Your Guide to Understanding the Small Business Tax Rate
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The Tax Cuts and Jobs Act presents exciting tax cuts for many small business owners. However, with all that excitement comes stress. Our tax code has not undergone such a massive revision since the 1980s, and several versions of the current law were proposed until the final version was signed in December 2017. All the changes make planning difficult.
Reduce your feelings of being overwhelmed with our 2018 guide to small business taxes. Understanding the law now can help you save when you file next April.
What is the small business tax rate in 2018?
|Business tax rates by business type|
|Type of Business||2018 Tax Rates|
|Sole proprietorships||You will be taxed at the individual rate, which will vary depending on the size of your income.|
How tax reform affects C-Corps
The new tax bill is overall a good thing for small businesses, including C-Corps. That being said, you’ll want to keep a few key changes in mind as you prepare to file in 2019.
The good news
C-Corps could be taxed up to 35%, prior to the passage of the Tax Cuts and Jobs Act. Moving forward, the max rate is reduced to 21% in perpetuity.
“C-Corps are in a better position than they were a year ago,” says Nathan Rigney, Lead Tax Research Analyst for The Tax Institute at H&R Block. “On top of the rate cut, there are more generous expensing provisions in Section 179. What that means is that they’ll be able to deduct more of their expenses that they incurred this year instead of depreciating these costs over several years.”
So if you purchase new equipment for your business, you’ll be able to deduct the entire expense in the same year you make the purchase rather than only deducting a portion of it over the course of subsequent years as the tax code previously required.
The bad news
If you run a C-Corp and find yourself frequently courting clients, you may be disappointed to learn that you will no longer be able to deduct certain expenses, like golf outings or theater tickets. You’ll also have to be careful which meals you deduct as the money you spend on food will be more closely scrutinized. If it’s determined to be an entertainment expense or a business meeting, you’ll no longer be able to deduct these expenses.
“Some meals are still deductible,” says Rigney, “like travel expenses. If you stay at a hotel or eat meals while you’re away, that’s still deductible by the business. It’s more so on-premise meals, group outings at work, and entertaining clients that you now have to watch out for.”
How tax reform affects S-Corps, Partnerships, and Sole Proprietorships
S-Corps, partnerships and sole proprietorships also benefit greatly from the Tax Cuts and Jobs Act. However, the cuts here are temporary and are unlikely to extend to your state tax return.
The good news
Starting with the 2018 tax year, S-Corps, partnerships and sole proprietorships will benefit from a massive 20% qualified business income deduction.
“This deduction has also been called the ‘pass-through deduction,’” says Rigney, “though that title is kind of misleading as it applies to individuals and not just pass-through S-Corps.”
It is important to note that there are limits on this deduction. According to Rigney, you will only be able to claim the full deduction if your income is $157,500 or less if you’re a single filer, or $315,000 if you’re married and filing jointly. If you’re in a specified service business, such as accounting, law, medicine or sports, he says the deduction will fade out completely at $207,500 or $415,000 if you’re married filing jointly.
If your business operates outside of one of these specified service areas, phase-out limits above the $157,500/$315,000 threshold will vary depending on two factors: the amount of wages your business pays out and the amount of property your business owns. Rigney informs us that the more wages you pay to your employees and/or the more property you own, the higher these phase-out limits will be.
On top of this 20% deduction, tax rates have gone down in four of the seven individual tax brackets. This is good news for S-Corps, partnerships and sole proprietorships as their business income is taxed at the individual rate. Not only are they decreasing the amount of income they have to pay taxes on with the deduction, but most small business owners won’t have to pay as much tax on their reduced taxable income.
The bad news
Unfortunately, both the reduced individual tax rates and the 20% qualified business income deduction are set to expire at the end of 2025. Rigney says that in order for these cuts and deductions to continue past that date, additional legislation would need to be passed.
If they are not continued, this could spell trouble for owners of S-Corps, partnership and sole proprietorships. While positive aspects of the Tax Cuts and Jobs Act such as individual tax rate reduction and the qualified business income deduction come with expiration dates, new limitations on personal deductions are permanent. Two of the biggest of note are the state and local income tax (SALT) deduction, which most benefits those who live in high-tax states and has been capped at $10,000, and the mortgage interest deduction, which now does away with home equity lines of credit and no longer applies to interest paid on any part of a mortgage over $750,000 if they were taken out after December 14, 2017.
Because these personal deduction limits are permanent, Rigney says there is a possibility that after 2025, small business owners who do not file as C-Corps could end up paying today’s higher tax rates on a higher amount of taxable income. This is due to the fact that they will no longer be able to take the larger pre-2018 personal deductions or the 20% deduction on their business income, and their tax rates will revert to the higher rates we are paying today in the majority of personal tax brackets.
The same concept applies to states that charge income tax starting immediately. Rigney says states are unlikely to be able to sustain the 20% qualified business income deduction, so the vast majority are not going to conform to the new federal tax bill. Potentially, that means that small business owners will appear to have a higher income because of the new limitations on personal deductions, and they won’t be able to reap the benefit of that 20% business deduction at the state level. They could be left paying on a much higher income at the state level–where rates may or may not be either reduced or increased as they are not codependent on the federal tax bill.
Iowa is the only state that has taken concrete action towards accommodating the business income deduction at the state level, but state legislation does not change anything for the 2018 tax season. It will phase the 20% deduction in slowly until 2023, and two years after that the deduction could disappear at the federal level anyways. There are only three other states that currently look like they could potentially accommodate the 20% deduction: Idaho, Colorado and North Dakota.
“Even in Idaho, Colorado and North Dakota–that would cost the states a lot of money to conform to,” says Rigney. “It’s not too late for any of those states to say no to the pass through deduction.”
How tax reform affects LLCs
LLCs can file either as C-Corps or as pass-through entities, making many of the pros and cons to the new tax bill repetitive considering what we’ve already reviewed. If you think switching the way you file would save you money in taxes because of the recent changes with this bill, you need to know that changing your tax filing status is not as simple as just checking a box.
Rigney says there are several factors that should be taken under consideration when you’re thinking about restructuring your business. Tax implications are one of them, but you also need to think about the size of your business, what your business’s goals are, and other factors unique to your industry and business model which should be discussed with an attorney.
However, if we were to consider the tax implications in isolation, Rigney says it would typically make more sense to switch your LLC to C-Corps status from S-Corps status rather than the other way around.
“The 20% deduction will probably not justify a change from a C-Corps to an S-Corps,” says Rigney. “Switching from an S-Corps to a C-Corps can make sense if you’re at a higher income level. This is especially true if you’re in highest marginal tax bracket because the dividend rate plus corporate tax rate may still be lower than if you filed as a pass-through entity.”
What businesses can do now to prepare for tax season 2019
With new tax law comes new forms of preparation. Rigney has three tips for small business owners as they prepare to file under the new legislation in the spring.
First, you need to be aware that of all the calculators you see online, none of them are endorsed by the IRS. There are still some questions surrounding the way the Tax Cuts and Jobs Act will be implemented, so it’s going to be very difficult to calculate accurate estimated quarterly payments in year one.
“We haven’t had access to good calculators yet,” says Rigney. “For that reason, most firms were advising small businesses to continue paying as if you weren’t going to qualify for the 20% deduction. Moving forward, you’ll be able to reduce estimated tax payments.”
Changes in policy around net losses will also be important in planning. From here on out, you will only be able to claim net losses moving forward–not backwards. However, you can claim portions of that net loss indefinitely into the future.
“We’d like to eliminate all taxable income as early as possible because of the way time valued money works thanks to inflation,” Rigney explains. “A deduction this year is worth more than a deduction next year. However, because you can now carry net losses forward indefinitely, it may be advantageous to reduce your income that falls into a higher tax bracket.”
For example, let’s say your business lost $10,000 this year and that you fall into the 35% tax bracket thanks to income from other businesses or your spouse’s wages. But only $2,500 of your income is taxed at that 35% rate. Theoretically, you could take $2,500 of the loss today. Then, assuming your household income stays stagnant, you could take $2,500 of the loss next year eliminating the portion of your income which is taxed at the 35% rate. You could do the same for four years.
If you took the $10,000 loss all in year one, you’d avoid paying taxes on $2,500 in the 35% tax bracket, but the next tax bracket down is only 32%. That means you’d only avoid paying 32% in taxes on the remaining $7,500, rather than avoiding the 35% you’ll end up paying in years two, three and four if you carry your loss over.
Rigney also notes that for those who bring in an income in excess of $250,000/year–or $500,000/year for those married and filing jointly–you will only be able to carry forward these losses if the amount you are claiming each year is 80% of your income or less; you cannot carry forward losses and reduce your household earnings down to $0 at this income level.
Finally, Rigney encourages small business owners to consider if upping wages paid or looking for new hires would incur a tax benefit large enough to offset the costs of giving raises or brining on a new team member to expand your business. These calculations are complex, though, so it’s important to take this step with the help of a tax professional.
In fact, Rigney suggests all of these considerations be made with professional assistance.
“You should go in to talk to a tax professional and figure out just how all these changes are going to impact you so you know what to expect,” he says. “You don’t want to end up owing money or receiving a refund much smaller than you were hoping for. And if you’re thinking about restructuring your business, be sure to employ the help of an attorney who practices corporate law.”