Small Business Owners: 4 Ways the New Tax Act Impacts Them
A 20% deduction for small business owners sounds good, but the small business deduction is one of the trickiest elements of the tax act to understand. We discuss four areas where you can get clarity and make the most tax-savvy decision for your situation.
The hotly debated Tax Cut and Jobs Act passed in the last days of 2017 gave many large corporations a break as their corporate taxes dropped from a high of 35% to a flat rate of 21%. The new legislation is also providing some much-needed relief to small business owners by introducing a 20% deduction. This deduction means a lot because about 80% of small business owners file as pass-through entities, including partners, shareholders in S corporations, members of limited liability companies, and sole proprietors. But, before you get too excited, note that the pass-through deduction expires in 2025.
We have several clients who own a small business and are anxious to see if their bottom line could improve as a result of the new tax act. Indeed, according to LPL Financial, for a couple with taxable income of $291,000, the new law would save $20,370 in taxes. But understanding the complicated rules is most likely causing a bit of a struggle. As it turns out, the small business deduction is one of the trickiest pieces of the tax act. Below we outline some features to consider.
1. There will be more money in the pockets of small business owners.
Prior to the Act, small business owners usually paid taxes based on the generally higher pass-through rates for individuals. Now, many small business owners will be allowed to take a 20% deduction for qualified business income (QBI) and therefore these individuals will only be taxed on 80% of their pass-through income. According to the business and economic think tank, Pacific Research Institute, this deduction “is meant to provide a break on capital income that stems from assets that accrue value over time.”
This deduction can be claimed without restriction by small business owners with taxable income of $157,500 (single filers) or less and $315,000 (married filers), and combined with the new 37% top individual rate, the top tax rate for eligible pass-through income is 29.6%. If taxable income exceeds $415,000 for business owners in professional service industries, then the deduction is completely phased out, but there are still opportunities for tax savings with more advanced planning (see below). In short, taxable income may determine eligibility, but the tax break is applied to business income.
For high earners in industries outside of professional services, a calculation is used to cap their deduction. Their exemption is the lesser of 20% of business income or the greater of 50% of total wages paid or 25% of wages plus 2.5% of the cost of tangible depreciable property.
To make this more clear, we cite two examples from InvestmentNews:
Betsey is the unmarried owner of Betsey’s Bakery and has business income of $100,000 and total taxable income of $300,000 (which is above the phase-out income limit). Her business pays the bakers $15,000 in wages but has no depreciable assets. Betsey will exclude from her taxes the lesser of $20,000 (20% of business income); or the greater of $7,500 (50% of wages), or $3,750 (25% of wages [$3,750] + 2.5% of assets [$0]). Betsey will be able to exclude $7,500 of pass-through income from tax.
If Betsey decides to purchase a new store for $500,000, she will exclude the lesser of: $20,000 (20% of business income); or the greater of $7,500 (50% of wages), or $16,250 (25% of wages [$3,750] + 2.5% of $500,000 [$12,500]. Because of the real estate purchase, her exclusion is now $16,250.
In short, because individual tax rates have been lowered, most small businesses will see at least some modest relief.
2. My client is a local dentist and is therefore considered a professional service provider. Given his high income, will he benefit from the new tax act?
For higher earning people in professional service industries, such as dentists, lawyers, and investment managers, the extra 20% deduction on taxable income will most likely not apply. The deduction phases out beginning at incomes of $157,500 for singles and $315,000 for joint filers. The deduction completely phases out when taxable income reaches $207,500 for singles and $415,000 for married filing jointly.
So what can you do for the professional service provider whose income exceeds the phase out? Be sure to explore income-shifting strategies with your clients, which can include moving money to a lower-earning spouse or child. A business could even give shares to different family members; then each person could file a separate tax return that is below the income limit. This may be a strategy that your clients will want to explore, since the new tax act increased the lifetime gift and estate exemption from $5,490,000 to $11,200,000 for individual filers and $10,980,000 to $22,400,000 for those filing married jointly. This provision sunsets in 2026.
Additional strategies are being tossed about, but they are mostly untested and clearly designed for tax avoidance. For example, there is talk of splitting professional service companies into two divisions, whereas the “non-professional services provider” will be taxed at the lower rate.
For example, an attorney could split her practice into one entity with seven lawyers and another entity holding twelve paralegals. The business holding the paralegals could be taxed at a lower rate because they could deduct 20% of their business profits from their income. But, in some cases, the tax savings may not be worth the setup of two separate businesses, so this decision needs to be well-thought-out.
A more traditional strategy is for a professional to purchase an office building and pay higher amounts of rent to a separate entity, which will be taxed at the lower amount because it is a real estate company (not a professional company). The separate entity, such as a leasing company, would be subject to the 20% deduction.
Also, if your clients have large amounts of pass-through income, they may want to consider whether to change their business entity to a “C” corporation to take advantage of the new 21% top tax rate. For example, a company that organizes itself as a partnership could be subject to a maximum 37% individual tax rate, so a change in the entity could save your client a considerable amount of money. Be sure to review these items with a qualified tax professional, as the numbers can be complicated and may not work to your advantage.
Business owners may also want to repurpose their work so that they are not subject to the income limits for service professionals. For example, high-earning engineers who consult for various firms could indicate on their tax returns that they are ‘engineers’ rather than ‘consultants,’ the latter of which are subject to income limits for service businesses. If you have a non-service firm, consider whether you should add more people to payroll or releverage debt obligations to increase your qualified business income deduction. Another way for an advisor to add value is to look at methods to keep taxable income below $157,500 (or $315,000 for a couple), which could include increasing charitable or retirement plan contributions.
3. Does keeping my company’s 401(k) plan still make sense?
All businesses should review their 401(k) plan in light of the new laws. If the small business doesn’t qualify for the tax break due to the income limitations, then consider a 401(k) plan, or a SEP or SIMPLE IRA, and make sure you advise your client to max out contributions to receive the highest tax benefit. Also, consider a defined benefit profit-sharing plan, which can provide a significant opportunity to defer pretax income.
Any business that claims the 20% deduction, however, should review its 401(k) plans for a different reason. Because of the low tax rate on qualified business income, the 20% deduction decreases the incentive for owners to contribute on a pretax basis to a 401(k), since they may pay higher taxes when they withdraw the money during retirement. Therefore, if your client qualifies for the deduction, consider a Roth 401(k) and/or 401(k) after-tax contributions to the 401(k) plan.
4. Many itemized deductions, such as investment expenses have been eliminated with the new regulations—what about business deductions?
Several business deductions have been eliminated, including business entertainment expenses such as appreciation parties and shows, employee parking, and local lobbying expenses. Although slightly murky, meals are still deductible. Check to see how these eliminations could impact your clients.
The National Federation of Independent Businesses has said that this legislation “will help the economy by providing significant tax relief to small businesses throughout the nation.” Time will tell if these new measures will provide that stimulus.
Many small businesses are trying to take immediate advantage of these benefits since they could end or be limited if there is a shift in political power in Congress in November 2018. Be sure to reach out to your advisor and tax professionals to discuss these strategies to increase your bottom line. And remember, pass-through deduction expires at the end of 2025, so stay tuned!