As an independent, freelancer or 1099-er you may have been keeping a close watch on tax time this year as there are some significant changes to business tax code that could put extra money in your hands this year. The 20 percent pass through deduction is a significant change and benefit for those whose business income passes-through to their individual income. Now that it’s time to file your business taxes, it’s worth knowing how to maximize this important deduction to lower your tax liability as much as possible. If you can’t implement these tips this year, make sure you use them going forward so you can maximize the pass-through deduction in future tax years.
About the deduction
The Tax Cuts and Jobs Act — signed into law on December 22, 2017 — created a net new provision in Section 199A. The provision permits owners of sole proprietorships, S corporations, or partnerships to deduct up to 20% of the income earned by the business. The motivation for the new deduction is clear: to allow these business owners to keep pace with the significant corporate tax cut offered by the Act.
Know if you qualify
The potential for you as an individual business owner to receive the 20 percent pass through deduction applies only if you operate a partnership, S-corporation, or sole proprietorship. This deduction is available if your income is less than $157,500 ($315,000 for married filing jointly) and your business is not considered a non-qualified business.
The deduction applies to what the new tax law calls “qualified business income,” or QBI, and which is defined as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” Broadly speaking, that means your business’s net profit.
But it also means that not all business income qualifies. QBI excludes:
- Capital gains or losses.
- Interest income.
- Income earned outside the U.S.
- Certain wage and guaranteed payments made to partners and shareholders.
Non-qualified businesses include those in the fields of law, consulting, health, accounting, athletics, financial services, investment management or performing arts.
You should also check to see if these other limitations apply to you and your business:
- If 20 percent of your business’s income is greater than 50 percent of its W-2 wages; or
- If 20 percent of your business’s income is greater than the sum of 2.5% of your business’s depreciable property and 25% of its W-2 wages.
- Make sure to calculate where you fall in terms of qualifying for the pass-through deduction by calculating both of the scenarios above to make sure that your deduction will not be limited by the wages or asset threshold as applies to your business.
How to maximize the 20 percent pass through deduction
To maximize the pass-through deduction for your freelance business — if not on your current tax return, then for your 2019 taxes — remember:
SSTBs (as defined above) don’t fully qualify for the pass-through deduction unless the owner’s taxable 2018 income is equal to or below the threshold amount ($157,500 for individuals or $315,000 for married individuals filing jointly). That’s indexed for inflation for tax years that begin after 2018, and SSTBs don’t qualify at all if the taxpayer’s taxable income is above $207,500 ($415,000 for married individuals filing jointly). As such, you may want to increase your retirement contributions if it will keep you in the qualifying income range.
For 2019 and beyond, consider shifting taxable income into a different tax year if you estimate your taxable income to be near the applicable threshold range (which in 2019 is $160,700 to $210,700 for singles and head of households, $160,725 to $210,725 for married taxpayers filing separately, and $321,400 to $421,400 for joint filers.) You can do this by invoicing after the end of the year for work completed in the same tax year or purchasing equipment that you can deduct from your business income before the end of the tax year in which you plan to claim the deduction.
If you own an SSTB and have a high taxable income that disqualifies you for the pass-through deduction you may want to consider incorporating and/or changing your business entity type to gain alternative tax advantages for the coming tax years. Be sure to seek the advice of a tax professional before making changes to the structure of your business so you know how it will affect your taxes.
The general takeaway is that this is a far more complicated deduction than it seems. You may think that you simply multiply your pass-through income by 20%, but unfortunately that’s not always the case.
Furthermore, it’s important to point out that these are just the key points. There’s obviously a lot more in the IRS’s 184-page guidance document than I can thoroughly cover in a roughly 1,000-word article. So, if you have a pass-through situation that isn’t obviously qualified or not qualified, it’s a good idea to consult a tax professional (which I am not) when the time comes to do your 2018 tax return.
The best course of action is to sit down with your accountant or tax preparer and discuss the options. Neat has a find and accountant feature right on its website of qualified QuickBooks ProAdvisors that can help!
You can also read more about the 20 percent pass through deduction on the IRS website.
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