I’m A Small Business Owner.  Does The Tax Plan Simplify My Taxes?

The tax plan generally won’t simplify taxes for small businesses. If anything, the tax plan will make them more complicated. While the tax plan creates potential new benefits for some small businesses, those benefits come with complex new rules that make it unclear whether many businesses will be able to claim the tax break ­– ­­except for very wealthy business owners, who will very likely receive significant benefits. Guidance from the Internal Revenue Service (IRS) is still needed to determine how particular businesses will be affected.

Complicated New Rules for New Tax Cuts

The biggest potential change for small businesses is a new 20 percent deduction for “qualified business income.” The deduction is not available specifically for “small” businesses, but rather for “pass-through” businesses that pay their taxes on individual tax returns instead of paying the corporate income tax. Pass-through businesses include S-corporations, limited liability companies, partnerships, and sole proprietorships, and they vary dramatically in size, from small local shops to massive companies with billions of dollars in profits. In fact, income earned by pass-through businesses is highly concentrated among the wealthy: More than half of pass-through income goes to the top 1 percent.

Some of these pass-through businesses may receive a tax cut under the provision, while others may not be eligible. Generally, whether a business can claim the deduction depends on its income level, wage structure, and industry. The value of the deduction begins to phase out for single taxpayers with incomes above $157,500 and married couples with incomes above $315,000. First, there is an upper limit on the value of the deduction that is the greater of either 50 percent of W-2 wages paid through the business or 25 percent of the W-2 wages paid plus 2.5 percent of the value of qualified property when it was purchased. The value of the deduction cannot exceed the greater of these two calculations. Second, pass-through businesses in “service” industries, such as health, law, and accounting, are not eligible for the tax break if they have incomes above those thresholds. But there are clear exceptions to the income limits for other industries, such as real estate. Finally, there are special rules for how to treat particular types of compensation, for particular industries, and for what counts as qualified income.

If this sounds complicated, it’s because it is. Making use of the pass-through deduction will involve gathering additional information and performing calculations to determine whether a business is eligible and how big their deduction can be if they are. The changes interact with other changes in the tax plan that affect pass-through businesses, including changes to expensing and accounting provisions for businesses below certain income levels, and changes to the broader individual tax system. There are potential opportunities for tax cuts, but there are also tripwires that could prevent many businesses from benefiting.

Overall, wealthy business owners will likely receive the biggest tax cuts under the bill, since they receive most pass-through income and because the value of the deduction is bigger for taxpayers in higher tax brackets. Even if high-income people might face the deduction’s income limitations, there will be opportunities for them and their high-paid lawyers to exploit the deduction’s complicated structure to take the most advantage of the tax cuts possible.

Additionally, these changes are not permanent. They expire at the end of 2025, meaning small businesses will need to factor in the switch between tax systems as they plan their operations and tax strategies. To be able to take full advantage of the pass-through deduction, small businesses would be best served by consulting accountants and tax lawyers specializing in business taxes.

IRS Guidance Needed

Many of the details for how the pass-through business tax deduction will work still need to be addressed by IRS guidance. For example, rules will be needed to further clarify how the tax plan affects businesses in specific industries and with particular compensation and business structures. Rules will also be needed to try to prevent taxpayers from changing their business structure on paper to benefit from the tax cuts even though they should be ineligible. This guidance could determine whether certain businesses can benefit from the new tax cuts, and the size of their tax benefit. Therefore, small businesses should closely monitor the rules and regulations the IRS is expected to release over the next year.

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