It’s that time of the year again — tax season. If you’re digging out your toolbox and preparing to crack open the piggy bank, stop right there. Put the hammer down and let us show you how the 2018 tax changes are likely on your side.
The 2018 Tax Cuts and Jobs Act (TCJA) cuts taxes for many business owners, letting you keep more of your hard-earned money, or if you choose, pour more of it back into your business. But the new tax law means different tax cuts depending on your type of business.
For small businesses registered as C corporations, the top corporate tax rate drops from 35 to 21 percent. However, you’re likely organized as a so-called “pass-through entity” — a Sub S, LLC, proprietorship or partnership. In this case, and if you clear certain hurdles (more on those later), you’ll be able to deduct 20 percent of your “qualified business income” (let’s call it QBI, for short) from the sum that will be taxed at your personal tax rate.
So what is QBI? It’s basically ordinary, non-investment income from business conducted in the U.S., including income from sales and, in certain conditions, rental income. If eligible, you’d deduct that 20 percent of QBI in a similar manner as you’d write off itemized deductions. In other words, the deduction comes after you determine your adjusted gross income at the bottom of the first page of the Form 1040.
Show Me the Money
The 2018 tax changes also reduce personal tax rates, compounding the net result of the 20 percent QBI deduction. “This sounds like good news, but what does it actually mean?” I hear you cry from across the ether. To help explain, here’s a rough, hypothetical illustration of how the 20 percent QBI deduction might affect you (but please consult a tax professional for a more precise calculation).
Suppose that in 2017, you file a joint return and your taxable income from your business, after you’ve taken all the other deductions you’re eligible for, is $200,000. That would put you in the 28 percent marginal personal tax bracket, and you might be looking at a liability in the ballpark of $42,000. Ouch.
Under the new tax law, in 2018, $200,000 in taxable income would land you in a 24 percent marginal tax bracket. But, if all of that $200,000 is QBI, and you are able to deduct $40,000 worth of QBI (i.e. 20 percent of $200,000), you’d only be taxed on $160,000. Result: Your 2018 tax bill could be around $27,000 — that’s a $13,000 drop. Not bad.
About those previously mentioned hurdles for nabbing the 20 percent QBI deduction: You’re pretty much home free if you’re filing a joint return and your taxable income doesn’t exceed $315,000 ($157,500 for single filers). If you do exceed those limits, the amount of the QBI deduction you can take is based on a formula involving the size of your payroll, and could be lower.
Also, if you exceed those thresholds and have a certain kind of service business, like most professional practices, you might be ineligible for the full QBI deduction.
As with any massive change in the tax law, the TCJA opens the door to some new tax planning opportunities. It will take a while for the IRS to wrap its arms around the new tax law and spell out the fine print. Aggressive tax accountants might encourage you to make certain moves right away to maximize your tax reduction opportunity, as long as they aren’t clearly in violation of the law.
And here’s the fun part. Now with a lower tax liability, you’ll have more free cash to invest in your business, and you get to start planning how you’d like to spend those extra bucks. Whether you’d like to upgrade your equipment or take out a loan so you can make an even larger investment in your business, the tax law changes will likely have you adding to your piggy bank, rather than taking a hammer to it.