You might have noticed, but there were some big tax law changes in 2018. While the focus in the news was mainly on how much the rich were going to pay and how much the rest of us regular folk were going to save, there were some big changes to business deductions that may affect lots of small business owners.
While there are many helpful tax deductions for small businesses (read here for the list), there is one deduction in particular that is new in 2018 and may be very helpful to small business owners. As with any new tax law, the IRS is still figuring out the specifics, so it’s not a bad idea to consult with an accountant to confirm you qualify. But for those who are able to take advantage of this deduction, it could mean a big win on your tax return this year.
Introduction of the 20% Qualified Business Income Deduction
Beginning in 2018, owners of pass-through entities (sole proprietorships, S corporations and partnerships) will get a nice tax boost. Taxpayers that qualify will get to take a 20% deduction on qualified business income, assuming they are eligible and don’t meet the criteria for this deduction to be otherwise limited.
The intent of this change is to specifically help out small business owners. While there were some pretty significant tax cuts for large businesses in the new tax laws, Congress didn’t want to leave small businesses out. Since most small businesses are not C corporations but are instead pass-through entities, this tax cut is made especially for you.
As a reminder, pass-through entities (sole proprietorships, LLCs, partnerships and S corporations) don’t pay taxes themselves. Instead, their business profit or loss “rolls up” to the individual owner(s) and those individuals reflect these profits or losses on their own returns.
So, if your business is one of the pass-through entity types, you may be able to get this deduction on your return.
This tax deduction is intended for individual owners of sole proprietorships, rental properties, S corporations or partnerships. Note that by default, an LLC with one member/owner is treated as a sole proprietorship for tax purposes; by default, an LLC with more than one member is a partnership for tax purposes.
What businesses count?
All trades or businesses qualify EXCEPT 1) the trade or business of performing services as an employee (basically, you’re an employee, not an owner, of an otherwise qualified business) and 2) a specified service trade or business (see below).
A specified service trade or business (SSTB) is really focused on businesses whose value is based on the services and skills of the employees or owners. For example, this likely means businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, and trading or dealing in securities, partnership interests or commodities. Click here for more info.
But don’t give up yet if you’re running a SSTB. This exclusion to the deduction only applies if you have income above $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly. And even if your income is above those levels, the deduction phases out and doesn’t completely go away until you get to $207,500 for single taxpayers and $415,000 for married taxpayers filing jointly.
Also, the IRS has recently issued regulations that allow for another exception to the SSTB exclusion. If your business has gross receipts (meaning sales before expenses) of $25 million or less for the tax year, it will NOT be treated as a SSTB if less than 10% of the gross receipts are attributable to the performance of services. So if you sell courses and do some consulting, you’ll want to pay attention to this exception.
There’s one part of the SSTB exclusion that concerns a lot of people and that’s the part that says that any business “where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees.” Fortunately, the IRS has released guidance on this and they’ve narrowed this exclusion. Essentially, you’re still considered a SSTB if the following are true:
- Your business received fees, compensation or other income for endorsing products or services (heads up influencers!)
- Your business licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity
- Your business receives fees, compensation or other income for appearing at an event or on radio, television, or another media format
Note that if you have any of these elements in your business, it’s worth asking an accountant whether you can separate out the SSTB income from your non-SSTB income so that you can at least take the deduction on some of your business’ income. One of the examples the IRS gives in its guidance highlights this – describing a well-known chef who owns several restaurants and who receives an endorsement fee for putting his name on a line of steak knives. The chef is able to take the 20% deduction on the income from his restaurants, but not on the endorsement fee income.
What income does the deduction apply to?
The deduction applies to “qualified income.” Qualified income is the net amount of qualified income, gain, deductions and losses with respect to the business. Note you can only include amounts for a business within the United States. For most small business owners, your qualified income will simply be your net profit or loss, adjusted for compensation you received from the business, for the year, since many small businesses don’t have the excluded items (see below).
Qualified income DOES NOT include reasonable compensation paid to you by the business for services you rendered for the business, capital gains or losses, dividend income, interest income that is not properly allocable to the business, net gain from foreign currency transactions and commodities transactions, and a few other exceptions.
How much is the deduction?
For taxpayers who aren’t subject to any of the limitations (see below), the deduction is 20% of the qualified business income. If your taxable income is $157,500 or less for individuals or $315,000 or less for married taxpayers filing jointly, then your deduction is likely 20% of the net income of your business.
If your income exceeds $157,500 for individuals or $315,000 for married taxpayers filing jointly, your deduction is limited to the larger of 50% of the W-2 wages you paid to employees in the business, or the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after the acquisition of all qualified property. If your eyes just glazed over, stay with me. An accountant can help you figure out what this limitation is, but you don’t even need to figure it out if your income is below the above threshold.
If your income is between $157,500 and $207,500 for single taxpayers or $315,000 and $415,000 for married taxpayers filing jointly, the amount of the deduction will be reduced as your income increases. Taxpayers who earn over $207,500 if single or $415,000 if married filing jointly will not receive the deduction at all.
For many small business owners, this new tax deduction could be huge. While the rules surrounding the deduction may seem overwhelming, spending a few minutes working through the exceptions or even consulting with an accountant to help you may result in a very nice tax deduction when you file your 2018 taxes. Also, it’s good to remember that with any new tax law, there will always be bumps and the IRS will continue to put out guidance to refine how this law is applied.