What was Congress thinking, passing major tax reform a week before the holidays when there was still some serious shopping days left? Even if you did take time away from the festivities to read a few details of the Tax Cuts and Jobs Act of 2017, the media were so focused on the reduced rate for large corporations (now 21%, down from 35%), that you might have missed the fact that some rewards trickled down to small businesses as well. So without getting into the politics of the bill (tis what it is…), let’s focus on the new 20% deduction for qualified business income of pass-thru entities.
First, don’t panic. All the changes apply to 2018 income. When filing your taxes this April for the 2017 tax year, you’ll be following the same rules as for 2016. So even though the tax reform bill was passed hastily (with amendments scribbled in the margins in the dead of night), the IRS will have some time to clarify the details. However, if you like to file accurate estimated taxes for the first quarter of 2018 (deadline is April 16), then you’ll want to include this deduction (if you qualify) as well as take into account the lower rates and expanded tax brackets.
Second, I (Trish here) am not a financial or tax professional; I researched this deduction for our own situation (Crish Design is a Partnership, filing married jointly). For this article, I’m going to assume that you are a self-employed freelancer or small business (not an employee who receives W-2 wages) and that you provide professional services (the rules are a bit different if you manufacture widgets).
Third, you might want to make a nice cup of tea before you dive in. (And yes, reading about taxes means you also deserve a nice choccy biccy…)
It’s worth noting that the IRS has no concept of a “freelancer”: If you are an independent contractor receiving Form 1099 from your clients, then the IRS considers you a small business (or “business entity”). Congrats – you qualify! How you structure your business is up to you. If you prefer to stay small, you can operate as a sole proprietor.
Pass-thru entities include partnerships, LLCs, and S Corporations. These entities file a business tax return (usually by March 15), but don’t pay taxes on any profit; instead they report the profit to their owners “on paper” (for instance, a partnership would prepare a Schedule K-1 to report each partner’s share). The owners then pay taxes when they file their individual tax return.
A sole proprietorship is not treated as a separate entity for Federal tax purposes; the owner files a Schedule C for business income and expenses and includes this form with their individual return. However, for the purposes of the new tax bill, all pass-thru businesses including sole proprietors can take advantage of the 20% deduction for qualified business income (QBI for short).
This particular part of the tax bill (known as Section 199A) is confusing enough that I thought I’d share what I’ve learned after searching for days on the intertubes. I’ll assume that you are reasonably familiar with the tax code and know your way around your Form 1040. If not, I’m working on a follow-up article for those who are more likely to give a shoebox of receipts to their tax preparer on the afternoon of April 14 (you know who you are…).
First, and most importantly, all the tax cuts for individuals (including the QBI deduction) have a “sunset provision” built in, so they all go “poof” and expire after the year 2025 unless Congress acts to make them permanent (you can mark your calendar now for complete chaos around that date).
Second, let’s dispel a myth regarding freelancers “no longer being able to deduct their expenses.” That’s pants-on-fire wrong (it originated in a badly written article that some people misread and then spread all over social media). What is true is that if you are an employee who works for a mega corporation and receives a W-2 (yippee, you’re not!), you can no longer claim certain unreimbursed employee expenses related to your job or your home office. When you are running your own business, you are actually an employer, and there is no change to the business expenses you can claim on your Schedule C or business return.
For a super-quick roundup of all the major changes in the tax reform bill, I refer you to the list posted by CPA Kevin Tully on the TBC Blog Network. These are the main highlights:
- Tax Brackets: Drops of individual income tax rates ranging from 0 to 4 percentage points (depending on the bracket) to 10%, 12%, 22%, 24%, 32%, 35% and 37%
- Near doubling of the standard deduction to $24,000 (married couples filing jointly), $18,000 (heads of households), and $12,000 (singles and married couples filing separately).
- Elimination of personal exemptions
- Doubling of the child tax credit to $2,000
- New $10,000 limit on the deduction for state and local taxes (on a combined basis for property and income taxes; $5,000 for separate filers)
- New 20% qualified business income deduction for owners of flow-through entities (such as partnerships, limited liability companies and S corporations) and sole proprietorships
The Qualified Business Income Deduction
Assuming that you receive business income from a pass-through entity, I expect you have a few questions at this point: Do I have qualified business income? What are the limitations? How is the deduction calculated? And exactly where is the deduction taken on my tax return?
To cut to the chase, if you receive business income from professional services and your taxable income (not your gross business income, but the amount on [currently] line 43 of Form 1040) is less than $157,500 for individuals (or $315,000 for married filing jointly), then you can claim this deduction. Whether or not you can claim the full deduction will depend on another important calculation (covered later).
The first limitation covers what exactly is qualified business income (QBI): It does not include any guaranteed payment for services in a partnership or LLC (health care premiums are one example, as you already get to deduct those elsewhere on Form 1040). It also doesn’t include any investment business income (capital gains, dividends, or interest).
The reason I’m assuming you provide services is that the new law differentiates between businesses that build stuff versus those that provide professional services. Because the Senate decided that it didn’t want this deduction to apply to rich actors and lawyers, they added a threshold for high income earners in specified service industries:
A specified service activity means any trade or business activity involving the performance of services in the fields of health, law…performing arts, consulting…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…
Whoa, that would seem to cover many independent contractors reading PVC – graphic designers, animators, video editors, authors, and consultants – where our reputation and skill is our main selling point. So how successful do you have to be to lose out?
The tax deduction starts to phase out for owners of professional service businesses whose taxable income exceeds $157,500 for individuals or $315,000 for married filing jointly (MFJ). If your 2018 income rises above those thresholds, the deduction will phase out over the next $50,000 of income for individuals ($100,000 for married couples), which means the pass-thru deduction will be completely gone at income levels of $207,500 for individuals and $415,000 for married couples.
So unlike some deductions, where you can avail of the deduction for income up to the threshold, this phase-out is a sliding “cliff”: at the top of the cliff you can claim it, as you earn more you start to lose it – and when you end up on the beach you get no deduction at all. Another way of looking at it is that the income that falls into the phase-out zone ($157,501 – $207,500 for singles, $315,001 – $415,000 for couples) is being hit with a much higher tax rate as it gradually loses the benefit of the deduction.
Again, this phase-out is based on taxable income (currently line 43 on Form 1040) – which is the amount after all deductions are applied except the QBI deduction itself. And bear in mind that all income (including other non-business income, such as interest income) would be used in determining whether the service business threshold has been breached.
Also remember that if your business makes widgets (or you are an engineer or architect), then your QBI is not subject to the phase-out threshold for service businesses.
Where is the deduction taken?
It’s important to note that the QBI deduction is not taken on your business return or Schedule C, so it does not reduce your self-employment tax. From what I have read, the Sec. 199A deduction for qualified business income will be applied at the top of page 2 of Form 1040, after Adjusted Gross Income is calculated. Why is this important?
Where any deduction is taken in the “flow” of tax forms can have big implications not only for how valuable the deduction is, but also how it affects other thresholds. If you’re not familiar with what you’ve claimed in the past, grab your last tax return (or even a blank Form 1040 from IRS.gov) and review it.
First off, the big picture: business expenses reduce your business income which reduces all taxes – Self-employment (SE) tax and Federal income tax (plus State taxes if applicable). Any adjustments and deductions claimed on Form 1040 only reduce Federal tax – they do not reduce your SE tax. And Self-employment tax (calculated on Schedule SE) remains unchanged at 15.3%. (In fact, your SE tax may amount to more than Federal and State taxes combined when all is said and done.)
If you review Form 1040, after reporting your Business Income (under Gross Income), you reduce that total with adjustments, such as half of your self-employment tax, contributions to retirement accounts, HSAs, health care premiums, and so on. These above-the-line deductions reduce your Gross Income to arrive at Adjusted Gross Income (AGI), which is carried over to the top of page 2.
On page 2, you claim below-the-line deductions such as personal exemptions (which are going away), and either Itemized Deductions or the Standard Deduction, to calculate the all important line 43, Taxable Income. This is the amount that is fed into the tax tables to arrive at the amount you will owe in Federal taxes. After that, tax credits are applied (if applicable), and the Federal tax owed is added to your Self-employment tax (line 57) to arrive at Total Tax owed (line 63).
One implication of the QBI deduction not being an above-the-line deduction, is that it does not reduce your AGI if it’s just a bit too high to qualify for subsidies under the ACA (Obamacare). Similarly, AGI is used to determine if you qualify for Roth IRA contributions. On the other hand, it is also not an itemized deduction, so you can claim it in addition to the standard deduction.
While it remains to be seen exactly where the new deduction will be inserted on Form 1040, remember that taxable income, not AGI, will be the threshold used for the phase-out discussed above. As experts point out:
From The Games They Will Play: Taxable income is calculated after taking into account other deductions, like the standard deduction or itemized deductions. As a result, individuals with even more actual economic income could still fully qualify for the [QBI] deduction.
Note: It also appears that most States won’t take the pass-through deduction into account, because they use Adjusted Gross Income as a starting point.
How is the deduction calculated?
I mentioned that you might not be able to claim the full deduction, and here’s why. Even if your taxable income falls well below the taxable income threshold, there is another very important limitation – what I call the “lesser of” rule:
You can claim either 20% of qualified business income or 20% of ordinary* taxable income – whichever is less.
According to the Evergreen Small Business blog:
A first limitation that applies to every taxpayer: Tax law limits the Sec. 199A deduction to no more than 20% of the taxpayer’s taxable income subject to ordinary income tax rates.
A taxpayer with $100,000 of pass-thru income might hope for a deduction equal to 20 percent of $100,000, for example.
But if the taxpayer’s taxable income taxed at ordinary income rates equals $50,000, the actual deduction equals 20 percent of that $50,000.
You’re probably wondering how you can have $100,000 of business income but only $50,000 of taxable income! But if you only have business income, and contribute to a retirement account as well as claim health care premiums plus the standard deduction, it’s likely that your taxable income will be far less than your business income.
On the other hand, if you have both regular W-2 wages with some self-employment income on the side, you may be able to deduct the full 20% of your side gig income. Or you may have other sources of taxable income (from savings interest, a working spouse, or from retirement account withdrawals), which would allow more of your business income to qualify for the deduction.
As you can see, there are a lot of moving parts. Expect to spend some time with a spreadsheet or calculator to get your head wrapped around the “lesser of” rule. It will be a challenge figuring out how to maximize the QBI deduction without losing out on other subsidies or credits. Also, some moving parts are not well defined and are awaiting more guidance from the IRS.
* Note that the lesser of rule uses ordinary taxable income; that would seem to exclude long-term capital gains income or qualified dividends (which are already taxed at more favorable rates). However, this favorable income would be added to ordinary income to determine if you have breached the income limitation threshold.
I don’t envy those who have to code online tax software…
S Corporation Specific
Up until now I’ve been assuming that you receive only pass-through income from professional services. However, entities that elect S Corporation status for tax purposes can reward their owners with a combination of wages (W-2 income subject to self-employment taxes) and distributions (that are passed-through). To stop an owner avoiding paying SE taxes, the IRS requires that “reasonable compensation” for a trade or skill is paid in the form of W-2 wages.
If you are researching the pass-through deduction for S corporations, you need to be aware that qualified business income does not include W-2 wages received from the business, as per this excerpt from a very detailed article from Forbes’ Tax Geek Tuesday:
If you are a shareholder or a partner in a flow-through business, it is important to note that QBI also doesn’t include any wages or guaranteed payments received from the business. To illustrate, if you own 30% of an S corporation that pays you $40,000 of wages and allocates you $80,000 of income, your QBI from the S corporation is only the $80,000 of income; the $40,000 of wages do not count. And…if you’re a shareholder in an S corporation who provides significant services and you don’t pay yourself any wages, the IRS may treat you as if you took wages anyway, in which case this “reasonable compensation” will not be treated as QBI.
[Update: a previous version suggested that this applied only to higher incomes, but it applies to all income. Thank you to Glen Birnbaum, CPA, for the clarification. ]
To clarify: Below the taxable income threshold, you get to claim 20% of your pass-through income (similar rules to sole proprietors). But if you are not a service business and your taxable income breaches the threshold, the limitations (i.e., the “lesser of” rules) get far more complicated as there are addition “W-2 limits” that come into play. Check out the full TaxGeek article for details.
The more complex your situation – you have stakes in multiple businesses, you have carryover business loss from the previous year, or you have a capital-intensive business – the more you will have to rely on a good CPA to sort it out.
How much will you save?
The Tax Cuts and Jobs Act retains the current seven individual income tax brackets, but changes both their widths and tax rates. For a quick overview, check out Forbes.com: What the 2018 Tax Brackets, Standard Deductions and more look like under Tax Reform.
How valuable the QBI deduction will be to you will depend on how much of a deduction you are allowed times the tax bracket that income falls in to. For example, if you are allowed a $10,000 deduction ($50,000 x 20%) and your marginal tax rate is 12% (married filing jointly), then you could save $1,200 in Federal taxes – and even more if that income fell into the 22% marginal tax bracket.
Also pay attention to other major changes that affect your household, such as the elimination of the personal exemption, the $10,000 limit for State and Local Taxes (SALT), and the expanded child tax credits.
To better understand the other major changes in this bill and how it affects your household, I recommend this excellent article from Michael Kitces on his Nerd’s Eye View blog: Individual Tax Planning under the Tax Cuts and Jobs Act of 2017 – the section titled New “Qualified Business Income” 20% Deduction For Pass-through Entities is half-way down.
There are more article links in Sources (below) plus a few Tax Calculators that may help you figure out if you’ll save on taxes under the new bill (although I don’t believe any of them are sophisticated enough to include the many permutations of the QBI deduction yet).
When I started this article, my intention was to help us all figure out this new deduction and wrap it all up with a nice bow in as few words as possible. It was not to be… Even the tax geek at Forbes had this to say:
New Section 199A, however, is anything but simple, and the 20% deduction is far from guaranteed to business owners. Claiming the new deduction requires navigating a tangle of limitations, terms of art, thresholds, and phase-ins and phase-outs, with one critical definition thrown in the mix that could potentially jeopardize the whole damn thing.
It’s clear that the IRS will need to issue guidelines for how to interpret some rules. Not only that, but it is also being debated that if a CPA interprets the new law the way it is written, different business entities (sole proprietors vs. partnerships vs. S corporations) could qualify for more or less of the QBI deduction, instead of all small business owners benefitting equally regardless of their business structure.
So much for doing our taxes on a postcard…
Sources & Reading List
When searching online for more information, make a note of the date the article was written. The tax law was settled on December 15 and signed on December 22, 2017, so information posted before that date could be based on the House bill, the Senate bill, or an early reading of the conference committee’s compromise bill. Also consider the source: articles written by CPAs for their clients tend to be pretty solid.
Note that the correct name for the section of the Internal Revenue Code that covers the QBI deduction is Section 199A. Also useful for search purposes: the tax code refers to the entities that benefit from this deduction as pass-thru entities and not pass-through entities.
Finally, I found most articles are applying their advice to “builder” businesses with a mix of W-2 and distributions at high-income levels, or those with rental income. Remember that you can skip those complex calculations if you provide services and are a sole proprietor! Also, the entire bill is full of exceptions, followed by exceptions to the exceptions! So when you read any article, be sure to read the entire text to avoid reading something out of context.
Tax Cut and Jobs Act Conference Report (708-page PDF; section on pass-thru entities starts on page 205). Good luck with that…
Washington Post: The Final GOP Tax Bill and What’s In It
Watson CPA Group: Section 199A deduction
BDO.com: Section 199A Deduction
Evergreen Small Business: pass-thru-income-deduction
Forbes.com Tax Geek Tuesday by Tony Nitti: Making sense of the new 20% qualified business income deduction
The Games They Will Play: An Update on the Conference Committee Tax Bill; download the paper as a PDF
Tax Calculators (may not apply the QDI deduction properly):