How The New Small Business Tax Break Phases Out

Published Friday, May 25, 2018 at: 7:00 AM EDT

If you own a small business, you're likely eligible for a special 20% deduction on your profits. But getting the full benefit is tricky. Not everyone can claim it and some business owners are subject to a phase-out of the 20% deduction based on income.

Most small businesses are pass-through entities - sole proprietorships, limited liability companies, partnerships, and S corporations. They pay no taxes themselves. Their profits move untaxed until they fall into their owners' hands. The problem is, tax rates on individuals are higher than they are for C corporations (which mainly are larger businesses): 21% rate for C corps and a top rate of 37% for individuals.

If you can get it, the 20% pass-through deduction is a good deal. If this deduction applies, a pass-through owner is effectively taxed on only 80% of business income. Thus, the effective rate for pass-through owners in the top 37% tax bracket is 29.5%.

Business owners can take this personal deduction whether they itemize or not. But it won't last forever: This deduction is slated to end on Jan. 1, 2026.

This deduction and phaseout rules are complex. Here's how they work:

Income Below $315,000 ($157,500 for singles)

As a pass-through owner, you qualify for an income tax deduction, 20% of net pass-through income, if you are both:

  • a sole proprietor, LLC owner, partner in a partnership, or S corporation shareholder
  • married filing jointly, earning a total taxable income after deductions of less than $315,000 ($157,500 for single-filers).

This deduction is gradually phased out however, if your income tops the $315,000 ($157,500 for single-filers), and it is entirely eliminated for married couples filing jointly with income over $415,000 ($207,500 for single-filers).

Owners of non-service businesses who file a joint return with income exceeding $415,000 ($207,500 for singles) face slightly different rules. If you are in a non-service business - not a lawyer, doctor, accountant or in a business resting upon the reputation or skill of one more of its owners or employees - your deduction will be the smaller amount of:

  • 50% of the owner's applicable share of the W-2 employee wages paid by the business, or
  • 25% of the owner's share of the W-2 wages paid by the business, plus 2.5% of the original purchase price of the long-term property used in the production of income - for example, the real property or equipment used in the business.

Because many pass-through owners have no employees, the 25% plus 2.5% deduction is the better deal for owners of non-service businesses. You can take the 2.5% deduction during the entire depreciation period for the property, although it can't be shorter than 10 years.

The pass-through deduction covers businesses such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, and trading and dealing in securities or commodities. That is, any business where the principal asset is the reputation or skill of one or more of its owners.

These service business owners are entitled to the 20% pass-through deduction only if their taxable income from all sources after deductions is less than $315,000 if married filing jointly, or $157,500 if single. The deduction gets phased out if income exceeds the $315,000-$157,500 limits. It goes away completely for marrieds filing jointly with income over $415,000 and for singles over $207,500. If you're a service business owner above those limits, then you are not entitled to take the 50% of the W-2 employee or the 25% of the W-2 employee plus 2.5% of the business property deduction.

These new tax laws are complex and we are here to answer your questions, and help you figure out how these rules affect you. It is important to know where you fit in with these rules.

Many small business owners pay close attention to investing, but tax planning early in 2018 instead of waiting is wise because these rules are new and planning for tax savings this way is more tedious but can be financially rewarding.

The Standard & Poor's index of America's 500 largest publicly-held companies closed Friday at 2721.33, barely budging since last week and not far off from its all-time record high.

This article was written by a veteran financial journalist. While these are sources we believe to be reliable, the information is not intended to be used as financial or tax advice without consulting a professional about your personal situation.

This article was written by a professional financial journalist for Phase 3 Advisory Services, Ltd and is not intended as legal or investment advice.

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