*This article was updated January 8th, 2019, to provide more detailed information as it has been issued and clarified by the IRS.
If you’re anything like me, you anxiously followed the white house legislation to see what the new tax bill means for small business owners and the self-employed. Taxes owed can often feel like the difference between success or failure (and sometimes truly are), so I wanted to break down what the tax bill *actually* means for small businesses.
Spoiler: For a majority of small business owners, the tax bill is beneficial – feel free to skip to the summary.
Now, first things first… If you’ve spent any time watching the congressional debates or reading online synopses over the tax bill, you might have noticed discrepancies in what people think makes up a small business. So let’s address this first…
What exactly is considered a Small Business?
It’s a little complicated (understatement of the decade)… As far as tax discussions go, all kinds of numbers have been implied for “small business.” Some suggest small businesses as those that make less than $100k per year, others as businesses that make less than $300k, and still others as businesses that make over $500k. Confusing, no?
Then you’ve got to take into consideration the difference between net and gross business income–are the referenced numbers above talking about gross sales OR profit after expenses? And then what about the difference between corporations vs pass-through entities vs sole proprietorships? Suffice it to say, it gets confusing really fast!
So let’s look to the big-guns! The Small Business Administration defines small businesses as less than X amount of employees or X amount of receipts per industry (the amount of employees and receipts changes by industry capping out at 1,500 employees and $38.5M in gross receipts). The IRS defines a small business as those who file Form 1040, Schedules C, E, F or Form 2106 and have less than 10 million in assets. Based off of those two definitions, you may think, “Uh, neither of those upper limits even remotely define what I thought of as being a small business.” Yeah. You’re not alone.
For the past 5 years, I’ve worked exclusively with small business owners and their financials. And I’ve got to say the range of what qualifies as a “small business” exists in everyday real-life too. For instance, I’ve worked with sole proprietors making as low as $30k a year to C-Corporations making a few million each year (both self-identify as “small business”).
However, generally speaking, most small businesses operate as sole proprietorships or pass-through entities and define themselves not by how much money they make, but rather how they operate.
For the sake of this article, I’ll define small business as anyone who operates as a sole proprietorship or pass-through entity – (partnership, LLC or S-Corp). 95% of businesses within the U.S. are organized this way.
Note: I’m NOT going to address C corporations here (although I realize some C corporations are run as small businesses) or anyone in the farming industry (because farming laws have been and continue to be more separated from general tax laws).
So assuming you operate a sole sole proprietorship or pass-through entity, let’s look at what this tax bill means for small business (YOU).
#1 Small Business Tax Deduction Rate Change (Minus 20%)
The #1 change that will affect your small business is that 20% of your business’ net income can likely be deducted from your taxes (again, we are talking only about sole proprietorships and pass-through entities). This is HUGE!
Here’s an example:
A business sells $150k worth of services.
The business spends $50k to provide those services and run the business.
This means the profit was $100k, which the business owner passes through to pay herself.
Under the new law, she can deduct 20% automatically off the top, meaning she will only pay taxes on $80k.
However, there are a couple of things to note here:
First, know that the 20% deduction phases out as your AGI income increases. If you earn over $157.5k as an individual (or $315k as a married couple filing jointly), you’ll still get to deduct a percentage but it won’t be the full 20%. Even those making over $500k (the media is calling these “high-earning, service based businesses”) will still get to deduct a percentage. As you make more, you’ll be able to deduct less.
A recent Payscale study found that the median income for small business owners is $71k, so basically the majority of small businesses will be able to deduct that full 20%. Awesome!
Second, IF your income is over $157.5k as an individual (or $315k as a married couple filing jointly), and you work in one of a few specific professional fields, you will NOT qualify for an extra deduction. In November 2018, the IRS issued more guidance on this and specified that the following fields will not receive any extra deduction if their income is over the stated amounts: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, and dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employee.
#2 Claiming Business Tax Deductions
This is where I’ve seen the MOST confusion from my friends and fellow entrepreneurs: anxiety over business tax deductions.
So how will businesses claim business deductions?
The simple answer? There’s no change for how a business claims tax deductions. (But, yes, there are changes for personal tax deductions related to itemizing and standard deductions.) Confusion seems to come from a lack of understanding the different tax schedules (forms), as well as how to claim employee expenses vs business expenses.
Up until now, when you claimed personal deductions (such as employee expenses), you used your Schedule A form. So, if you were an employee (meaning you didn’t own any part of the company you worked for and you received a W2 form at the end of the year), you could deduct personal expenses including work expenses (for instance uniforms if you’re a civil servant or classroom supplies if you’re a teacher). If you owned your business you would NOT report business expenses on a Schedule A. Schedule As and employee expense have now changed.
Previously, if you ran your business as a sole proprietor, you’d report your business expenses on a Schedule C form. The rules for this have not changed – you still claim and report your business tax deductions on a Schedule C.
Furthermore, if you’re the owner of a pass-through business entity (LLC, partnership or S-Corp), you report your portion of the business’ income and expenses somewhere else entirely. (Stick with me as I’m trying to simplify this.) None of the legislation for how you report or can take business tax deductions has changed for pass-through entities.
The main point is while there have been changes as to what personal expenses you can deduct using Schedule A, this only applies to people who work for someone else’s business and are paid on a W2 form. Business owners will still claim tax deductions for running and operating their business on their relevant tax form.
*February 5th update: For clarity purposes, as happens most business tax years, a few specific business tax deductions have been altered. I did not intend to address the specifics of this in the post as my intention was to give a clear, large-scale view for business owners. Specifically when it comes to business tax deductions, I wanted to clarify that businesses still get to claim business tax deductions. The MAIN change that will affect most small business owners is that entertainment expenses have been done away with.
#3 Cash vs Accrual Basis
Another actual change that the tax bill means for small business has to do with your method of accounting.
Basically, there are two main methods of accounting: cash basis or accrual basis. Broadly speaking, cash basis means that you record income when you receive it, and expenses when you pay them out (though there are some exceptions). Accrual means that you record income when it’s billed, and expenses when they are actually incurred. So, under an accrual accounting basis, you would record $20,000 worth of sales the moment you make the sale, even if the buyer won’t actually pay you until next month.
For small businesses, cash based accounting is widely used because of its simplicity. It reduces the bookkeeping burden on owners and helps with cash flow. Under the old tax law, you could only use cash-based accounting if your business brought in under $5M each year. The new law allows businesses that make up to $25M to use cash-based accounting. This is especially useful for companies who make products and have inventory because you won’t have to pay taxes on income you haven’t yet received, and you can deduct expenses for making your products before they are sold.
#4 Finally, Let’s Talk About Capital Investment and Section 179
Say your business buys a $600k machine…
Now if you’re thinking “true small business owners don’t have that cash flow…” I get it. But remember how small businesses are defined by the SBA and IRS? Yeah. So it can happen.
Under the old bill, you would have had to depreciate that machine as a capital investment over it’s life. That means if you determined that the machine would last ten years, you would deduct some of that $600k for the next ten years. Under the new tax bill, you can deduct the full $600k the year you make the investment. Pretty great, huh? What’s changed here is that, under the old law about Section 179, you could only make these types of deductions up to $510k and no more than your company’s net profit (you couldn’t deduct these expenses to show a loss).
Now, that limit is raised to $1M of profits. So, if your company makes a net profit of $1 million and incurs $1 million in capital investment expenses you could deduct all of those expenses and possibly pay no taxes same year. Capiche?
In Summary: What the Tax Bill Means for Small Business…
This article is a lot to take in, but it’s better than reading the 1,000+ page printed document, right? (Trust me, I read it. This is a lot more entertaining 😉).
So, ultimately what does the the tax bill mean for small business?
Let’s sum this up nicely:
For sole proprietors and pass through entities…
- If you are filing by yourself and make less than $157.5k, you will save money.
- If you are filing jointly and make less than $315k, you’ll save money.
- If you are filing by yourself and make over $157.5k, the bill could still benefit you (you’ll get a deduction unless you’re in one of the unfavored profession–just not the full 20%).
- If you are filing jointly and make over $315k, the bill could still benefit you (you’ll get a deduction unless you’re in one of the unfavored profession–just not the full 20%).
- If your business makes more than $500k, you might want to consider moving to a C-Corporation because the new corporate tax rate was cut to 21% under the new bill. Although you might have some problems with double-taxation, this low rate may make it worth it. (Personally, I suspect we’ll see more higher-earning small businesses move to C-Corporation status in the next few years.)
As a Business Financial Coach and Enrolled Agent (an Enrolled Agent holds the most prestigious tax credential in the U.S.), my main interest is to help you gain a thorough understanding of your business finances and keep as much of your hard earned cash as legally possible. I know both the benefits and hardships of owning your own business, and I’m rooting for you every step of the way.
If you need help further help wrapping your head around your specific tax situation, I’d love to work with you–I offer both hourly consultations as well as longer-term coaching to support you and your business.
So, over to You:
How do you think the new bill will affect your small business? Would love to hear your thoughts and comments below!