When I was growing up, my mom had a saying: “You can choose to change or change will choose you.” The latter can be applied to 2018 and the new tax rates for small businesses. Seeing as it’s the beginning of the year and most people are still open to changing things in their lives, let’s look at this change and what small business owners can do for their tax situation.
First let’s discuss the difference between a C-Corporation and pass through entities (Sole Practitioner, Partnerships, and Subchapter S Corporations, also known as “S-Corps.”). You can find that here.
C-Corporations will pay tax at a flat 21%. Under the old law, corporations had a progressive tax that taxed income at various income levels. Most small businesses aren’t C-Corporations, but some business owners may have a C-Corporation as an entity in their structuring strategy. If that sounds like you, it may be time for a change.
Pass through businesses could see their tax rate grow to as high as 39.6%, or the top individual tax rate. Luckily the new tax bill put in a deduction for these entity types. Since most small business are set up as pass through entities, let’s focus on the changes that these owners need to be aware of in 2018.
- 20% deduction on net taxable business income- To keep the tax rates between C-Corporations and pass through entities near even, there is a 20% deduction for pass through entities taken on the owner’s personal return. This deduction will show up on the owner’s Form 1040 personal return as a reduction to taxable income or the income on page two of the Form 1040 after the itemized or standard deduction.
There are some exceptions, and the calculation can get complicated. Let’s dive in to this calculation.
- All businesses- No matter what your business is, the tax bill provides a deduction on 20% of your QBI “Qualified Business Income” (essentially, income minus deductions related to your business) if the taxable income on your Form 1040 falls under $315,000 for married filers and $157,500 for any other filer.
- Some businesses- To further complicate matters if your business is a Specified Service Business or a business that involves the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners, there is a reduction of the 20% deduction based on the amount of taxable income over the threshold up to $100,000 for married filers and $50,000 for any other filer, with a hard deduction phase out of taxable income over $415,000 for married filers and $207,500 for any other filer.
- All other businesses- If your business is not a Specified Service Business and your taxable income is over the $415,000 and $207,500 limitations, you would apply the following calculation:
- 50% of the W-2 wages associated with the qualified trade or business or
- The sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of unadjusted basis, immediately after acquisition of all “qualified property.”
With all of that change forced upon small business owners, some changes you should make include:
- Educate yourself. Either reading and understanding the new tax laws or meeting with a trusted advisor early in 2018 as opposed to later in the year.
- Keep an eye on your taxable income in 2018. If you find yourself creeping toward the phase out limitations, look for ways to maximize your deductions and minimize your tax liability.
- Review your current tax structure. If you are a Sole Proprietor or filing as a Partnership should you change your entity structure?
- Evaluate your current business structure. Do you have a C-Corporation as part of your overall business entity structure, and is there a good reason to keep it active?