Learn about the impact of the Tax Cuts and Jobs Act of 2017. How will it affect your small business taxes? Are you qualified to get the deduction?
Implications of the New Tax Code on Small Businesses in 2018
While many have cited that the updated tax code is good for larger corporations, what does it do to help or harm small businesses? Get some expert information on small business taxes. We will examine the real-life implications of the new tax bill on small businesses to help them prepare accordingly throughout the year, or adjust how they do business, for the next tax season.
The Tax Cuts and Jobs Act of 2017 allows for a 20 percent deduction for all pass through businesses. A “pass through” business refers to the way a business pays taxes on income from the business. For pass through entities, those taxes are paid by the individual owners on their personal tax returns, instead of where the company itself pays taxes on the income the company derives. Pass through entities include:
- Sole proprietorships – an unincorporated business owned by one person, but not a legal entity.
- Partnerships – a business formed between two or more people who share profits and losses, but doesn’t have to be in equal proportions.
- S-Corporations – a special type of corporation that shares company profits, losses, deductions and credits with its shareholders (between 1 and 100 people), who are then taxed on their individual tax returns.
- Some Limited Liability Companies – legal business entities formed by one or more persons in which members of the company are not personally responsible for the company’s debts or liabilities.
In America, as of the mid-2010s, only 8 percent were corporations subject to corporate tax on their profits. That means that 92 percent of American businesses are pass through companies and are taxed at the individual level. That is why individual and business tax reform was such an important part of the Tax Cuts and Jobs Act of 2017.
The Tax Cuts and Jobs Act of 2017 offers a 20 percent deduction across the board
The great thing about the 20 percent deduction in the new tax code is that it is based on annual income of the small business, not on particular activities of the small business, so there are not specific descriptive examples of deductions to give. This is an across-the-board cut so to speak. It’s different from the way people think about the individual tax code – the small business doesn’t have to be in a particular industry or do a particular activity (e.g., buy a piece of equipment, hire an employee, sell X number of goods) to claim the deduction in the same way a person has to do an activity to get certain credits in the individual tax code, such as have a child to get the child tax credits or buy a house to get the mortgage interest deduction. It should affect almost all small businesses equally (with some exceptions discussed below), and most small businesses will be able to deduct 20 percent from the income of their business before accounting for taxes owed on that income.
Additionally, tax rates were lowered on the individual side of the tax code as well as the business side. Since pass through small business income is claimed as part of an individual’s income tax, the overall tax rate for the business income will in most cases be reduced from the rate the small business paid before 2018, on top of the 20 percent deduction.
Finally, and in addition to the 20 percent deduction, there may also be other aspects of the new tax code that small businesses can take advantage of, like immediate bonus depreciation of business investments such as new equipment, computers, office space, or vehicles for the business.
The 20 percent deduction and other tax benefits are based on a number of factors including qualified business income, payroll, income versus salaries, and type of business investment. Please refer to IRS guidance or seek the advice of a qualified tax professional for assistance with calculating the deductions as applied to your particular small business and financial circumstances.
How to take advantage of the tax code reforms
Every small business is unique. Given your industry or service, the number of employees, the type of investments your business needs to make, and a multitude of other factors – it is best for every concerned small business to consult with a qualified tax professional to discuss its individual circumstances for how best to maximize tax advantages or minimize negative impacts.
However, more generally speaking, there are some small businesses that will not be able to take advantage of the tax reform provisions as much as their peers. Service-based businesses have annual income limits on claiming the 20 percent deduction. Service-based businesses are those where the essential asset is the reputation or skill set of one or more of the business’ employees or owners. Service-based businesses include law or accounting firms, doctor’s offices, consulting, athletics, performing arts, financial services firms, brokerages, investing and investment management, securities and commodities trading, actuarial science, engineering and architecture firms.
For these service-based businesses, the 20 percent deduction is not allowed if the annual income of the person is $157,500 or more, or in the case of a married couple, $315,000 or more. These limits were put in place to close potential loopholes and abuses of the tax system.
In addition to this limitation, the tax reform legislation also eliminated several deductions that small businesses have used in past years. The legislation eliminated deductions for business entertainment expenses, travel costs, membership dues for professional organizations, meals provided to employees for the convenience of the employer, parking/mass transit/commuting expenses, domestic production activities, and local lobbying expenses. Small businesses should be aware that these deductions are no longer eligible on their tax returns and may choose to make business decisions accordingly.
For any small businesses that have income overseas, the bill introduced a new system of international taxation that may impact those profits. Concerned small businesses should seek the advice of a qualified tax professional for any international tax issues.
The long term effects for small businesses when the corporate tax rate drops from 35 to 21 percent in the new tax code
Although small businesses are typically thought of as “pass through” entities that are claimed on a person’s individual tax reform, that is not always the case. A small business can also be organized as a corporation for tax purposes. In fact, some limited liability companies choose to be taxed as corporations instead of as individuals. The Small Business Administration’s definition of small business is not tied to tax status, and the number of employees can vary greatly depending on the industry – from one or two individuals to as many as 5,000 employees for certain sectors of the economy.
For small businesses that are organized as corporations, the reduced corporate tax rate will have an immediate effect on these companies when they file returns for 2018. The cost savings from lower taxes could mean higher wages for employees, or investments in new employees, equipment, office space or other items that help the business grow. In addition to the lower corporate tax rate, the new tax code provides several other benefits to corporations, such as bonus depreciation, the ability to choose certain accounting methods up to certain revenue levels, and the ability to carry forward net operating losses indefinitely. These changes could generate additional savings for small corporations in compliance, accounting and to make up for difficult periods in the business where it experienced losses.
For small businesses that are currently organized as pass though entities, the lower corporate tax rate effects may not be as immediate, but there is potential positive impact down the road. As these small businesses grow, they may consider changing their organizational structure for tax purposes, which may be a more attractive option or have benefits they did not consider before the corporate tax code was changed. Forming an LLC and being taxed as a corporation may also be a more attractive option for certain service businesses which are excluded from the 20 percent deduction due to income limitations, or for some partnerships where the partners have differing income levels. As corporations and LLCs have additional costs and compliance requirements, it is best to seek the advice of a qualified tax professional before making a decision to change the tax structure of your small business.
Schedule C Deductions remain unchanged
Outside of what has been discussed here, in many ways, the tax code remains the same. Filing deadlines have not changed. The ability to seek assistance from the Taxpayer Advocate is unchanged. Outside of the deductions previously mentioned that have been eliminated, most all of the other deductions in Schedule C remain unchanged. For specific advice on particular deductions or credits, or assistance with tax preparation or compliance, please seek the assistance of a qualified tax professional.
Misconceptions Regarding the Tax Cut and Jobs Act of 2017
Although most small business owners know this, the tax code changes did not affect their 2017 tax returns, despite the name of the act itself. Because the new tax code changes were effective for 2018, the majority of benefits will be visible for the 2018 tax season and may have potential impact on estimated tax payments made during 2018. From a cash perspective, benefits derived from the tax law changes could have been realized during 2018. From a compliance perspective, small businesses have likely already updated their payroll systems and processes to reflect the lower individual rates for their employees’ paychecks.
Probably the biggest misconception is that the Tax Cut and Jobs Act would reform the tax code so significantly that you could do your taxes yourself on a piece of paper the size of a postcard. Unfortunately, that did not turn out to be the case. Although the Tax Cuts and Jobs Act made a number of major revisions to the code in terms of tax rates and modest simplifications in some areas, the overall code remains as complex as it was before. Tax compliance for small businesses likely won’t be any simpler than it was prior to the bill’s passage, but small businesses should still see net benefits in terms of reduced tax burdens and keeping more of the money that they earn.
To ensure that you and your business understand the implications of the new tax laws, reach out to a qualified tax professional as you prepare for the upcoming tax season.
Santander Bank does not make any claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained in this article.
Readers should consult their own attorneys or other tax advisors regarding any financial or tax strategies mentioned in this article. These materials are for informational purposes only and do not necessarily reflect the views or endorsement of Santander Bank.
Equal Housing Lender. Santander Bank, N.A. is a Member FDIC and a wholly owned subsidiary of Banco Santander, S.A. ©2018 Santander Bank, N.A. All rights reserved. Santander, Santander Bank, and the Flame Logo are trademarks of Banco Santander, S.A. or its subsidiaries in the United States or other countries. All other trademarks are the property of their respective owners.