Yes, we know your 2017 taxes are due in barely a month. But even as you labor over filing those returns on time, make sure to think ahead to how the new tax law (passed in December) will impact your next several months. In many cases, the changes may not be dramatic, but they might make your life simpler—and even save you some money, if you set yourself up properly.
“Some of the changes are actually simplifications,” observed Scot Pannepacker, a partner in the accounting firm of Lear & Pannepacker in Princeton, N.J. For example, a new standard deduction on business income will remove requirements for keeping records on mileage, calculating deductions for office space, and so on. “I think for a lot of independent contractors who earn less than several hundred thousand dollars, there’s not a lot to do,” he said. “But as a business grows and becomes more complicated, so will its taxes.”
Even so, the Tax Cuts and Jobs Act of 2017 (as it’s officially known) covers such a wide range of issues that anyone (tech professional or not) can be forgiven for feeling a bit dazed as they try to figure out what it means for them. Even accountants say it’s not clear how a number of the details will be applied, since the IRS has yet to provide clarification on many components.
At this point, independent contractors should probably focus on two aspects of the law: What type of business entity they’ve set up, and how they can use the 20-percent business-income deduction most effectively. The two go hand in hand.
Before going further, let’s be clear who we’re talking about: By “independent contractors,” we mean 1099 workers: people who contract directly with a company to develop software, implement a network, or manage a development project. We’re not talking about those who work for a staffing agency or consulting firm, noted Mike Slack, lead tax research analyst at H&R Block’s Tax Institute in Kansas City, Mo. They’re considered full-time employees and receive a W-2 form to document their wages.
The 20-Percent Deduction
The new law allows many businesses to deduct 20 percent of their taxable income right off the top. This is why you’ll hear many experts refer to the deduction as a “haircut.” So long as they fall within certain parameters, certain entities can take the deduction without having to do anything.
Here’s a simple example: If you invoice $125,000 in 2018 and have expenses of $25,000, you’re left with taxable income of $100,000. Now you can deduct 20 percent of that—or $20,000—so you’ll only be taxed on $80,000.
Of course, we’re talking about taxes here, so things can’t be that simple in practice. The law limits the deduction’s availability to specific professional services, which would include most consultants, Slack said. But, he added, it also has unique provisions for consultants: “With regards to the technology field, it may be advantageous to examine one’s business to determine whether they’re offering consulting services or engineering services, as businesses offering engineering services are not subject to the phase-out of the 20 percent deduction.”
By “phase out,” Slack is referring to income amounts that trigger a decrease in the deduction’s benefits. If you provide specified services, the deduction starts to be phased out once taxable income exceeds $157,500 for single filers or $315,000 for joint filers, he said. It’s phased out completely after income exceeds $207,000 for individuals or $415,000 for couples filing jointly.
Also, the deduction only applies to the independent contractor’s income. So if you’re filing jointly, you can’t deduct 20 percent of your spouse’s corporate salary if they’re a corporate employee.
What Kind of Business Are You?
Exactly how the deduction applies depends on how your business is organized or, in tax-speak, what type of “entity” you are. As much as we hate to do this to you, it means we should look at the most common types of small businesses:
- Sole Proprietorships are individuals who file a 1040, the standard form used to report and calculate an individual’s taxes. Sole proprietors report business income and expenses on the form’s Schedule C.
- Single-Member LLCs do the same. Amy C. Barry, a CPA in Bellevue, Wash., pointed out that LLCs are designed to provide legal protections more than tax advantages, and that doesn’t change with the new law. However…
- Multi-Member LLCs can be taxed as a partnership or a corporation.
- Formed by at least two parties, Partnerships file their own business tax return and pass income and losses to the partners themselves. The partners then report that information on their own tax returns.
- C Corporations file their own returns and pay any necessary taxes. Members of the corporations—officially called “shareholders”—also pay individual taxes for income they’ve earned from the corporations through dividends or other payouts.
- S Corporations are treated much like partnerships. Most income or losses are passed on to shareholders, who report them on their own tax returns.
“The new benefit will benefit sole proprietors and pass-through entities [partnerships, LLCs and S corporations] equally,” Barry said. The traditional advantages of pass-throughs, such as avoiding paying separate corporate taxes on top of your individual taxes, haven’t changed with the new law.
The Undiscovered Country
Finally, remember three important things:
First, Pannepacker pointed out, every case is different, and the law’s impact will vary by the nature of the work you do, as well as your business entity and, in some cases, even your marital status. “The law relies on your individual circumstances,” he said.
Second, a number of misconceptions have worked their way through the media and tax-paying public. For example, much coverage was given to the new advantages that limited liability companies would enjoy, such as a flat 20-percent tax rate. However, Slack said, that rate in fact only applies to some LLCs—specifically multi-member entities that have elected to be taxed as a C corporation. As Barry said, “the great panacea for LLCs” doesn’t apply to most self-employed people who are operating as individuals.
Next, accountants themselves are waiting for the IRS to clarify a number of the law’s gray areas. Because of that, accountants are still “hesitant to segment things out,” Pannepacker said. For example, a service business might be taxed at one rate—unless it also sold hardware, sales of which would be taxed at another rate. Should they be split into two different businesses for tax purposes? The answer’s not clear.
“It’s really important to reevaluate your quarterly estimated payments,” Slack said. “Not only are there new tax benefits that may lower your taxable income, but there are also lower tax rates for pass-through income. You need to make sure your estimated payments are in line with the outcome you want next tax season, whether it’s a big refund, as close to zero dollars or just to avoid underpayment penalties.”