When Congress overhauled the nation’s tax laws in 2017, corporate tax cuts were front and center. Not wanting to leave out tinier operators, lawmakers also handed a gift to certain small-business owners: a new classification of income and a 20 percent tax deduction to go along with it.
For anyone who freelances, consults, runs his or her own shop or has a gig on the side, this can add up to big tax savings.
But the rules for taking the deduction can be complicated — and unfamiliar, this being the first filing season the law is on the books. Here’s what you need to know as you finish up your 2018 return.
This deduction is a great deal if you qualify. Under the new tax law, you can deduct up to 20 percent of qualified business income (QBI) from a sole proprietorship, an S corporation, a partnership or a limited liability company (LLC) — what are called pass-through businesses. You’d typically pay ordinary income tax rates on the money you make from that business. Now, as much as 20 percent of it could be tax-free. “This is a real biggie,” says New York City CPA Sallie Mullins Thompson. “By letting you pay taxes on lower taxable income, it has the effect of lowering your tax rate.”
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Small business can really mean small business. You don’t need a fancy office and business plan to grab this break. A qualified business can include the consulting gig you’re doing to bridge the gap between a career and full-time retirement, or the side project you picked up to bring in extra money in retirement, like renting out a room on Airbnb or driving for Lyft. These kinds of businesses are common late in your working life: More than a third of independent workers such as contractors, freelancers and side giggers are 55 and older, according to the 2018 MBO Partners State of Independence in America report.
As long as your income isn’t too high, figuring out if you qualify is easy. The rules for what kind of business income qualifies can get complicated fast (see below). But if your taxable income is under certain thresholds — $157,500 if you’re single, $315,000 if you’re married and filing jointly — those caveats go out the window. No matter what kind of work you’re doing, you’re good. “A high majority of Americans will still qualify because they are under the income,” says Troy Lewis, a Draper, Utah, CPA and teacher at Brigham Young University.
With a highly successful business, the rules get far thornier. Once your income is over those cutoffs, qualifying for the 20 percent deduction hinges on other factors, including what type of business you run. For professionals who provide a service, including lawyers, doctors, consultants, brokers, accountants and performing artists, eligibility phases out at $207,000 in taxable income for single filers, $415,000 for married couples filing jointly. For other businesses, the deduction varies based on the wages you pay employees. Talk to your accountant to be sure.
A real estate side hustle could qualify, too. If you own rental property, you also may qualify for the deduction, and that’s regardless of how much you make. The key is that it has to be an actual business that involves at least 250 hours of work a year (by you or an employee). You must keep separate books for the business and careful records of all the work that’s done. “If it rises to this level of trade or business, the income is eligible for the QBI deduction,” says Tim Steffen, director of advanced planning at Baird Private Wealth Management. If you use the property yourself — say, a vacation home that you also rent out — it won’t qualify. Also, if you own real estate via a REIT, the dividends are qualified business income as well, and that will be specified on the 1099 tax form you get.