Attention Business Owners. The first 20% of your profits in 2018 may be tax free!

by Wayne Lenell, CPA, Ph.D.

The Tax Cuts and Jobs Act of 2017 afforded a new tax deduction for business owners beginning in 2018.  Many business owners will find that 20% of business profits are tax free, so a business owner with a taxable profit of $100,000 may pay tax on only $80,000 of that profit.   

As is the case for most tax benefits, there are rules and limitations.  Luckily, for the majority of small business owners who have taxable incomes below $315,000 (if married filing jointly) or $157,500 (If filing as single) there are only three common limitations that apply.  

  1.  The taxpayer may deduct 20% of the lesser of the business profit or taxable income.  If, in the example above, the taxpayer’s only source of income was the $100,000 business income, the taxpayer would not reap the full 20% benefit.  If the taxpayer were single, the IRS allows a standard deduction of $12,000.  The taxable income would be the $100,000 business profit, less the standard deduction of $12,000 resulting in taxable income before the 20% deduction of $88,000.  Then the 20% factor is applied reducing taxable income by $17,600. 

  2. Not all income is subject to the 20% deduction.  Qualified Business Income (QBI) includes “pass-through” business income from sole proprietorships, farms and ranches, partnerships, rental properties, and Subchapter S companies.  It does not include wages, interest income, dividend income, capital gains, retirement income, certain other types of unearned income, nor does it apply to Subchapter C corporations.  

  3. Capital gains are not counted when computing the taxable income limitation.  Let’s say, for example, that in addition to the business income of $100,000 and the standard deduction of $12,000, the taxpayer discussed above also had capital gains income of $20,000.  Taxable income before applying the new 20% deduction would consist of $100,000 business income, plus $20,000 capital gains, less $12,000 standard deduction netting to $108,000.  The taxpayer may think that he or she would get the 20% deduction based on the lower of the $100,000 business income or the $108,000 after the standard deduction.  In reality, however, the taxpayer’s deduction would be limited to 20% of taxable income without considering the capital gains income of $20,000 so the deduction would be $100,000 less $12,000 standard deduction, equals $88,000 times 20% equals $17,600. 

These are the basic rules for taxpayers with taxable incomes under $315,000 married filing jointly and $157,500 for taxpayers filing as single.  See the article entitled “The Pass-Through Deduction for Higher Income Taxpayers” for the rules for taxpayers exceeding those taxable income thresholds. 

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