One group of taxpayers is getting a big break that may help them come out ahead under the new tax rules.
That group includes small-business owners and freelancers as beneficiaries of the Tax Cuts and Jobs Act, which allows these workers to lop off 20 percent of their income before paying the tax man. For example, an independent contractor who earns $100,000 would deduct $20,000 of that income, paying taxes only on the remaining $80,000.
It’s a welcome win for many freelancers and independent workers, given that they often pay higher taxes than corporate employees. Self-employed workers fork over a payroll tax of 15.3 percent, which covers Social Security and Medicare obligations. By comparison, corporate employees pay half that tax, with their employers covering the remaining half.
Called “one of the biggest perks in the 2017 Republican tax overhaul” by trade magazine Accounting Today, the so-called pass-through deduction was designed to provide some parity for businesses that don’t pay the corporate income tax, which the tax law sliced to 21 percent from 35 percent. Proponents of the pass-through deduction say it equalizes the tax treatment between big corporations and smaller businesses.
“It is a huge tax benefit — it is one of the best benefits,” said Harvey Bezozi, a CPA and the founder of YourFinancialWizard.com in Boca Raton, Florida.
Take an independent worker with $1 million in income. The pass-through deduction would allow her to lop $200,000 from her taxable income. If she were in a 30 percent tax bracket, she would save $60,000 in taxes, Bezozi noted.
Most people who qualify for the pass-through deduction are seeing a drop in their tax bill, said Angela Reed, partner at Tarbell and Co. in Des Moines, Iowa. “It’s a pretty significant tax deduction,” she noted.
How to qualify
Taxpayers who are eligible for the deduction include sole proprietors, S corporations, trusts and estates, and partnerships. Taxable income earned through those businesses qualifies if the income is below $157,500 for an individual or $315,000 for a married couple filing a joint return. Those making more than these amounts can still qualify, but the IRS imposes restrictions — and that’s causing frustration for some taxpayers and their accountants.
Professionals who earn above the income threshold and work in what the IRS calls “specified service trade or businesses” — jobs that rely on specialized training or skills — are barred from the deduction.
“Generally when the income comes from something you are doing personally and is based on your skill, like a doctor or a lawyer or singer, they thought to exclude that, versus a company that sells something or makes something,” Bezozi said. As a tax expert who works with athletes and entertainers, he said some consider this rule to be “totally unfair.”
Grounds for confusion
Those restrictions are also causing some concern for tax experts, who want to ensure their clients aren’t claiming tax benefits they might not qualify for.
“The areas we see are businesses that are considered service-type businesses,” Reed said. “And it’s a pretty significant tax deduction, so we have to see if it someone qualifies or not. We don’t want to be wrong and give it to someone who doesn’t qualify for it.”
Income inequality controversy
The pass-through deduction has sparked plenty of other questions, such as whether the measure will benefit the wealthy more than middle- or low-income workers. The top 1 percent of income earners will grab more than half the benefit from the deduction, according to an estimate from the Tax Policy Center.
By comparison, the lowest quintile of workers — those in the bottom 20 percent of the income distribution ladder — will receive just 0.1 percent of the benefit, the group forecast.
While freelancers and gig workers will benefit from the pass-through deduction, plenty of large businesses will also prosper under the new law. For instance, real estate companies are among the businesses able to take advantage of the break.
As the Tax Foundation noted last year, “The rules for claiming the deduction are relatively complex, and will arbitrarily favor certain economic activities over others.”
For many freelancers and gig workers, that may be a welcome change.
“A lot of folks under that, they’re really going to be better off. As self-employed, they have a business deduction that they didn’t have before,” said Ivan Havrylyan, a CFP and financial planner in Chicago.
— With reporting by Irina Ivanova