Reducing Taxes for Small Business Owners
The new tax reform legislation passed by Congress in Dec 2017 provides a special tax treatment for pass-through companies (subchapter S corporations, LLCs, partnerships, and sole proprietors). The IRS refers to these entities as a pass-through because the income passes through the entity to the individual’s tax returns.
Ultimately, many owners of pass-through entities may have the opportunity to reduce their taxes with this regulation. Congress used this deduction as a means to help smaller businesses.
The 20% deduction available in addition to itemization
With this new regulation, individuals with pass-through income can deduct 20% of their qualified business income, QBI, from their taxable income. The legislation states that individuals can take this deduction separately from their itemized deductions.
This is good news for small businesses. Pass-through entity owners can take the standard deduction, and still claim this 20% deduction.
The deduction is “below-the-line”
Congress established this 20% deduction to be a “below-the-line deduction.” This means individuals, taking this deduction, will deduct this 20% from their final adjusted gross income (the line.) The IRS uses adjusted gross income (AGI) to determine a taxpayer’s eligibility for certain tax credits. This deduction will not affect AGI.
Above-the-line deductions occur on the first page of your tax return and can reduce your adjusted gross income. For example, contributions to retirement accounts happen above the line.
IRS will clarify the specifics in early 2018
At this point, the IRS has not fully defined how it will treat this deduction. Currently, the regulation vaguely restricts the types of industries that can take the deduction and places some ceilings in income levels for eligibility. We expect the agency will issue a guidance to clear up some of the confusion about this regulation in the next few weeks. We’ll explain more when the IRS provides the details.
Based on what we have seen so far, we created an example of how this pass-through deduction could help a sample individual couple.
In our example, a married couple, files jointly and in 2018 has a joint taxable income of $250,000.
One spouse, a teacher, has w-2 wages of $50,000
The other spouse operates subchapter S engineering business and has a taxable income of $200,000
In this example, the couple would fall under the 24% income bracket in the new tax law and owe $42,819* in taxes if they did not use the pass-through tax reduction option. They would take the standard deduction of $24,000 for a married couple, which computes to a taxable income for them of $226,000.
*In this tax bracket (for tax year 2018), the couple owes $28,179 + 24% of their taxable income over $165,000.
If the business owner decides to take proceeds from the business as:
$60,000 in employee (w-2 wages) and $140,000 as qualified business income, QBI, the couples’ taxes change as follows:
$50,000 teacher w-2 wages
$60,000 business owner w-2 wages (note owners must take a reasonable wage)
$140,000 QBI income
Less ($24,000) for the standard deduction for a married couple
Less ($28,000) 20% of the QBI (20% times $140,000 = $28,000)
Final taxable income $198,000 and taxes owed = $36,099**
In this second scenario, the couple gets a tax savings of $6,720.
**$28,179 + 24% of the taxable income amount over $165,000.
Contact Us for Clarification
If you operate a pass-through, entity and want to learn how to take advantage of this new regulation, please contact us. This new tax law offers great potential tax benefits for small business but you must be proactive and understand your particular situation.