With last week’s passage of the hotly debated Tax Cuts and Jobs Act, proponents and opponents are offering different versions of the “winners and losers.” How any particular taxpayer will fare depends on a number of factors, including marital and family status, amount and type of deductions and in which state they live. However, one type of taxpayer, in particular, stands to gain more than most: small-business owners.
For most of the year, the focus of the tax bill had been on the reduction of corporate tax rates — from 35% down to 21% — to bring them in line with the tax rates of some of the more competitive countries. This cut is significant for C-corporation filers.
20% Blanket Reduction of Taxable Business Income
Original versions of the tax bill sought to extend a similar provision to pass-through businesses, such as sole proprietors, S-corporations, LLCs and partnerships. The final version didn’t go so far as to reduce the tax rate on pass-through filers, who pay income taxes based on their personal tax rates. But it did provide them with a substantial, across-the-board 20% reduction of their business income. So, a sole proprietor generating $200,000 of business income would be able to deduct $40,000 on his Schedule C. Instead of adding $200,000 to his adjusted gross income, he would add $160,000.
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The exception for the 20% business income reduction is for service-based businesses, such as doctors and lawyers, earning more than $315,000 a year. The thinking is that the deduction could become a loophole for certain businesses that weren’t intended to benefit from the tax break or that taxpayers would look for ways to convert income from other sources into business income.
It should be noted that the pass-through deduction was included as an individual income tax provision, which means that it expires at the end of 2025, along with the other individual income tax reductions. (Meanwhile, the corporate tax cut is permanent.)
Providing Small Businesses with More Room to Grow
The tax break is intended to provide small businesses with some much-needed breathing room as they struggle to compete with larger businesses and global competitors that have a smaller tax burden. Business owners can use their tax savings to hire new employees, increase employee wages and incentives, purchase inventory, expand their workspace, pay down debt or reduce their prices. Or they could just give themselves a raise.
More Tax-Planning Opportunities
The tax bill made very few changes to the Schedule C, keeping in place most of the deductions businesses can take for eligible expenses. The biggest change favors businesses that invest in equipment, allowing full expensing for five years and increasing the Section 179 small-business expensing cap to $1 million from $500,000.
Many Business Owners Also Benefit from Lower Tax Rates
Beyond the reduction in business income, business owners may also benefit from the reduction in individual tax rates. Business owners living in high-tax states (such as California, New York and New Jersey) who itemize deductions may benefit less due to the new caps on state and local taxes and mortgage interest. However, for those in low-tax states (such as Florida, Nevada and Wyoming), the combination of reduced business income and lower individual tax rates is likely to result in a lower tax bill.
The new tax law is expected to take effect Jan. 1, 2018, which leaves little time to make adjustments to your 2018 strategic plans and budgets. However, it is advisable to review your plans with the guidance of your CPA to ensure you understand the full impact of these tax changes on your business and personal tax situations.
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