A small-business tax break
The recent tax overhaul offers pass-through businesses a big opportunity to save.
What is a pass-through business?
Sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations are all types of pass-through businesses—named after how they are taxed. Instead of being taxed at corporate rates, as with C corporations, profits “pass through” to the business owners, who then pay taxes on them as personal income. Of the 26 million businesses in the U.S. in 2014, 95 percent were pass-throughs. Most are small businesses: Sole proprietorships are operated by a single person, who can be anything from a housekeeper to a doctor, while a partnership can be a law firm or a car dealership, for instance. But some pass-throughs are very large businesses with millions of dollars in profit, such as the Trump Organization or the Dallas Cowboys Football Club. The new tax law enacted in December allows certain pass-through businesses to deduct up to 20 percent of income from their tax bills, which can lower their effective tax rate.
Can I be a pass-through business?
It’s possible, but it may not be in your best interest. “This is one of the most pressing issues for taxpayers and business owners,” says Mark Everson, vice chairman of tax-consulting firm Alliantgroup LP. “They are looking carefully now at how they are legally organized.” Obviously, you’d first have to own a business. Less obvious: You might qualify as a business owner without even realizing it—for example, if you’re a freelancer. But before you jump into making yourself an LLC or other kind of pass-through, know that qualifying for the full pass-through deduction under the new law can be tricky. It depends on many factors, including what your taxable income is and what kind of business you do.
What are the new rules?
If your taxable income is less than $157,500 for single filers, or $315,000 for joint filers, you can deduct 20 percent of either your eligible business income or your taxable income, whichever is less. Above those income limits, what you can deduct depends on your business. For specified service providers—including doctors, lawyers, accountants, consultants, and investment advisers—the deduction is phased out until your taxable income reaches $207,500 for individuals or $415,000 for married couples filing jointly. At that point, the deduction is eliminated for these types of service businesses. But even with the phase-out, many highly paid professionals, such as lawyers, athletes, and stockbrokers, will probably still want to turn themselves into LLCs or other pass-throughs. Tax experts have noted that there are plenty of ways to game the system and get around the restrictions.
How much are the savings?
You’re going to need a calculator—and probably an accountant—to figure out your own potential benefit. But “the deduction…has the potential to reduce your taxable income by tens, if not hundreds, of thousands of dollars,” says Jeffrey Levine, director of financial planning at wealth management firm BluePrint Wealth Alliance in New York. He offers these examples: Jack is single and makes $100,000 a year at his day job. He also works as a consultant on the side and makes $50,000. His taxable income is $133,500. Filing as a sole proprietorship, he can deduct a full 20 percent of his side business’s $50,000 profit, bringing his taxable income down by $10,000, to $123,500. On the other hand, Jill is also single and makes $100,000 a year as a real estate agent. Her taxable income is $73,000. Unlike Jack’s, her taxable income is less than her eligible business income. So she can deduct 20 percent of the $73,000 figure, which gives her a $14,600 deduction.
How do I set it all up?
If you do decide to go the pass-through route, seriously consider working with a certified public accountant or other financial pro to ensure that you maximize the tax benefit available to you. “The most complicated piece of the reform is the deduction for pass-through income and how it is limited for taxpayers with joint income above $315,000,” says tax law expert and professor Bradley Heim. “I would advise anyone in that income range with a pass-through business to work with a tax professional, since correctly applying those tests and figuring the proper deduction will not be easy.”
The pros and cons of forming an LLC
About 2.4 million businesses in the U.S. were structured as LLCs as of 2014 (the most recent data available), up from just 1.3 million a decade ago, according to the IRS. With the added incentive of the new tax law’s 20 percent pass-through deduction, those numbers are likely to jump even higher. But should you join their ranks? On the pro side, doing so protects your personal assets—such as your home, car, and bank accounts—if your business gets in trouble. Getting started is also pretty easy, with light initial paperwork and fees ranging from $40 to $500, depending on your state. The downside: You have to register in every state where you plan to do business. Also, unless you opt for your LLC to be taxed as a corporation, the IRS considers you self-employed, putting you on the hook for Social Security and Medicare taxes on all of the business’s profits.