In late 2017, the United States government issued the Tax Cuts and Jobs Act, the biggest overhaul of the U.S. tax code in more than 20 years.
The IRS has yet to issue formal guidance on the new tax code, including updating standard tax forms, but we do know that major changes are afoot, particularly as they relate to business entities. Below, we’ll break down the new changes and what they might mean for individuals currently working as independent professionals.
The Tax Cuts and Jobs Act has changed many things about the tax code, adjusting both individual and corporate tax rates, changing the standard deduction, and much more.
While these changes are large, the most important changes for independent professionals come from a new portion of the Internal Revenue Code that impacts small businesses.
The pertinent text is in Section 199A, sometimes called the Qualified Business Income (QBI) deduction.
In general, the deduction as the law states is equal to the LESSER OF:
Note: There are several limitations including income thresholds, specified services as well as wages paid, and capital invested.
Effectively, this means that many independent professionals might be able to take an immediate deduction of 20% of their qualified business income.
However, the law limits the deduction in two key ways. *
First, it requires that the QBI deduction be used by qualifying business types—pass-through entities. These include sole proprietorships, LLCs, S-Corporations, and partnerships.
Second, it has income cap thresholds. This deduction is available to anyone with 1040 taxable income of less than $157,500 ($315,000 if filing jointly). Above that income cap, the deduction is phased out over the next $50k ($100k if filing jointly) in earnings. Above $415,000, several other limitations apply including the types of business activity, the amount of W2 wages paid to the owners and the amount of capital deployed in the business. We will not address these limitations in this blog.
Let’s explore what that looks like in the calculation below:
Sample Calculation: Independent Contractor—Married
Sole P Income
Income from Client Billings
Qualified Business Income
Health Savings Account
Income Before 199A
199A Deduction Lesser of:
20% Taxable Income
20% Qualified Bus Income
Net Taxable Income
Tax Savings via Section 199A
Using the sample calculation above, and assuming a federal tax rate of 24%, there is a $5,760 annual savings as a result of this new provision.
For qualified independent contractors, this means there’s never been a better time to work independently.
If you are already set up as an independent business operating in a pass-through structure, you’re set to continue working as you have been. If you are set up as an S Corporation or a Partnership, there are rules that you must pay yourself a reasonable and fair wage before you can pass through any QBI. If you are operating as a Sole Proprietor, the requirement for a reasonable and fair wage appears to be omitted. Should the IRS adjust this in its revisions later this year, we will update guidance accordingly.
If you’re earning more than $415,000 in taxable income annually, or working in a restricted specified business activity, you will likely not be able to take advantage of these deductions, but we encourage you to speak with your preferred tax or legal professional for advice.
Next week, we’ll look at what this law means for those who are considering going independent but haven’t yet made the leap.
We’re happy to answer any general questions you may have, but please note that content from MBO Partners® does not constitute legal or financial advice. If you have questions about your unique situation, please contact your preferred tax or legal professional.
*There are additional limitations, but these are the two most likely to apply to independent professionals.
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