You don’t actually need to watch the news or follow Trump’s tweets. But if you run a small business, you do need to understand the Trump tax reform that came into effect on January 1, 2018.
This legislation changes how much tax your business pays, and removes a few tax deductions too (sorry, no more writing off golf games with clients).
In print, the Tax Cuts and Jobs Acts (TCJA) runs 274 pages. We’ve distilled that down to 1,536 words—just the essentials of how this affects small businesses, and the action you can take to make the most of it.
How the tax reform affects tax deductions
The TCJA completely eliminates some common expense deductions for businesses. Other expense deductions are cut in half.
In 2017, employee transit and parking benefits were 100% deductible. Now, they can’t be deducted at all (except reimbursable costs, like parking downtown in another city for a business meeting—that’s still 100% deductible.)
Also, client entertainment expenses used to be 50% deductible. But as of 2018, you cannot deduct any client entertainment costs from your taxes—including golf games, football games, concert tickets, and any other form of client entertainment.
However, the 50% expense deduction for client meals is still in effect.
One other deduction has been reduced, but not entirely eliminated. In the past, when employers provided employees with office snacks and meals at work, they were able to deduct 100% of the cost. That’s been reduced to 50%.
| Type of Expense | 2017 (old rules) | 2018 (new rules) | 2019 (new rules) | ----------------------------------------------------------------------- | ---------------- | ---------------- | | Entertaining Clients (Concert tickets, golf games, etc.) | 50% Deductible | 0% Deductible | 0% Deductible | | Office Snacks and Meals | 100% Deductible | 50% Deductible | 50% Deductible | | Company-Wide Party | 100% Deductible | 100% Deductible | 100% Deductible | | Meals & Entertainment (Included in Compensation) | 100% Deductible | 100% Deductible | 100% Deductible | | Transportation Fringe Benefits (Transit passes, employee parking, etc.) | 100% Deductible | 0% Deductible | 0% Deductible |
You can now deduct more for car depreciation
Thanks to the TCJA, business owners who buy a passenger vehicle for work purposes in 2018 or later benefit from a significantly higher depreciation allowance.
Some perspective: the maximum first year depreciation allowance in 2017 was $10,000. Starting in 2018, it’s $18,000.
The depreciation allowances for your second, third, fourth, and additional years of owning a passenger vehicle for work have also been increased. You can deduct even more if yours is a “heavy” vehicle—an SUV, pickup truck, or van, for instance.
For a complete rundown of the new vehicle depreciation allowances, check out this article from Iowa State University.
Further reading: What Is Depreciation? and How Do You Calculate It?
How to adjust your bookkeeping post-TCJA
In light of the TCJA deduction changes, there are two changes we’d recommend making to your ledgers.
- Create a separate ledger for client meals and client entertainment, since they may be deducted differently.
- Create a new ledger called Transportation Fringe Benefits. These are non-deductible now, but other fringe benefits may still be deductible.
If you’re a Bench client, we’ll take care of this for you.
How the tax reform affects C corporations
The TCJA is great news if you own a C corp—the corporate income tax rate has been reduced to a flat rate of 21%.
So, whether your C corporation earns $1 in 2019, or $100,000,000, you’ll pay 21% of that amount in income tax.
How the TCJA affects pass-through entities
If your company is a pass-through entity, the most significant TCJA change is a tax deduction of up to 20%—if you qualify for it. It’s called the Qualified Business Income deduction.
Put simply, a pass-through entity is any company with a business structure other than a C corporation.
Sole proprietors, limited liability companies (LLCs), S corporations, and partnerships are all considered pass-through entities.
When a C corporation earns income, it’s charged corporate income tax. Then, when the owner or owners of that C corporation are paid by the corporation, they’re charged on their personal income. That’s why it’s sometimes said that C corporation owners are “taxed twice.”
With a pass-through entity, on the other hand, the income of the company “passes through” to the owner or owners. They report the company’s income on their individual tax returns, and then pay income tax on it. They’re only “taxed once.”
Who qualifies for the 20% deduction?
In general, all pass-through entities qualify for a 20% tax deduction.
However, Specified Service Businesses are limited in how much they are able to apply this deduction.
If your business’s main asset is the skill or reputation of one or more of its employees, you’re a Specified Service Business.
The following are typically defined as Specified Service Businesses:
- Healthcare providers
- Financial service providers
- Performing artists
If you’re a Specified Service Business, the 20% deduction begins to phase out at an income of $157,000 (single filer) or $315,000 (joint filers). For a thorough breakdown of how the deduction phases out, check out this report from the Tax Policy Center.
For Specified Service Businesses, the pass-through deduction becomes completely inapplicable over an income of $207,000 (single filers) or $415,000 (joint filers).
How the 20% deduction is applied
If your pass-through entity qualifies, the 20% tax deduction is applied to your Qualified Business Income (QBI).
Your QBI is the total income of your business for the financial year, minus any of the following:
- Capital gains or losses
- Dividends or interest
- Annuity payments
- Foreign currency gains or losses
- Compensation paid to the owner of the business*
- Guaranteed payments to business partners for services rendered*
*In the case of compensation or guaranteed payments for services rendered, the amount paid must be within the bounds of what’s considered “reasonable” by the IRS. This can be a gray area. For more about “reasonable” payment, ask your accountant, or check out the IRS’ coverage of the topic.
The W-2 wage limitation
The W-2 wage limitation comes into effect if your business income is over $207,500 (or $415,000 for married joint filers.) At that point, the W-2 wage limitation phases in over a $50,000 range ($100,000 for married joint filers).
Then, when it comes time to file, you must either claim the 20% deduction, or an amount equal to one of the following—whichever is lowest:
- Either 50% of wages paid to W-2 employees over the course of the financial year, or
- The sum of 25% of W-2 wages, plus 2.5% of the cost of qualified property.
In this case, qualified property is anything your business owns, including real estate, and uses at any point to earn QBI.
For a longer explanation of the W-2 wage limitation, and some examples of how it might apply, check out this article from the Tax Policy Center.
How to take advantage of the tax reform
In light of the TCJA, here are some money-saving business moves you can make for the 2019 financial year.
Change your business structure
It depends heavily on your specific circumstances, but you may benefit from converting your pass-through entity to a C corporation.
Keep in mind the concept of being “taxed twice,” which may make the 21% corporate flat rate less appealing: You’ll pay tax on both your C corporation’s income (21%), and your own personal income (whatever your bracket is).
By the way, tax brackets for personal income have also changed—although not drastically. You can check out the new income tax rates here.
If you have a Specified Service Business that earns more than the threshold amount (it doesn’t benefit from the 20% deduction), you may still be better off converting from a pass-through entity to a C corporation, and taking advantage of the 21% corporate tax rate.
But this is only a good idea if you plan to reinvest most of your profits back into the business. If you plan on paying yourself a large personal income from your C corporation, keep in mind that it will be taxed (and remember a higher income may move you into a higher tax bracket.)
In that case, even if you don’t qualify for the 20% deduction, you’d be better off running your business as a pass-through entity, so you’re only “taxed once.”
Create a separate C corporation for your Specified Service Business
If some of your business activities count as a Specified Service Business, and others do not, you may benefit from doing that work separately, under a separate C corporation.
Here’s an example.
Suppose you’re an award-winning pastry chef, and you run your pastry catering service as an LLC.
But since you’re respected in your field and have lots of experience to share, you also work as a consultant for a number of bakeries.
Catering services are not Specified Service Businesses, but consultancies are. By running your consultancy as part of the same LLC as your catering business, you potentially disqualify yourself from the 20% deduction.
In this case, you could benefit by forming a separate C corporation, just for your consulting work.
Yes, you’ll be taxed at both the 21% corporate flat rate, and on whatever personal income you earn from your consultancy business. Still, by separating your two businesses, you’ll qualify your pastry catering LLC for the 20% deduction. This could end up saving you more money in the long term.
Further reading: How to Choose the Right Entity Type for Your Business
The TCJA is a complex and far-reaching piece of legislation. Before making any major business decisions in response to the TCJA, meet with a tax advisor or CPA. If you don’t already have a CPA, check out our article on how to find, hire, and work with an accountant.