The tax reform generally taking effect in 2018 brought on several sweeping changes to both individual and business taxpayers. For small business owners, solopreneurs and freelancers, in particular, some of these new tax laws are going to drastically reshape the way that tax planning has typically been done. A majority of small businesses can expect to benefit from the tax code changes, but with some exceptions. Here are some of the top tax law changes that are most likely going to affect your imminent tax planning.
1. The business entertainment deduction has been killed, and there is still confusion surrounding business meals.
Your entertainment budget is likely to be cut because there is no longer a deduction for those season tickets to sports events or taking your clients out to the theater to angle for more business. There is a lot of confusion regarding whether the IRS has lumped business meals, where you take a customer or prospect out for a meal and discuss business, in with entertainment, but so far, it has not issued any rulings. Meals eaten on business travel are still deductible as normal as are normal business meals on your home turf until otherwise dictated by the IRS, but you should plan for the worst-case scenario in case they aren’t deductible in the future.
2. Qualifying freelancers and small business owners can get a 20 percent deduction of their income from pass-through entities.
Deciding whether to operate as a pass-through or a corporation has depended on both projected taxes as well as legalities in your area. For certain professionals like lawyers and doctors, you could be mandated to operate as a personal service corporation. But there is a new benefit to operating as a sole proprietorship, (including farm operations), rental, partnership or S corporation for tax purposes: a 20 percent deduction based upon your qualified business income (QBI) passed through to your individual tax return. This new wrinkle may make you consider reorganization.
This deduction is subject to both income limits and a phaseout range based on marital status. A taxpayer’s total taxable income (from their individual return) must be less than $315,000 if married filing jointly and under $157,500 for every other filing status in order to fully qualify for the deduction. If your business activity is what the tax code refers to as a “specified service business,” one identified in the new law or where your chief product is your knowledge and reputation, then the deduction phases out for taxable incomes between $315,000 and $415,000 for married filing jointly ($157,500 and $207,500 for other filing statuses), and no deduction is allowed at all when your taxable income exceeds the top of those ranges.
For other types of businesses, once the $315,000 and $157,500 taxable income thresholds have been exceeded, what is referred to as the wage limitation phases-in and is fully applicable when the $415,000 and $207,500 caps have been reached. The “wage limitation” is the greater of 50% of the wages paid by the business activity or 25% of the wages plus 2.5% of capital items used in the business activity. Once your taxable income has exceeded the $415,000 and 207,500 caps, the deduction is the lesser of the wage limitation amount or 20% of QBI.
This pass-through deduction can produce significant tax savings, but it only applies to the income tax and does not reduce business income for purposes of the self-employment tax or other federal, state, or local taxes based on business profits.
3. Corporate tax rates have been permanently reduced.
If you’ve considered reorganizing as a C corporation and your taxable income is more than the limits for the pass-through deduction, this could be a good time to go through with an entity conversion. The new maximum corporate tax rate is 21 percent, and unlike the pass-through deduction and other small business provisions, this cut is permanent. For professionals operating as personal service corporations, this 21 percent maximum rate also applies and is likely to be lower than the personal rates higher-income individuals can expect to pay on pass-through income.
In the event you don’t see any benefits from the new deductions or are severely impacted on the personal level, switching to C status could work in your favor.
4. Net operating losses (NOLs) are not deductible the way they used to be.
Traditionally, NOLs from business activities worked like this: You could carry back the losses two years to offset past income and then forward 20 years to offset future income. Of course, the carryback and carryforward are allowed only to the extent of the NOL itself. If your two years prior to the loss year were low-income years where you wouldn’t get much tax reduction by carrying the loss back to those years, you could elect to forego the carryback and only carry the NOL forward. Under tax reform, there is no more carryback and the 20-year carryforward limit has been replaced with perpetuity with a couple of strings attached.
For losses occurring after 2017, only 80 percent of your taxable income (figured before applying the NOL deduction) may be offset now, so if you rack up a lot of expenses with little or no income, then you’ll get far less relief than you would have in the past. (NOLs that arose in tax years beginning before 2018 and that are being carried back or forward are not subject to the 80 percent limit.) If you still work a day job, or your spouse does, to support your entrepreneurial endeavors, and the NOL deduction is limited by the 80 percent rule, you may see your income taxes increase in the future compared to what the pre-tax reform result would have been.
Tax planning just got more challenging, but if you have an adept business tax professional on your side, you can weather the 2018 tax reform or even come out ahead with the right tax strategy in place.