This spring, taxpayers will file their first returns since Congress overhauled the tax code a little over a year ago. Freelancers and small-business owners could find a lot to cheer.
One of the 2017 Tax Cuts and Jobs Act's biggest perks is a new 20% deduction on so-called pass-through, or qualified business, income available to anyone who is the owner of an LLC or an S corporation, a partner, a sole proprietor, or a gig-economy worker.
The deduction, which is available even to workers who also take the standard deduction, means a single freelancer with no kids making $50,000 will save about $1,750 under the new rules, according to the Tax Policy Center's calculator. That's nearly $700 more than for a similar wage earner. Wealthier taxpayers, such as business owners, could save tens of thousands.
What Is The New Pass-Through Deduction?
If you are an owner of an LLC or S corporation, partner, sole proprietor or gig economy worker, the new rule — formally enshrined in tax law as IRS Section 199A — lets you deduct 20% of your qualified business income (ie. the money you made after subtracting your expenses).
These earnings also are characterized as “pass-through” income, a term indicating that the income you earn passes through to your personal tax return, rather than being taxed as business earnings and then a second time as wages.
This 20% deduction reduces the amount of income you have to pay taxes on, and it could possibly drop you into a lower tax bracket, which also would yield savings. "When you get a deduction, that reduces your taxable income your tax rates go down because it’s a graduated rate," says Craig Wild, managing partner at tax and accounting firm Wild, Maney & Resnick.
Am I Eligible?
If you only get a W-2 and you take the standard deduction, the deduction for pass-through income doesn’t apply to you. But if you get one or more 1099 tax forms — say, if you moonlight as an Uber driver — you’ll want to see if some or all of that income is eligible. For the majority of people who work part- or full-time as independent contractors, it probably will be, according to tax pros.
“Gig, freelance, small business — they’re all in general going to qualify for that,” says Mark Jaeger, director of tax development at TaxAct.
However, take note, Etsy dabblers or weekend flea-market craft creators: You can’t take the deduction on money you make from a hobby. The IRS distinguishes a hobby from a business using nine criteria such as recordkeeping and intent for profitability. Jaeger says a good rule of thumb to follow is that if it’s something you’ve engaged in and made money in over the years continually, the IRS might be more inclined to view it as a business.
Are There Any Limitations?
There are some caveats: There is an income-based phase-out for certain types of businesses characterized as “specified service,” a category of professionals that includes doctors, lawyers, accountants and other financial service providers, certain categories of entertainers and consultants.
“It goes through about 15 bulleted paragraphs,” Jaeger says, and making things more complicated, there’s no hard-and-fast rule for who is and who isn’t subject to this. The IRS document addressing it, Publication 535, is still in draft status, Jaeger says.
People in these fields who have business income higher than $157,500 ($315,000 if married filing jointly) are subject to limits on how much of the deduction they can claim.
“When it starts getting really complicated is when your taxable income starts to exceed that,” Jaeger says, and the benefit phases out completely for people in these fields who make $207,500 ($415,000 if married filing jointly.)
“199-A gets a little bit more complicated for owners of S corps and partnerships,” Wild says. “When they receive their K1s, there should be a disclosure showing qualified business income as well as wages paid and original cost of depreciable assets,” he says. These taxpayers have to take into account factors like wages paid to employees and the value of business real estate holdings to determine how much of a deduction they can claim.
Given the complexity and that some of the key details still aren't finalized, Wild suggests people in specified service fields with earnings above $157,500 might want to hold off and have their tax preparer file an extension on their behalf.