We’ve spent the past few months discussing the effects of the new tax law on individuals. But we really haven’t touched on the effects of the new tax law on business income. One of the more common questions I get is, “How does the 20% business deduction affect the income from my partnership or small business on my federal tax return?”
The answer is simple and complex all at the same time. If your business is a C Corporation, then your tax brackets have been changed to a flat 21%. In prior years, it was similar to the individual tax brackets in the sense that it started small and increased as the corporation’s income increased. The maximum tax rate for a corporation was around 35%. So, with the new law, the tax rate is 21% for a C Corporation. That’s the easy one.
If your business is something other than a C Corporation, think S-Corp, Partnership, LLC, for instance, then the answer is much more complex. Because they gave a tax break to C Corporations by lowering the tax rate, the folks that wrote the new tax law thought it would be a good idea to give a tax break to the rest of the business entities, as well. The problem is, all the other business entities are pass-through entities.
What’s a pass-through entity? Instead of the income being taxed at the corporate level, the business owner passes the income through and puts it on his or her personal tax return. Consequently, it could be taxed as high as 37%, which is the max tax rate for individuals under the new law.
It would have been nice if all pass-through income could be taxed at a max of 21% to match the C Corporation, but the added complexity of trying to incorporate another tax rate into the individual’s tax code seemed too great. So, they came up with this:
Owners of pass-through entities will be able to take a 20% deduction on the income from the pass-through entity. Think of it as kind of a pretend deduction. They don’t have to have any kind of cash outlay but still get a deduction and, therefore, a reduction in taxes.
Seems like it’s pretty easy so far. But wait! There’s more.
If your taxable income is less than $315,000 for Married Filing Joint or less than $157,500 for everyone else, then you are good. There is no reduction in the deduction. Because the pass-through is on your personal return, the limits are based on your total taxable income, not the income from the business.
If your taxable income is between $315,000 and $415,000 for Married Filing Joint or between $157,000 and $207,500 for everyone else, then your deduction could be limited. This one is probably a little too complex for this blog, but it’s a nice little computation based on the W-2 wages paid within your business.
Finally, and this is where it hurts, if your taxable income is greater than $415,000 for Married Filing Joint or $207,500 for everyone else, you may not be able to take any of the 20% deduction. Specifically, service businesses other than architects and engineers fall into this category. Accountants, lawyers, healthcare professionals, and the like will not be able to participate in the 20% deduction at all if their income is in the highest income group.
Everyone else still may attempt to take the 20% deduction, but it will be limited to the same calculation used in the middle group that involves the totals of the W-2s paid for the year.
So much for reducing complexity.
My guess is, I put you to sleep about halfway through this blog. I apologize. I didn’t do it intentionally; it’s just the nature of the topic. If you have questions about how the new deduction will affect your tax return, reach out to your tax professional. If you are still reading this and want more info, stay tuned. I’m working on a riveting flowchart to help explain this section of the new law.
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