By now, you've probably heard that there's a new tax law. But have you stopped to think about how tax reform is going to impact your business? We've broken down some of the more salient points to help you understand what to expect in the first year of the new tax law.
The standard deduction nearly doubles under the new tax law. It's $12,000 for single filers and $24,000 for joint filers in 2018. Previously, it was $6,350 or $12,700. As in the past, the standard deduction may increase slightly in future years for inflation.
You don't pay income tax on any amount up to your standard deduction. For a single filer, you have to make at least $12,001 to pay income tax, and only that $1 above the standard deduction is taxed.
One thing that goes away is the personal exemption. Previously, you could claim a $4,050 exemption for each of yourself, your spouse, and your dependents.
This eats up some of the standard deduction increase, but you still come out ahead if you don't have kids. In 2017, a single filer would have paid income taxes if they made more than $10,400, and that number would have been $20,800 for joint filers. Since joint filers now get an extra $3,200 in tax-free money with the $24,000 standard deduction, they could save $800 assuming a 25% marginal tax rate.
If you have kids, it gets a little more complicated. You only get your $12,000 or $24,000 standard deduction with no extra amount for having dependents. But, the Child Tax Credit doubled to $2,000, and up to $1,400 of that is refundable. A $2,000 credit is worth anywhere from $501 to $1,598 more than a $4,050 exemption because credits reduce your tax bill directly, while exemptions reduce your income and get multiplied by your marginal tax rate. The catch is that your child must be under 17 at the end of the tax year — if you have college-age dependents, you're out of luck.
The pass-through deduction is a completely new deduction that lets you deduct 20% of your qualifying business income as a sole proprietor or independent contractor. Pass-through means that you report your business income on your own tax return rather than filing a separate tax return like a corporation. The reason this deduction was passed is because corporations got a large decrease in their tax rates, and Congress wanted to level the playing field.
This deduction basically means that you pay income tax on only 80% of your business income. For example, if you had a $100,000 profit, your deduction is $20,000, and your taxable business income is $80,000.
This is not an itemized deduction, so you do not have to itemize to claim it. You still get your full standard deduction on top of the pass-through deduction, or you can get your full itemized deductions if you choose to itemize.
Pass-Through Deduction Phaseout
The catch to this deduction is that it phases out if your income is too high.
- You get the full deduction if you make up to $157,500 as a single filer or $315,000 as a joint filer.
- You get a partial deduction if you make up to $207,500 as a single filer or $415,000 as a joint filer. The deduction is on a sliding scale from the numbers above to the numbers on this line, so it's 20% at $157,000/$315,000, 0% at $207,500/$415,000, 10% if you're exactly in the middle of the range, etc.
- If your income is even higher, you may get a deduction calculated based on how much wages you pay to employees and/or your capital investment in your business. This is a complicated formula, and certain types of businesses aren't eligible, so ask your tax adviser if you qualify.
Itemizing vs. Standard Deductions
Some personal itemized deductions were reduced or eliminated in exchange for the higher standard deduction, but these changes don't affect your business deductions. Some people have been confused because employees can no longer itemize business expenses their employers don't reimburse them for. As an independent contractor or sole proprietor, you are not an employee and can continue to deduct your ordinary and necessary business expenses as you did in the past.
To learn more or to find out how the new tax reform impacts your specific situation, talk to a tax adviser today.