Mariam Furmanau and David Hall | What a long and strange trip 2017 has been. And just before the year let out, the GOP-controlled Congress passed the Tax Cuts and Jobs Act and President Trump signed it into law. If you’re alive and living in the US, you’ve likely seen and heard about this act more commonly referred to as “The Trump Tax Plan.”
So here we are now, talking about taxes more than we ever wanted to. Even though we do not offer tax preparation services, taxes are an important factor to consider when developing financial strategies. Most of what the media has been exploring is how the new tax plan affects households, not businesses. Even when companies are mentioned, they’re mostly spoken about in the context of large multinational corporations that generate billions in revenue. What about other companies? What about small businesses? Let’s dig a little deeper and talk about how Trump’s Tax Plan is going to affect small businesses.
What are the big changes?
As you might already know, the biggest change is the reduction of the maximum corporate tax rate from 35 percent to 21 percent. To date the U.S. had one of the highest corporate tax rates in the world. Trump’s Tax Plan effectively brought it down to be on par with corporations in Europe. The logic behind this cut in corporate tax is to allow business owners to reinvest the saved income back into their business to further develop and generate growth. The new rate will affect all C corporations, but other businesses like S corps and LLCs will be unaffected.
One feature that allows you to deduct the cost of depreciable assets in one year, rather than over time, might also affect your 2017 taxes. This new provision allows businesses to deduct the entire cost of depreciable assets in one year rather than amortizing them over time. There are only two caveats: this does not apply to structures like buildings, nor to any assets purchased prior to September 27th, 2017.
Another big change is the raised standard deduction for pass-through businesses to 20 percent. We’ll unpack what a pass-through is, whether that affects your business, and how you might become a pass-through business below.
What is a pass-through entity and is it relevant to me?
The new tax plan provides much more relief for corporations than individuals. As an individual, one way to reduce your taxes is to turn yourself into a company known as a “pass-through entity.” This could allow you to deduct up to 20 percent of your taxable income.
A pass-through entity is a legal entity that allows owners of businesses to pay taxes on their company’s income as part of their personal tax filing. The pass-through legally protects the owner’s personal assets while allowing them to treat their company’s income as personal income. Some examples of pass-through businesses are sole proprietorships, partnerships, LLCs, and S corporations.
So, how exactly do pass-throughs work under the new tax plan? Let’s consider this simple example to illustrate the underlying logic: You are a freelance podcast producer whose gross income is $85,000. According to the Trump Tax Plan, the entire $85K will be taxed at 24 percent. However, if you filed as a pass-through entity, you could deduct 20 percent from your gross income and then pay taxes, which in this case would decrease your taxable income to $68,000. The basic principle of this provision is to lower your taxable income and therefore the amount of tax you pay. Keep in mind, there are limitations and reductions to the benefits of this provision, things like income limits, whether you sell services or goods, dividends, losses. It gets complicated very quickly.
Should you file to become a pass-through entity? The short answer is, maybe. Filing as a pass-through not only qualifies you for a personal tax break, but also allows you to skirt corporate taxes and limit your own personal liability. Becoming a pass-through might also help with further tax breaks if you work from home or have significant business expenses that can be written off. However, filing as an LLC or S Corp will also add an extensive amount of extra bookkeeping and their benefits are dependent on how much income you generate. So don’t jump on this opportunity without consulting with a tax professional first.
When does the new tax plan take effect?
There was some speculation as to whether President Trump was going to sign the Act into law after January 1, 2018, which would have delayed the effects until 2019, but he signed it on December 22, 2017. So, does the new tax plan affect your 2017 taxes? For the most part, no. The only exception is the provision mentioned above regarding deducting depreciable assets in one year. So, if you bought new equipment or machinery in the final months of 2017, you might be able to further reduce your company’s taxable income.
How long will Trump’s Tax Plan last?
Without any further repeals or amendments, the current tax plan for individuals would expire in 2025 while the corporate cuts are permanent. However, 2018 is a big election year: all seats in the House are up for grabs, as well as enough seats in the Senate to flip both. Turning Congress over to the Democrats could see the rise of reforms and repeals to the current tax plan as it has been widely criticized as blatantly favoring the rich. What repeals would mean for small businesses is uncertain.
One last thing to keep in mind is that Trump’s Tax Plan is huge, it’s long, and we all know that very few have read it in its entirety, which means that it’s going to take time to figure out what and how it means. So, be proactive and reach out to your CPA or tax advisor if you haven’t already, and start coordinating elements that will be most useful for your business.