The New 20% Deduction for Small Business Owners (Explained as Simply as Possible)
My favorite part of the new tax bill is the 20% deduction for small business owners.
It’s not quite as generous as the 40% tax rate cut the big corporations received, but it will have a noticeable positive impact for most small business owners.
Of all the changes, this one may also be the most complicated for “higher income” small business owners.
Fortunately, most small business owners I work with will be able to take full advantage of this new deduction.
Keep reading to find out who is eligible for the deduction, how it is calculated, the maximum you can make before this new rule becomes more complicated and more.
Who is Eligible for the Deduction?
You’ll hear the term “passthrough businesses” a lot when it comes to discussing what businesses are eligible for the deduction.
Then, your eyes will probably glaze over and you’ll zone out a bit because as soon as you hear nerdy accountant jargon you shut down and die a little on the inside!
The good news is that “passthrough businesses” describes the vast majority of businesses in America.
Unless your business is organized as a traditional C-Corporation (and most small businesses are not), you likely own a “passthrough business”.
This essentially means your business’s income passes through to you and is taxed on your individual return.
If your business is a sole proprietorship, LLC, partnership or S-Corporation, it is likely a passthrough business and you are likely eligible for this deduction
You meet this requirement.
Let’s see how it is calculated.
The Deduction for Most
As promised at the outset, I am going to try to explain all of this as simply as possible.
And for most small business owners, it really is pretty simple.
The deduction will equal 20% of your business’s net taxable profit.
No need to complicate this if it doesn’t need to be.
The majority of you reading this who own a small business will run this calculation and be done.
Simply determine your business’s taxable income and reduce it by 20%.
So far this seems pretty straightforward, right?
Well…if you make over a certain amount of $$$, it can get complicated.
If you report less than a certain amount of total income on your personal tax return, including your business profits, this calculation will usually be pretty straightforward.
However, if you report total income on your personal return that exceeds certain amounts, the 20% deduction may be limited, and possibly eliminated altogether for you.
The calculation for the deduction limitation may be the most complicated aspect of the new rules.
But first, what are the income thresholds?
If you are married and file a joint tax return, the most you and your spouse can report as income on your personal return is $315,000.
All other taxpayers need income of under $157,500.
If your total income is under these limits, there is probably no need to continue reading.
If you have income that exceeds these amounts, things get pretty interesting.
So, you make over these thresholds.
There are two different groups of businesses when it comes to determining your (potential) limitation; “service based businesses” and all others.
Service Based Businesses
A service based business for purposes of the limitation is any business that relies on the reputation or skill of one or more of it’s employees.
There are specific industries listed in the new rules (health, law, accounting…), but, generally speaking, the above definition describes most service businesses.
The General Limitation
If your income is over the threshold that applies to you (discussed above), your small business deduction may not be 20%.
It now becomes the lesser of:
- 20% of your business income OR
- The greater of:
- 50% of your share of your business’s W-2 wages or
- 25% of your share of your business’s W-2 wages plus 2.5% of your share of the unadjusted basis of all qualified property of the business.
Talk about confusing!
And that’s not all.
Additional Limitation for Service Businesses
If you are a service based business, you have to do the calculation above to determine the lesser deduction.
Then, it is further limited and eventually phased out completely.
The phaseout is based on the amount you are over the threshold by compared to the amount at which the deduction is completely phased out.
For married taxpayers, it is completely phased out when the income you report on your personal tax return is $415,000 or more.
For all others, it is phased out completely when your total income is $207,500 or more.
If you aren’t, you are one of only a few in the whole country!
I promised to keep this as simple as possible for the rest of us.
I could provide a bunch of examples of how this will work, but the reality is there is no easy way to illustrate these limitations.
Fortunately, most small business owners will not be impacted by them.
The bottom line is, if you own a small business and your total income from all sources is under the thresholds discussed above, you will get a deduction of 20% of your business’s taxable profit.
For service business owners, it may also be pretty straightforward.
If you are in between the threshold amount and the completely phased out amount, there are some additional calculations and you will probably be spending a little more time with your tax accountant this year.
Otherwise, it is simple.
If you are under the threshold, your deduction is 20%.
If you are over the completely phased out amount, your deduction is $0.
And for other business owners who have total income over their respective threshold, you will probably fall into the camp of business owners who will spend more time with their tax accountants figuring this out.
So, hopefully you like them!
I think that is as easy as I can make this.
Believe it or not, Republican politicians did make preparing a tax return easier for a large segment of the American population.
However, for small business owners who are over the income thresholds discussed above, preparing an accurate tax return just became significantly more complicated.
The small business deduction will be easy to calculate and will be beneficial for most small business owners.
It won’t be as beneficial and will be harder to calculate for some.
And for a small segment of the population who own successful service based businesses, there won’t be any deduction available at all.
This is just one of several big changes in the new tax bill.
I breakdown several of the others here.
I’ll be answering questions on the changes throughout 2018.