You may have heard the Republican tax bill cuts the corporate tax rate, but many small business owners will enjoy a tax break of their own in the form of a 20 percent deduction of business income.
This is money you won’t have to pay taxes on.
The 20 percent deduction is available to the majority of small businesses owners who classify their earnings as “pass-through income.” That means they pay taxes based on the owner’s personal tax rate.
This includes everyone from restaurant owners to sole proprietors who are self-employed, such as Uber drivers and freelancer writers.
But many of these temporary small business tax breaks are set to expire in 2026.
Given that small businesses employ nearly half of America’s private sector workers, the Trump administration hopes to spur job growth with these tax cuts. But the reforms could also increase the national deficit, critics say.
“We are making America great again,” Trump said during a White House ceremony after Congress passed the tax bill and sent it to the White House. “Ultimately what does it mean? It means jobs, jobs, jobs, jobs.”
Democrats fear it could also increase income inequality, benefiting wealthier Americans who own businesses at the expense of the middle class.
Only the higher echelon of small business owners make enough money to notice a big difference in taxes. A 2016 study from the Tax Policy Center found that the wealthiest 1 percent of small business owners earned more than half of small business income. http://www.taxpolicycenter.org/model-estimates/distribution-business-income-august-2016/t16-0184-sources-flow-through-business
While many mom-and-pop shops already pay low rates, so they may never realize these savings. http://www.taxpolicycenter.org/model-estimates/distribution-business-income-august-2016/t16-0185-sources-flow-through-business
This has led critics to suggest Trump’s tax plan would mostly benefit the wealthiest Americans, while merely paying lip service to small businesses.
The big winner is corporate America. The Republican tax bill lowers the corporate tax rate from 35 percent to 21 percent, and also shields multinational companies from paying taxes on the money they make overseas.
By comparison, single taxpayers who make more than $38,700 (and couples who make more than $77,400) each year will pay a higher 22 percent personal income tax rate.
Small businesses are caught in the middle.
A successful restaurant owner who makes more than $500,000 each year could pay the highest possible tax rate of 37 percent. While an Uber driver, or freelance journalist, who earns between $38,700 and $82,500 each year could pay 22 percent in taxes.
Given the large corporate tax cuts, you might be wondering whether you should incorporate your small business to save money on taxes.
But you might want to rethink that strategy.
It’s not exactly a fair comparison between corporate and small business taxes.
The owners of corporations pay taxes twice: First on the business income, and second on their investment earnings. So you may actually increase your tax rate.
Furthermore, pass-through business owners can also take the standard deduction, because they’re filing as individual taxpayers.
Republicans nearly doubled the standard deduction to $12,000 for single taxpayers and $24,000 for couples.
If you have young children, you may also qualify for the $2,000 child tax credit for each kid.
But what may be the largest deduction is exclusively reserved for small businesses.
Pass-through business owners who make less than $157,500 each year may be allowed to deduct up to 20 percent of their business income before paying taxes.
Considering these small business owners pay no more than 24 percent in taxes, this huge deduction could reduce their effective tax rate below that of larger corporations.
In fact, the 20 percent deduction may encourage some full-time employees to quit their jobs, and ask to be rehired by the same company as independent contractors, so they can take advantage of this small business tax loophole. But you should consider the costs of such a transition.
The tradeoff is you’ll be responsible for paying for your own health insurance and an additional 7.65 percent in self-employment taxes.
Keep in mind, not all small businesses qualify for the 20 percent deduction. For example, lawyers and doctors who run their own practices will be left on the outside looking in.
All in all, small businesses may be pleasantly surprised by the tax breaks they enjoy over the next few years.
Jason Hargraves is the managing editor of insuranceQuotes.com — which publishes in-depth studies, data and analysis related to auto, home, health, life and business insurance—where he studies the insurance industry in order to direct and oversee the management of editorial content that provides trusted tips, advice and insights for consumers.
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