The tax reform act of 2018 was a mixed bag for many, providing new tax breaks while also removing some valued ones. If you’re a small business owner, or a self-employed freelancer, you’ll be glad to know you’re now eligible for a major new tax break, known as the Qualified Business Income (QBI) deduction.
This new law offers a 20% tax deduction for all business income that flows through to your personal income statement (on form Schedule C). Only businesses structured as C-Corps are excluded. Know that upper-income small business owners in a “specified service trade or business” (SSTB) do not qualify for the QBI deduction if their taxable income is above $415,000 married filing jointly, and $207,500 for other filers. Those SSTBs include fields such as law, medicine, performing arts and athletics.
For anyone in one of those industries and with income that exceeds such thresholds, proper tax-planning (such as heavily funding a retirement account) can lower your income and help you get more of the QBI. Also consider Health Savings Accounts, Section 529 education plans, charitable giving, or any other measures to help you get below that threshold.
Small business owners at risk of exceeding those thresholds can also consider a range of other options to remain eligible for the QBI including, distributing taxable income among several family members, and shifting portions of business ownership to family members through several non-grantor trusts.
However, note that all sources of income, including capital gains and qualified dividends will be part of your income calculation. (As a good rule of thumb, it’s always best to park your income-producing investments in retirement accounts).
The QBI option creates a clear conundrum for some people. If they are hired as an employee, they are ineligible for this big tax break. Instead, developing an independent contractor relationship could be much more lucrative. Of course, there are other forms of compensation you’ll need to negotiate to strike a fair deal such as health benefit costs and self-employment taxes. A fee-only financial planner can help you with this kind of analysis.