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Translating the New Tax Bill for Small Businesses

Can small business owners and freelancers benefit from the business deduction in the government’s new tax bill?

(graphic Hrag Vartanian/Hyperallergic, original image via  Credit Score Blog)

“Am I going to benefit from the new business deduction?”

“Do I need to incorporate to take advantage of it?”

These are questions I’m hearing a lot since the passage of the massive new tax bill. Much of the worry centers around some misconceptions. So, I’d like to outline what’s in the new provision, who it affects, and why you likely don’t need to change a thing to benefit.

The most important outcome of the new tax law (officially the Tax Cuts and Jobs Act, or TCJA) was to give a large, permanent tax cut to corporations. The corporate tax rate went from 35% to 21%. Those numbers are a little deceptive, because most US corporations don’t pay nearly that rate once you factor in tax credits and loopholes. A 2016 U.S. Government Accountability Office study found that between 67% and 72% of all active US Corporations between 2006 and 2012 had no tax liability after credits. In fact, the effective corporate tax rate (a much more meaningful number) is closer to 15%. But despite the fact that most corporations don’t pay anything close to the corporate tax rate, the point of the TCJA was largely to cut that rate.

But most businesses in the US are small businesses, not large corporations. In fact, 30.2 million businesses (or 99.9% of US businesses) are small businesses, according to a government-sponsored  2018 US Small Business Administration report. About half the private workforce in the US is employed by small businesses, and more than a quarter of the small businesses are minority-owned. However, the big corporate tax cut rate did not help these businesses at all. So rightfully, Congress introduced a provision into the TCJA to create a little more parity, called the deduction for Qualified Business Income (QBI) (also known as Section 199A). This provision, unlike the corporate tax cuts, is strictly for businesses known as “pass-through entities.” (More on that in a moment.)

But first, here’s what it does: The new deduction for Qualified Business Income (QBI) (which expires in 2026), allows you to deduct 20% of your “qualified business income” from your total business income. So if I made $100,000 in profit from selling paintings as an artist, I get to deduct 20% of that — ie, $20,000. This benefit is phased out for individuals making between $157,500 ($315,000 if married) and $207,500 ($415,000 if married) in a number of service-based fields.* As good as it is (and it is!), there are a ton of details and restrictions in this particular new provision, especially if your income falls within the phase-out window, so know that you need to do research or talk to your accountant before you apply it.

(* The fields that will be phased out, according to Section 199A(d)(1)(A) of the Internal Revenue Code, are: “Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees [hello artists!].” Oddly enough, engineers and architects are specifically omitted from that list (they must have a good lobbyist).)

Now, let me clarify who qualifies for the big, permanent corporate tax cut, and who gets the temporary pass-through QBI deduction.

To you and me, there are lots of types of businesses, and we might think of a number of them as corporations. However, in terms of taxation, there is only one kind of business that we call a corporation, because there is only one corporate entity that actually pays taxes. That entity is called the C-Corporation. A C-Corporation is usually very large and is primarily structured in order to take on shareholders. All public companies are C-Corporations. Any business that is traded on the stock market, therefore, is a C-Corporation. And for tax purposes, it’s important to know that a C-Corporation is the only type of business subject to taxes at the corporate level. This means that it files and pays its own taxes on its corporate earnings.

Every other type of business, from a tax standpoint, is known as a pass-through entity. A pass-through entity is one where whatever profit and loss activity happens at the corporate level is not taxed at that level, but “passes through” to the individual(s) who owns the business. Partnerships are pass-throughs. What we call S-Corporations are pass-throughs. And you, sole-proprietor or freelancer, are also a pass-through.  In other words, my painting practice, which I file on a Schedule C on my individual 1040 tax return, does not pay its own corporate tax rate, but rather, I calculate the profit I made as an artist on my Schedule C and pay taxes on that at my individual tax rate. Partnerships and S-Corporations do file separate tax returns, but these are simply information returns, and the K1 reporting forms that these information returns produce are used to report the income from the company on the individual owners’ personal tax returns. In other words, S-Corp and Partnership corporate income still pass through to the individual level.

So, if you have a partnership, an S-Corp, or you’re a sole proprietor and you keep hearing “corporate tax rate,” and wondering if it means you, please know that it does not. You, me, and the 99.9% of other US businesses do not qualify for the big, permanent corporate tax cut. We get the 20% QBI deduction (until 2026, when it expires).

“But I’m an LLC. Doesn’t that mean I’m a C-Corporation?”

No. LLCs confuse people, and this is why: LLCs (or “limited liability company”) have no status in the tax world. The IRS refers to them as “disregarded entities.” That’s because the LLC is a legal entity, but not a tax entity. The purpose of an LLC is to give some liability protection to the business owner(s). Technically, what it does is separate out the company into its own entity, separate from the individual owners. So if you slip on the floor of the studio of Hannah Cole, the painter, you can sue me for damages, forcing me to sell my house, my car, and my kids’ college fund. However, if you slip on the floor of the studio of Hannah Cole Painter LLC, you can only sue my company for damages, and so you are limited to going after the assets of my company (my miter saw, my printing press), but you can’t touch my kids’ college fund.

I’d be a bad accountant if I didn’t tell you that LLCs can only protect you if your business practices are up to par. If you are sloppy with your accounting, it can actually allow a court to invalidate your LLC. So if you form one, be sure you also keep your business and personal accounts totally separate, and have a good bookkeeper.

But back to taxes. An LLC, therefore, is just a legal choice. LLCs can actually be taxed as any of the possible taxable entities — sole proprietorships, partnerships, S-Corporations, or C-Corporations. So, for the purposes of the new tax law, if you are an LLC, that has no effect on which part of the law applies to you. What matters is what taxable entity you are.

This leads us to the last confusion that people have about the new QBI deduction — “Do I need to incorporate?” Incorporating, for this purpose, means forming an LLC. So now that you know what an LLC is and is not, you know that forming an LLC will have no effect on whether you qualify for the QBI deduction. So getting back to my point about pass-throughs, most US small businesses and most readers here are already pass-through entities, whether that’s because we are S-Corporations, Partnerships or (for the great majority) sole proprietors. For us — most small business owners and freelancers — the new 20% deduction will apply.

The more relevant question from a tax standpoint is, “Should I become a C-Corporation?” First, I wouldn’t even consider this change unless my income was above the phase-out limit for the QBI deduction ($207,500 for individuals, $415,000 if married). If it is, then it’s possible that forming a C-Corporation could benefit you. But you should know that C-Corporations are subject to a lot more accounting rules, and unlike your pass-through entity, they pay tax at both the corporate level and at the individual level (yes, that’s double taxation). In other words, forming a C-Corporation means potentially more taxes, and definitely more accounting and legal work. So only do it if you’re prepared to budget in a good lawyer and accountant, and you’ll want to consult them both before making the move.

I hope this clarifies the confusion you’ve had around the new corporate tax cut and the Qualified Business Income deduction for pass-through entities. You are very likely going to benefit, and you probably don’t need to change a thing.

DISCLAIMER: True tax advice is a two-way conversation, and your accountant needs to hear your full situation to apply the rules correctly in your case. This post is meant for general information only. Please don’t act on this alone.

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