Congress recently passed the “Tax Cuts and Jobs Act” which impacts both individuals and businesses.
There are two important tax changes that will impact every business owner in the United States.
- Corporate tax rates are now a flat 21% (permanent change)
- Pass through entities such as LLC’s get a 20% deduction (temporary change that expires in the year 2025)
Just a reminder, taxation of your business at the federal level depends on how your business is formed:
Sole proprietorship: Business owner does not file a separate tax return, and instead, business income and expenses are reported on a federal form 1040, Schedule C.
Partnership: An association of two or more persons to carry on a business and can take different forms (like limited or general partnerships). Partnerships file a separate return, federal form 1065, and pass the income or loss to each individual partner who is responsible for reporting the information on their tax return.
Limited Liability Company (LLC) is a hybrid entity that offers the option to be taxed as a partnership or a corporation. Many SCORE clients are Single Member Limited Liability Companies, typically treated as a “disregarded entity” for federal tax purposes. This means there’s no separate tax form; income and expenses are reported on Schedule C, just like a sole proprietorship.
C Corporation: Files federal form 1120 and pays any tax due as a separate entity. Shareholders (owners) also pay tax at their individual income tax rates for dividends or other distributions from the Corporation and thus, corporations are subject to a “double tax.” Corporations can also take the form of a Professional or Personal Service Corporation – typically service professions like lawyers, doctors and architects.
S Corporation: A corporation with tax treatment similar to a partnership. An S corporation files a federal form 1120-S which passes most items of income or loss to shareholders (owners) who are responsible for reporting the information on their individual tax returns.
B Corporation: Benefit corporation that seeks to make a profit, but has a social mission as part of its existence. B Corps can elect to be taxed as a C Corp (corporate tax rates – form 1120) or S Corp (pass through to shareholders / owners – from 1120-S).
Corporate Tax Change
If your business is formed and registered as a corporation, then you will apply a single rate of 21% to your taxable income for the corporation. Additionally, there is no Alternative Minimum Corporate Tax starting in 2018.
Pass Through Entities – Section 199A Deduction
If your business is a pass-through entity (sole proprietorship, partnership, LLC or S-corporation), then you can now deduct 20% of your Qualified Business Income. Qualified Business Income represents the bottom line profits from your business; i.e. all of your business revenues less all business expenses.
NOTE: Be careful and make sure you include deductions for all W-2 payroll, including deducting out guaranteed payments to partners or a W-2 salary that the owner paid him or herself under a S-corporation when determining Qualified Business Income.
- You own a business that elects to be an S-Corporation, and you have calculated your profits from your business as $120,000 for 2018, before taking a salary of $50,000.
- For purposes of calculating the 20% deduction, your Qualified Business Income is $70,000 ($120,000 minus $50,000)
- And your deduction is $14,000 (20% x $70,000).
The law also imposes caps and phase out amount when taking the 20% deduction. The caps or ceilings are:
- $157,500 of total taxable income for a single tax payer; or
- $315,000 of total taxable income for married filing a joint return
NOTE: Total taxable income is everything – Adjusted Gross Income on your tax return which accounts for certain deductions that may not be related to how you calculate Qualified Business Income.
- You own a business and your total adjusted income, which includes both business and personal items, is $120,000.
- However, your Qualified Business Income is $160,000.
- Your 20% deduction is $24,000 ($120,000 x 20%).
Special Service Business
There are also phase out amounts that when reached, can eliminate the 20% deduction altogether if your business is a “special service business.” The phase-out amounts are:
- $207,500 of total taxable income for a single tax payer; or
- $415,000 of total taxable income for married filing a joint return
A “special service business” is a business in the fields of accounting, law, health, consulting, athletics, financial services or any business where the reputation or skill of the employee is such that it represents the critical asset for the businesses existence; i.e. can the business survive if this person were to walk out the door? For these types of businesses, you lose the entire 20% deduction once your total taxable income is over $207,500 (single) or $415,000 (married joint return).
If your taxable income falls in between the ceiling amounts ($157,500 / $315,000) and the phase out amounts ($207,500 / $415,000), then you can take a partial deduction which requires that you compare your deduction against the greater of:
- 50% of total W-2 wages paid by the business during the year; or
- 25% of total W-2 wages paid by the business during the year + 2.5% of depreciable assets at their acquisition cost to the business
The Bottom Line
As long as your total taxable income for the year is less than $157,500 as a single tax payer or less than $315,000 for married joint return, you can deduct the full 20% regardless of what type of business you have. About 70% of small businesses in the United States make below these ceiling amounts.
When you go above these amounts ($157,500 or $315,000), you will have to take a partial deduction, and this involves a number of calculations, including consideration of depreciable assets. So please see a CPA or other professional to help you calculate the partial deduction. Some of this could change when final rules are released by the IRS.
For more details and examples, read this “Section 199A Deductions – Pass Thru Tax Breaks” PDF.