First of all, if you have any questions about how the new tax bill will affect you, your business, or any decisions you want to make moving forward RUN DO NOT WALK to your tax advisor. This is meant as a general overview of some significant changes in how pass-through businesses are treated federally, and may not apply to every person’s situation the same.
As a reminder from a previous post, a “pass-through” business is one where the business itself does not pay income taxes, but instead passes the profits (or losses) through to the owners who pay income taxes on their personal income tax returns. This is in contrast to corporations which are first taxed on the corporate earnings, and then the owners pay taxes on any dividends the corporation pays. Pass-through businesses include limited liability companies, S Corporations, and partnerships.
The final tax bill passed on December 22, 2017 both lowered corporate taxes to 21%, and allowed pass-through owners to deduct up to 20% of the income of the business from the owner’s personal income. If you are doing business as a pass-through, however, or intend to set up a pass-through to take advantage of the deduction, there are a few key issues to keep in mind:
- The deduction expires December 31, 2025. Unless Congress decides to extend the deduction, it will only be useful for the next 8 years. That means you should plan carefully for the next 8 years.
- The deduction is not available to persons doing business in the following industries: “health, law, accounting, actuarial science, performing arts, 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 1 or more of its employees.” (26 U.S. Code § 1202(e)(3)(A)). In general this means that the deduction is really only available for businesses that make or sell stuff (with exceptions). Freelancers, consultants, and others who live off their skills may not get to use this particular deduction, limiting its usefulness to small businesses. Engineering and architectural businesses were left out here, meaning they still may get to claim the deduction. Employees cannot take the deduction.
- If you have an S Corporation, you are likely required to pay yourself a reasonable salary and pay income taxes on that salary, as well as collecting (and paying taxes on) profits from the business. This salary is not counted toward the income tax deduction.
- There are limits on the amount of the deduction that can get complicated and have to do with how much (if any) W-2 wages were paid to the person taking the deduction, the amount of property purchased, and how much the company made. For example, the owner of an S Corporation that paid no wages and made no capital investments may not be able to take any deduction under these new rules.
- Total taxable income matters here as well. For taxpayers with taxable incomes UNDER $157,000 ($315,000 if married), the limitations may be ignored, and the taxpayer can take a deduction of 20% of the business income. This may include service businesses. This is the part that is likely to be very helpful, especially to small start-ups turning their first profit. This benefit is phased out once the income threshold is reached.
As with most tax-related issues, your mileage may vary. Make sure to sit down with your tax advisor and go over your plans for next year and the next few years to make sure you are being as efficient as possible with all the changes in the tax code.
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