The newly-enacted tax reform law, dubbed the "Tax Reform and Jobs Act," will deliver major changes to the U.S. Tax Code. While it's not possible to examine all of them in one (or even several) blog posts, let's take a look at some of the changes most likely to affect individuals and small businesses, including pass-through businesses.
Pass-through businesses include sole proprietorships, partnerships, and S corporations. The term also encompasses limited liability companies that are taxed as partnerships or S corporation. Prior to the change in the law, owners of such businesses were taxed on the business's income at their own individual tax rates, which could be as high as 39.6 percent. Even if the income was rolled back into the business, not distributed to the owner, it had to be reported on the owner's personal income tax return.
The new law provides owners of pass-through businesses with a 20 percent deduction for tax years beginning in 2018 and ending in 2025. In addition to individual business owners, trusts and estates that own pass-through businesses may claim this deduction as well. The 20 percent deduction applies only to "qualified business income" (QBI) which includes business income other than income from investments, and excludes investment interest income, capital gains, foreign currency gains, commodities gains, and wages and dividends.
Not all pass-through businesses are eligible for the deduction, though. Specified service businesses, which includes medical, legal, consulting, and financial services, investment firms, and brokerages, are excluded. This would seem to eliminate the benefit for many small business owners, but there is one important exception to this exclusion. Joint filers whose income is less than $315,000, and other taxpayers with income less than $157,500, may claim the full deduction on income from specified service businesses. For taxpayers above those income thresholds, the deduction phases out.
Owners of those businesses who do qualify for the deduction will have a maximum effective tax rate of 29.6 percent.
Most individual taxpayers will also pay less tax than before the Act took effect. There are still seven tax brackets for individuals and joint filers, though the levels of income and tax rates are somewhat different. The lowest bracket is still 10 percent, and the top income level for that bracket is unchanged, at $9,525 for individuals. In general, though most people will find themselves in a lower tax bracket. The top tax bracket, now reserved for those individuals with income over $500,000, is 37 percent, down from 39.6 percent.
The standard deduction, which is indexed for inflation, will almost double from $6,350 to $12,000 for individuals and from $12,700 to $24,000 for married couples. The increased standard deduction, along with the lowering of tax rates and widening of most tax brackets, is intended to offset the elimination of personal exemptions by the Act.
Other changes that may affect individuals:
As you may have noticed if you've made it this far, many of the changes imposed by the Act have a "sunset" provision, meaning they expire after a certain period of time. The sunset provisions were put in place to limit increases to the federal deficit.
The Act has made, and will make, major changes to the federal tax landscape, the entire scope of which may not be made clear for some time. The take-away, however, is that planning you did for your family or business ten, five, or even one year ago may now need revisiting in light of the new legislation. A consultation with your estate planning, business succession, or wealth management attorney can help you take maximum advantage of the new law.
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