that the income limits they are talking about are for each person,” said Zaegel.

Let’s say there are three equal owners of a qualified trade or business, for example, and the pass-through income is $450,000, divvied up equally among the partners. Each owner (earning $150,000) would fall just under the income threshold for the new small-business tax deduction.

What if the business partners are married or single?

Let’s say the first owner is unmarried, so they avoid the phaseout. The second is married but his or her spouse doesn’t work, so they too avoid the phaseout. They can both deduct $30,000 from their taxable income and are left with taxable income of $120,000 each.

The third owner is married, and his or her spouse is a W-2 employee with a different company and brings home an annual salary of $100,000. They file taxes jointly, so at a combined $250,000, the pair also falls under the phase out limit ($315,000 for married filing jointly) and get the full pass-through deduction.

They would calculate their deduction as the lesser of:

  1. QBI* 20% = ($150,000) *0.2 = $30,000
    OR
  2. 50%*W-2 wages paid by the business =$100,000*0.5 = $50,000

So, the couple would be able to deduct $30,000 (see: the lesser) and their taxable income is reduced to $220,000 by the pass-through deduction. That being said, the ultimate amount of their taxable income will depend on any other allowable deductions they might qualify for.

For a visual explanation of the pass-through deduction, check out the flow chart below, provided by Leon LaBrecque, a Troy, Mich.- based lawyer and certified financial planner.

Should you take advantage of the new small-business tax break?

If you’ve been planning to monetize your talents into a side hustle, or switch to a contractor role with your current employer, seeing this deduction may motivate you to get on that, stat.

Gig workers like Uber drivers, who average $30,000/year according to Glassdoor, will likely be able to take full advantage of the deduction as they are generally considered independent contractors.

Intuit estimates there were about 3.2 million American workers in the 2017 gig economy, a number that could rise to 7.6 million and comprise about 43% of the total U.S. workforce by 2020.

Before you decide to start your own business in the hopes of earning a tax break, you should do your due diligence, experts warn.

“The 20% shouldn’t be the tax tail that wags the dog,” said Cartersville, Ga.-based certified financial planner Lane Mullinax. He says what’s important isn’t necessarily getting a deduction, but the overall potential of the business itself.

If you’re thinking of ditching your 9-to-5 to make more money working on your side hustle, you should make sure the switch is worth it for your budget as much as it may be worth it for your lifestyle or career.

Mullinax advises figuring out if the cash flows make sense first. He says aspiring entrepreneurs should add up all of the estimated income and expenses to see if the business is worth getting into.

How to set up a pass-through business

If you want to set up a pass-through business to take advantage of the deduction, you have several options. The main three forms of pass-through companies are sole proprietorship, partnership and LLC, which offers more protection and can be taxed as either the aforementioned structures or as an S-corporation.

There is no formal action you need to take to be taxed as an unincorporated sole proprietorship or partnership, as the IRS considers them disregarded entities. All you need to do is operate your business and take care to file the correct form, and you should be able to pass the appropriate amount of business income to your individual tax return, according to Mullinax.

You may elect instead to incorporate as an LLC, as it provides protection and limited liability to its owners. For example, if the business can’t pay its debts, the creditor can’t come after your personal assets and all you stand to lose is the money you put into the LLC.

You can choose to incorporate your company in any state. Taxes are not the same all around, so you may want to think about the pros and cons of incorporating in your home state, and check other states’ corporate statutes.

Think about things like how corporations are taxed, if there is an income tax, minimum tax or franchise tax. If you have time, compare what you project to earn in revenue with the taxes you should expect to pay, too. You can fill out a form to incorporate in any state online.

“There is more interest with the new tax law, but people also need to be aware that they will incur both pieces of the self-employment tax unless they go the S-corp route,” said Zaegel.

Know what you’re giving up as well.

As a full-time W-2 employee, you only have to pay half of the required Social Security and Medicare taxes out of your paycheck. Your employer picks up the other half. That’s no longer the case if you start your own business.

If your net earnings were $400 or more, you will be required to pay the entire self-employment tax. The 15.3% tax is comprised of Social Security (12.4%) and Medicare (2.9%) taxes due to the IRS.

Here’s a chart breaking down each pass-through option and the pros and cons of each.

Choosing your business entity

Entity

Setup

Definition

Pros

Cons


Sole Proprietorship

No formal action

An unincorporated business owned by one person.

  • Simplest and easiest to set up

  • Complete control of your business as a sole owner

  • Good for testing out a business

  • Personally liable for all business debts

  • Creditors can go after your personal assets if your business assets are no enough to cover your business debts.

  • Cannot pay yourself W-2 wages

  • Generally more difficult to raise money and get bank loans


Partnership

No formal action

An unincorporated business owned by two or more individuals.

  • Simple and easy to set up for two or more partners

  • Liability for business debts is spread out among partners

  • Cannot pay yourself W-2 wages

  • Each owner is liable for debts and losses


S-Corporation

Submit to IRS form 2553 by a Small Business Corporation signed by all shareholders

A corporation that elects to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes.

  • Can pay yourself a “reasonable wage”

  • Potential self employment tax savings

  • Provides protection for personal assets

  • Not subject to corporate tax rates

  • Must file with the IRS to get S-corp status

  • May be required to file for foreign qualification in other states where business is active.

  • More administrative overhead (payroll, paperwork, etc.)

  • Allowed no more than 100 shareholders

  • All shareholders must be U.S. citizens


LLC or Single Member LLC

Register online with state agency — declare if the business will be taxed as a sole proprietorship, partnership, C-Corp or S-corp

A limited liability company. A single member LLC has only one owner.

  • Benefits of both a corporation and partnership

  • Flexibility of taxation

  • Provides protection and limited liability to owners

  • Unlimited number of members

  • Annual renewal fees $300 or less in most cases

  • May be required to file for foreign qualification in other states where business is active.

  • Members must pay self-employment tax

  • Some states require you to dissolve and form the LLC again if one member leaves