Normally at this time of year, individuals and small business owners are solely focused on their 2017 taxes. But with the passage of the sweeping tax overhaul, this is no ordinary year. The Tax Cuts and Jobs Act takes affect starting with your 2018 return and beyond, but the changes are so significant, it’s important to understand the bill and how it will impact your small business.
Tax Planning for 2018
For small businesses, the two biggest changes are the lowering of the tax rate for C Corporations and the 20 percent tax deduction for pass-through entities. Here’s a high level look at both.
20% Deduction for Pass-through Income
The law creates a brand new tax deduction for owners of pass-through entities like sole proprietors, members of LLCs, partners in partnerships and shareholders in S Corporations. For taxable years beginning after December 31, 2017 and before January 1, 2026, these individuals can generally deduct 20% of their qualified business income (QBI) from a pass-through entity. Sounds good, right? And it is — but there are a few details to know:
- Haven’t heard of QBI before? You’ll become familiar with it now. QBI is the net amount of income, gain, deduction, and loss with respect to the trade or business. It does not include investment-related income/loss (i.e. capital gain/loss, dividend income or interest income).
- Service business limitations: The law places limitations on virtually every occupation that provides a personal service (the two notable exceptions are engineering and architecture). If your pass-through business is a service business, like consulting or a medical practice, there are limitations. If your taxable income exceeds a threshold of $157,500 for single filers and $315,000 for joint filers, the deduction is reduced; if income exceeds $207,500 for single files and $415,000 for joint filers, there’s no deduction. So, if your income level is below these thresholds, there are no worries. But if you’re in a highly-paid field, you may not qualify for the deduction. The details and applications are still murky, so keep an eye out for further guidance from the IRS (and talk to your tax advisor!).
- W2 wage limitation: When your taxable income is greater than the thresholds above, your 20 percent deduction is limited to the W-2 limitation. This is the greater of 50 percent of your allocable share of the company’s W-2 wages, or 25 percent of your share of the firms W-2 wages, plus 2.5 percent of your share of the company’s unadjusted basis of all qualified property.
In short, this new pass-through deduction can be a really nice tax break for those individuals who qualify. If you are not sure how it applies to your business, don’t worry — you’re probably not alone. But, it’s a good time to talk to a tax law professional or tax advisor. And lastly, unlike the corporate tax cut (which is permanent), the pass-through deduction is set to phase out in 2025 (unless Congress extends it).
Corporation Tax Rate Cuts
One of the other big tenets of the Tax Cuts and Jobs Act is the major reduction in the C Corporation tax rate… it was slashed from 35 percent to 21 percent. If you’re structured as a pass-through entity right now, you might be wondering if you’d be better off structured as a C Corp to take advantage of that 21% rate.
But keep in mind that double taxation is still a factor. Simply put, double taxation occurs when income earned by the corporation is taxed at the business level; then, when the corporation distributes income to shareholders, the shareholders are taxed on that dividend. For owners who also expect to take some profit out as distributions, this can mean you’re essentially being taxed twice (first at the corporate level, then at the individual level).
If you are looking to re-invest profits back into the business, then a C Corporation might be the optimal business structure – this has always been the conventional guidance but it’s even more true now with the tax rate at 21 percent. If you are looking to take a bulk of the profits out of the business and put them in your own pocket, a pass-through entity is still most likely better (but you may want to speak with a tax advisor).