President Trump and the Republican congress's federal tax overhaul recently signed into law was billed as a centerpiece for making American business and industry more competitive. Unfortunately, many small business owners are not likely to experience the savings that corporations receive. The primary reason is that most small businesses and professional service companies, like law firms, are formed as pass-through entities, not corporations who are now taxed at much lower rates (top corporate tax rate dropped to 21% from 35%). Essentially, any entities where earnings (or losses) are "passed through" to the owners' individual tax returns are considered pass-through entities. Partnerships, Subchapter S corporations, limited liability companies and sole proprietorships are all examples of Pass-Through entities.
You may have heard about the new 20% business income deduction for Pass-Through entities. That deduction can be significant for certain businesses such as manufacturing, technology or real estate entities. Unfortunately for professional service companies, which include law firms, the deduction phases out relatively quickly. Here's the general rule businesses organized as Pass-Through entities:
You can deduct 20% of your "qualified business income," subject to certain limits and restrictions
- Qualified business income is generally defined as total revenue minus business expenses but excludes items such as owner compensation and investment income.
- The 20% deduction "phases out" if your personal taxable income exceeds $157,500 for individuals ($315,000 for joint filers). The deduction phases out ratably up to personal taxable income of $207,500 ($415,00 joint).
So, if you have personal taxable income in excess of $207,500 ($415,000 joint) you get no deduction—nada.
One positive development for all income tax payers is that the federal tax rates have been adjusted downward. So, you will now receive some relief due to the lower federal income tax rates.
Needless to say, taxes are complicated, and the 2018 tax reform did little to simplify things. Additionally, the IRS has yet to release final regulations, so it is possible additional changes could be forthcoming. While we hope this overview has been beneficial, it is simply our understanding of the how the tax reforms will apply—it's always important to consult your tax professional for guidance.
While we are not tax professionals, we can help you with your business legal needs and may offer you valuable insight into how you can manage and maintain a healthy business.