The recently passed Tax Cuts and Jobs Act made some pretty significant changes to the U.S. tax code, and one in particular will have a huge impact on "solopreneurs" and taxpayers with side gigs: the qualified business income deduction, also known as the pass-through deduction.
Unfortunately, calculating this deduction can be tricky -- and you'll need to master it quickly, as the deduction takes effect this year.
What's the qualified business income deduction?
When Congress decided to change the corporate tax rate to 21%, there was concern that owners of other types of businesses would rush to incorporate and become eligible for the new rate. Legislators wanted to maintain roughly the same balance between corporations and noncorporations (also known as "pass-through entities" because of the way they pay taxes) that existed before tax reform, so they decided to give owners of noncorporations a tax break of their own in the form of a 20% deduction on their income.
Calculating the qualified business income deduction
If your side gig isn't a C-Corporation -- and it probably isn't -- you'll likely be able to take the 20% qualified business income deduction beginning with the 2018 tax year. But it's not quite as simple as just deducting 20% of the income from your side gig. The way the deduction works out in practice depends on the nature of your business and whether or not you exceed certain income limits.
If your taxable income for 2018 is under $157,500 ($315,000 for married taxpayers filing jointly), you can likely claim the entire 20% deduction on income from your sole proprietorship, partnership, or other unincorporated business. The only limit that applies if you're under the high-income threshold is that you can't claim more than 20% of your entire taxable income through the deduction, but it's unlikely that your taxable income for the year will be less than your business income -- so you probably won't have to worry about this rule. If your taxable income is above the income thresholds, however, things get a wee bit more complicated.
The qualified business income deduction for high-income taxpayers
For those whose income exceeds $157,500 (for single filers) or $315,000 (for joint filers), the type of work you do will affect whether or not you can claim the pass-through deduction. Certain professional service providers are barred from taking the qualified business income deduction at all if they exceed these high-income thresholds. This includes anyone in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
If you aren't a professional service provider but you managed to exceed the income thresholds, you may be able to take this deduction -- but you'll face a whole new set of limitations. In that case, your qualified business income deduction will be limited to the greater of 50% of the W-2 wages that your business paid or 25% of the W-2 wages that your business paid plus 2.5% of the value of your business's depreciable property. That latter provision was put in for real estate companies, which typically have few employees but many property investments.
The qualified business income deduction: two examples
To see how this deduction works in action, let's look at two specific examples.
First, suppose you have a total taxable income of $120,000 for 2018. Let's say $10,000 of that income came from your side gig, which is set up as a sole proprietorship (hint: If you didn't choose a specific type of business entity when you started your side gig and you're the only owner, then it's a sole proprietorship). Because you're under the high-income threshold for the deduction, you can simply take a 20% deduction on that $10,000 in pass-through income, which comes to a total deduction of $2,000. Assuming you use the single filing status, your income of $120,000 for the year likely puts you in the 24% tax bracket, so this $2,000 deduction would end up reducing your tax bill by $480.
Second, consider a hypothetical situation in which you're also single, but you earned a substantially higher taxable income of $200,000 in 2018, $10,000 of which came from a side gig. If that side gig is in one of the aforementioned professional service businesses, you're out of luck: Exceeding the income threshold for this deduction means you cannot claim it at all. If you're in another line of work, on the other hand, the deduction now has to be subjected to the W-2 limitation. If you have one employee who received W-2 wages of $1,000 in 2018, that means the most you can get from the pass-through deduction is 50% of $1,000, or $500. With a taxable income of $200,000, you're probably in the 32% tax bracket for 2018, so that $500 deduction will knock $160 off your federal tax bill.
Claiming the qualified business income deduction
The IRS hasn't released the 2018 tax forms yet -- in fact, the agency has barely started releasing the 2017 tax forms as of this writing -- so we won't know for a while exactly how to claim this deduction. However, the good news is that the qualified business income deduction definitely will not be an itemized deduction, which means you can take it even if you claim the standard deduction rather than itemizing. That's good news for solopreneurs, as itemizing deductions will be decidedly less appealing starting with the current tax year. All in all, this deduction will be a bonanza for many small-business owners -- including employees with a side gig.