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What Entrepreneurs Need to Know About the Changes to Pass-Through Taxes

The 20 percent deduction may be a game-changer, but you have to know what it means for your business.

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BY Sean Stein Smith - 13 Feb 2018

What Entrepreneurs Need to Know About the Changes to Pass-Through Taxes

PHOTO CREDIT: Getty Images

As the calendar ticks forward to April 15th, the pressure of tax season, tax reporting, and getting the best deal on your return will only increase. Running your business, keeping up with technology trends that include the disruptive force of blockchain, and dealing with the periodic tax obligations (including quarterly taxes) of any business can seem complicated enough, but that is not the end to this conversation.

Following the passage of tax reform at the end of the last year, and even taking into account the reality that some of these changes will benefit your bottom line, it can be difficult to understand what this legislation means for you and your business. One change that might impact your business, and that will impact the majority of American businesses, is the is the 20 percent deduction now applicable to pass-through businesses.

Deductions on taxable income will reduce how much you owe in taxes, but like any major legislative change there are complications and tweaks that will be addressed going forward. That said, it's important to take a serious look at some of the major changes that will impact entrepreneurs and their businesses, and understand what this means for your business.

Let's take a look at a few things you need to know about the 20 percent deduction of qualified business income as you start preparing your taxes, and your business:

1. Certain businesses are excluded.

Deducting 20 percent of your business income from your taxable income may seem like a savvy decision, and it is -- this is a change to the tax code that will have a positive impact on your bottom line. Even with this good news, however, it's important to pay attention to the details, especially when it comes to navigating the tax landscape.

Specifically, certain businesses, including but not limited to accounting firms, engineering firms, and law firms, do not qualify for this deduction.

Also, be sure to keep an eye on the income limits for this deduction, which start at $157,500 for individuals, $315,000 for married couples, but can vary depending on how your business is structured.

2. Qualified business income may not be as straight forward as you think.

Assuming you, as many entrepreneurs do, have a 9-5 job in addition to entrepreneurial endeavors, the following example illustrates the idea of qualified business income, which can otherwise seem abstract. The 20 percent deduction, based on interpretation of current guidance, will be applied to the lesser of salaried or self-employed income.

Assuming an individual is employed, and has earnings of $110,000 on a salaried basis, and also has an entrepreneurial venture that generates $45,000 in net profit, a simple analysis is possible:

  • Let's assume that this individual's taxable income, less existing deductions and credits is $115,000. In this example, the 20 percent pass through deduction will be applied to the $45,000 of business income, which in this case also happens to be self-employed income. This application will result in a deduction of $9,000 ($45,000 X 20 percent).

Every entrepreneur and small business owner is different, and interpretation is still an ongoing conversation, so it's important to work with your CPA or tax professional when analyzing these changes.

3. Other tax changes will influence your taxable income.

It's important to remember that you, and your competition, operate both as entrepreneurs managing businesses, and also are individuals attempting to navigate the changing tax landscape. These changes include, but are not limited to:

  • The changing deductibility of state and local taxes (SALT)
  • Changes to the deductibility of individual charitable contributions
  • Increased assessment and enforcement of online sales taxes

These changes and updates to the tax code will impact you, your employees, and your customers -- not analyzing these changes will leave you unprepared in fast changing business environment.

Taxes, especially as a small business owner juggling a variety of obligations, can be a stressful time of year even without taking into account the recent changes. Digging through these the changes enacted as a result of tax reform can seem daunting, but they do not have to be. Understanding your tax obligations, working to position your business to take advantage of these updates, and working your tax professional will you leave in a position to win tax season in 2018.

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