After eight months, the IRS finally clarified how the new small business deduction works for LLCs and S-Corporations. Given its complexity, it’s no great surprise it took 184 pages to explain.
Here’s why it’s so important to understand.
If you happen to have lots of kids or pay high property taxes or pay big state income taxes or took out a mortgage that funded something other than home improvements, you’ve likely lost a lot of tax deductions and exemptions. When all is said and done, the new law effectively subjects more of your income to taxation.
However, if you are fortunate enough to own your own business, Congress found a way to make it up to you. You may now qualify for the very large 20% small business income deduction under Section 199A.
Here’s how it works. But, remember, it only applies to pass-through businesses; LLCs or S-Corps. C-Corps got their own tax break, so don’t feel bad for them!
Section 199A’s very first eligibility test is based on your taxable income. If your taxable income is less than $315,000 as a married person (or $157,500, if filing single), you’ll get the tax break.
Importantly, below these income levels, you don’t need to have any employees to qualify for the deduction. And, despite what you may have read, this tax break applies to “service” businesses too. Below these income thresholds, it’s not just for “non-service” businesses. The IRS’ recent guidance made it clear that many service business owners will qualify for the 20% small business tax deduction.
Now, if you make more than $315,000 (or, again, more than half that level, if you’re single), the tax break fades away fast. To be clearer, it fades away fast for service businesses only.
Service businesses are defined as fields that look like paper-pushing, such as investment advisors, accountants, attorneys or catch-all “consultants”, as well as businesses providing health services, like physicians.
For these service businesses, as you make more than the taxable income limit, the deduction begins to decline. Once you reach $415,000, it totally disappears.
Interestingly, no matter how much the business owner makes, this big tax break is never gone for “non-service” businesses. Bizarrely, it also sticks around for certain carved-out paper-pushers; engineers, architects or real estate agents!
For “non-service” business owners, there’s a two-pronged test to determine the level of the small business deduction you’ll get. The tax deduction you’ll get is the smaller of two distinct calculations.
The first calculation is equal to 20% of your business income. The second calculation is the larger of (a) 50% of your employees’ total wages or (b) a combination of 25% of employee wages plus a factor of how much money you invested in your business.
Only Congress, in its infinite wisdom, would think all of this represents tax code simplification. They deserve stacks of love letters from CPAs across the country thanking them for their continued job security!
Speaking of the new tax rules, we’ll be discussing the possible benefits of Donor-Advised Funds at this season’s kick-off Money Series presentation on Wed., Sep. 26 at 3:30pm at the Traverse City Senior Center. Front Street Foundation is a local non-profit whose mission is to provide open-access to financial education, for all. To register, visit www.MoneySeries.org or call (231) 714-6459.
