Why the New Tax Bill Means You Should Own a Small Business
Part 1: An Overview of the New Tax Rules
If you haven’t heard, a new tax bill has been passed that will impact every American taxpayer in some way.
It’s called the Tax Cuts and Jobs Act of 2017 and it is the biggest change in the tax code in over 3 decades.
What you may not quite grasp yet is how it will impact you.
You’ve probably heard some sound bytes on the news and may have even formed something of an opinion on the changes, but there’s a good chance that you don’t totally follow exactly how the new rules will impact you.
If this is the case, you’re in luck.
I’ve created this two part, easy to digest explanation of what the new tax rules are and how they impact you if you consider yourself a middle class American.
In this Part One, I explain and rate each major change in the tax rules using my super technical, proprietary rating system.
Each major tax rule change gets a rating from 1 to 5 nerdy CPA heads, with 1 nerdy CPA head indicating I think the change is bad for the middle class, and 5 nerdy CPA heads , indicating I think the change is great for the middle class.
I also suggest that, if you don’t already own a small business, you should consider starting one (Hint: the new tax bill gets for small business owners!).
By the end of Part One, you should have a solid understanding of the most important changes, but I do my best not to overwhelm you and try to avoid using nerdy tax jargon whenever possible.
Once you have an understanding of the big changes, check out Part Two, where I provide a few examples of how the new tax rules will impact typical middle class Americans and explain why, in each example, the Taxpayers would be better off if they owned a business.
If you’ve considered starting a small business in the past but have not done it yet, 2018 may the year to take the leap.
Let’s explore why.
Change in Tax Rates
Individual tax rates have, in general, been lowered across the board.
When looking at this, it is important to understand that the tax brackets are progressive.
This means, if you are single and have $50,000 in taxable income, you are in the 22% tax bracket under the new rules.
But, if you are in the 22% tax bracket, you don’t pay 22% on all of your income.
You pay 10% on the first $9,525 of income, 12% on the next $29,174 and 22% on the rest.
Small Biz Tax Guy Score
In almost all instances, middle class American taxpayers should benefit from the across the board tax rate cuts.
It looks like there may be some rare scenarios in the upper-middle class (35% tax bracket) where taxpayers could pay a slightly higher effective tax rate, but overall I score this a win for the middle class.
Increased Standard Deduction
The standard deduction has been significantly increased for taxpayers, another significant change for middle class taxpayers.
Before understanding the impact this will have, you need to understand what the standard deduction is.
Taxable Income Calculation
– “Above the Line Deductions” (Taken whether you itemize or not)
– Greater of Total Itemized Deductions or Standard Deduction
– Personal Exemptions (Gone in 2018) =
When you prepare your tax return, you report all of your income in the first section of the return.
Then, before determining “taxable income”, or the amount of income your tax is based on, you are entitled to certain deductions.
The biggest deduction for most individuals is the standard deduction or total itemized deductions, whichever amount is greater.
Individuals add up their itemized deductions, including:
- Mortgage Interest
- Real Estate Taxes
- State and Local Income Taxes
- Charitable Contributions
If your total itemized deductions are greater than the standard deduction, you itemize your deductions on your tax return.
If the standard deduction is greater, you take the standard deduction.
As a general rule, if you own your home and pay a mortgage and property taxes, you’ve probably itemized your deductions in the past because the total of these deductions was usually higher than the standard deduction.
Under the new tax rules, the standard deduction will be nearly double what it was before, increasing from $6,350 in 2017 to $12,000 in 2018 for single taxpayers and $12,700 in 2017 to $24,000 in 2018 for married taxpayers.
This means that a lot fewer taxpayers, especially married taxpayers, will benefit from itemizing their deductions.
The standard deduction will yield a better result for a lot more people.
It also means preparing a tax return will be a lot easier for a lot more people, which is why you hear a lot of Republicans touting that you will now be able to do your tax return on a postcard.
Small Biz Tax Guy Score
While preparing a tax return will be a lot easier for more people, the financial incentive to own a home in America just took a big hit.
A lot less people will benefit from the tax benefits offered with home ownership going forward.
If you don’t own a home or didn’t itemize in the past, this increase in the standard deduction should benefit you.
But it may not, because it is being offset by eliminating the deduction for personal exemptions.
I see this as a sneaky play by the Republicans.
They can tout that they doubled the standard deduction, but the elimination of the personal exemption deduction makes it a wash or worse for most middle class taxpayers.
Personal Exemption Deduction Eliminated
In the standard deduction section above, I referenced that your tax liability is based on “taxable income”, which is calculated by reducing your income by several deductions you are entitled to.
The biggest is usually your standard deduction or your total itemized deductions, whichever is greater.
Right behind that deduction for most taxpayers is the deduction for personal exemptions.
Under the old law, you were able to reduce your income by $4,050 for each person that was claimed on your tax return.
This typically meant you got an exemption deduction for yourself, your spouse and your children.
Under the new rules, this deduction is eliminated.
Small Biz Tax Guy Score
I understand that some deductions needed to be cut or eliminated to pay for all of the other tax cuts in the bill, but I think eliminating the deduction for personal exemptions is a sneaky way to pay for the doubling of the standard deduction.
Republican politicians can now go in front of the media and sell the American people on the fact that they will be “better off” because the standard deduction has doubled.
However, this comes at the expense of being able to take a deduction for personal exemptions, leaving many middle class Americans worse off when the final amount of taxable income is tallied up.
For example, a typical middle-class family of four (husband, wife, two kids) who took the standard deduction of $12,700 and a deduction for four personal exemptions of $4,050 each in 2017 got a total deduction of $28,900 in 2017.
Under the new rules, they will only get the standard deduction of $24,000, a reduction in deductions of $4,900.
This has a greater impact on families with more than two children.
Fortunately, the typical American family does benefit with another significant change in the new rules.
The child tax credit was significantly modified.
Child Tax Credit Increased
For a lot of middle-class Americans, this will work out to be close to a wash.
However, if you have children, the new rules do have another tax break for you.
The child tax credit is increased from $1,000 to $2,000 for each qualifying child you claim on your tax return.
There is also a $500 credit for dependents who aren’t qualifying children (generally meaning they are over 16 but claimed as dependents), which did not exist before.
The phaseout limits also increased significantly for this credit.
Under the old rules, if you were married and made more than $110,000 combined, your child tax credit was “phased out” and eventually eliminated depending on how many kids you have and how much you make.
Under the new rules, this phase out does not begin until you make more than $200,000 if you are single with children or $400,000 if you are married with children.
A tax credit is more valuable than a tax deduction.
A credit reduces the actual amount of your tax liability.
A deduction only reduces the amount of your taxable income.
So, if you have $100,000 in income and owe $20,000 in tax on this income:
- A tax credit of $2,000 would mean you only owe $18,000
- A tax deduction of $2,000 would mean your income is reduced to $98,000, only reducing the tax you owe by a few hundred dollars
Small Biz Tax Guy Score
For middle class taxpayers with children, this should more than make up for the elimination of the deduction for personal exemptions, especially if you have several children or weren’t able to take advantage of this credit in prior years because of your income level.
If you don’t have children, you’re out of luck.
This one does you no good.
Corporate Tax Rate Decreased
Under the old rules, large corporations were taxed at a maximum rate of 35%.
The new law has a corporate tax rate of 21%.
Of course, very few corporations were previously paying close to the 35% tax rate after taking advantage of the various deductions and credits available to them.
Most will pay less than the new 21% rate as well.
Small Biz Tax Guy Score
On the surface, the 40% tax cut for corporations appears to be something that only rich corporate shareholders will benefit from.
This 40% tax cut to corporations is the biggest tax cut in the bill by far.
There really isn’t even a close second if you net the effects of the reduced individual tax rates, increased standard deduction and elimination of the deduction for personal exemptions.
And, this corporate tax cut is permanent.
All of the adjustments to the tax rules for individuals I highlighted above are set to expire in 2025.
With that said, it is important to understand that the whole point of this corporate tax cut is to stimulate the economy.
If it does what it is supposed to do, middle class workers will be better off.
Better wages, fewer jobs being outsourced, etc., etc.
In my assessment of the new tax bill, this HAS to happen.
Otherwise, my grandchildren could end up paying for these tax cuts!
In the spirit of hoping these cuts do what they are supposed to, I give the corporate tax cut three nerdy CPA heads out of five, but I do so with an ***.
*** Corporations and rich corporate shareholders need to reinvest their tax savings into their employees and into the American economy for this new bill to not be disastrous. If the corporations and shareholders hold onto their tax savings, this bill will increase the US deficit to crazy levels and my 3 nerdy CPA head vote of confidence will change to zero!
20% Deduction for Small Business Owners
The new tax rules provide for a 20% deduction on “pass-through” business income.
What the heck does that mean?!
Almost all small businesses in America are organized as passthrough entities for income tax purposes.
Whether you are a sole-proprietorship, partnership, LLC or S-Corporation, your share of taxable profits from your business “passes through” and ends up on your individual tax return, where your tax liability is calculated.
You may file a separate business return if you are an LLC, partnership, or S-Corporation, but you don’t pay any tax on that return.
With the new tax bill, if your income is under certain limits, you get to reduce the amount of this taxable passthrough business income by 20%.
If you are single and your income is greater than $157,500 or married and your combined income is greater than $315,000, this deduction MAY be limited (the limitation calculation is convoluted and beyond the scope of this post).
This is a huge break for small business owners.
Small Biz Tax Guy Score
I’ve always admired anyone who is willing to forgo the relative security and stability of full time employment to take the risk of starting and building a small business.
This tax break is huge for all small business owners that fit this bill and, for this reason, if I could give it 6 nerdy CPA heads, I would!
If you own a profitable small business, this tax cut should have a noticeable positive impact on your tax bill.
On the other hand, if you don’t own a small business but have any interest in starting one, this is another good reason to do so.
Check out Part Three of this three part post to learn why starting an online business is a viable option.
And if you need more reasons for why starting a small business is more beneficial from a tax perspective compared to being an employee, consider that the new tax bill also eliminated all miscellaneous deductions that were previously available to employees.
Miscellaneous Itemized Deductions Eliminated
Under the previous rules, if you itemized your deductions, you were able to deduct a lot of “miscellaneous” expenses if they exceeded 2% of your income.
So, if you had $100,000 in income and you itemized your deductions, you could total up the following expenses and deduct any amounts that exceeded $2,000 (2% x $100,000):
- Financial Advisor Fees
- Tax Preparation Fees
- Unreimbursed Employee Work Related Expenses, Including:
- Business Use of Auto/ Business Mileage
- Use of Home Office
- Tools and Supplies
- Professional Dues and Subscriptions
- Continuing Education Expenses
- Job Search Costs
This isn’t an exhaustive list, but all these deductions previously available to employees and individuals are eliminated.
For workers in certain professions, this could have a significant impact.
Salespeople who drive a lot, receive an auto allowance from their employer and deduct their mileage each year could take a significant hit.
Nurses, police officers, firefighters and others who have to spend money on uniforms and other expensive necessities will no longer get a deduction for these expenses.
Mechanics, constructions workers and other employees who often spend thousands of dollars every year on tools will not be able to write them off.
It is another big reason to consider figuring out a way to start a small business or become self-employed.
Small business owners and self-employed individuals can still deduct most of these expenses from their business income and they are not subject to the 2% limitation.
Small Biz Tax Guy Score
For most middle class workers who were able to take advantage of any of these deductions in the past, eliminating them will have a negative impact.
I only give it two nerdy CPA heads because it may encourage some people who have previously considered starting a small business or venturing into self employment as an option to actually take the leap.
I am all for that!
Other Important Changes
I elaborated on all of this biggest changes as they impact middle class taxpayers above, but there are also several more important changes that will impact many:
- The deduction for state and local income taxes and real estate taxes is now limited to a combined $10,000 for Americans who itemize their deductions. In earlier discussions and versions of this bill, these deductions were being completely eliminated. The compromise was to limit the deduction to $10,000. This is another big reason why a lot of middle class Americans will now take the standard deduction instead of itemizing.
- Mortgage interest deductions are now limited to interest on mortgages of $750,000 or less. Previously, you could deduct interest on mortgages of up to $1,100,000. If you have a mortgage of greater than $750,000, your mortgage interest deduction will be reduced.
- Businesses are no longer able to deduct entertainment expenses. Under the old rules, if you took a customer, client or employee golfing or to an NFL football game but discussed business during the game or it had another legitimate business purpose, you could take a deduction of 50% of the expense. This deduction is eliminated.
- Starting in 2019, there will no longer be a penalty assessed for not having at least “minimum essential health insurance coverage”, which is part of Obamacare. While most of the new tax rules take effect starting January 1, 2018, this change doesn’t happen until January 1, 2019.
- Contributions to 529 College Savings Plans can now be used for elementary and secondary education.
- While there were discussions and eliminations in previous versions of the bill to several education related tax benefits (ie. education tax credits, deductibility of student loan interest), education related tax benefits remain largely unchanged.
Overall Small Biz Tax Guy Score
The biggest problem I have with the new tax bill is in the way it was sold to the American people.
Sure, most middle class Americans will end up paying a little less.
But to hear Donald Trump or Paul Ryan talk about it leading up to its passage, you would think that the average, middle class worker was going to benefit the most.
This is far from the case.
Corporations are the big winners, followed by small business owners.
The corporate tax cuts will hopefully have a positive indirect impact on middle class workers, but only time will tell if that actually happens.
It is true that filing a tax return got easier for more American taxpayers, but only at the expense of many people being able to realize the tax benefits of owning a home.
As a small business owner and self employed tax advisor, I will benefit significantly from the new cuts.
So will most other small business owners.
From this standpoint, I would selfishly give the new bill 5 nerdy CPA heads.
However, I think the Republican party should have been more transparent and honest in communicating it to the American people.
Instead, the new bill reinforced that our political system is still incredibly flawed, and for this reason more than any other, I only give the new bill 3 nerdy CPA heads.
Hopefully you found that overview to be helpful but not too overwhelming.
If so, check out the next part of this two part series to see some practical examples of how the new tax rules will impact typical middle class Americans.