Attention freelancers, your 2018 taxes are going to look different than your 2017 taxes due to some major changes signed into law with the Tax Cuts and Jobs Act.
The big change for 2018 is a new deduction equal to 20% of the net profits from a freelance trade or business, which is detailed below. There are some other important changes to be aware of as well.
This article will cover ten changes across four major sections of the tax code for freelancers:
- The new 20% deduction
- Self-employment taxes
- The new business loss limitation
- Changes to various business deductions
New 20% Deduction in the Tax Cuts and Jobs Act
Starting in 2018, freelancers may be able to take a new pass-through deduction for 20% of their net profit from their self-employment income. There are limitations for people with higher incomes. Here is a quick overview of how this new deductions works.
The deduction is calculated as the lesser of 20% of either the net earnings from the business or taxable income (whichever results in a smaller deduction amount). This deduction reduces how much income becomes subject to the federal income tax.
Unfortunately, the deduction does not reduce the self-employment tax, only the income tax.
As a quick example, Mary Lou is a freelancer reports the following items on her Schedule C (self-employment income):
$130,000 of gross revenues
-$30,000 of various expenses
=$100,000 of net earnings
In this example, the freelancer has $100,000 of net earnings from their business. The 20% deduction would be $20,000, leaving only $80,000 of her net earnings subject to the income tax. In this simple example, Mary Lou’s tax savings would be $4,800.
The calculation for the pass-through deduction changes once taxable income for the year exceeds $315,000 for married couples or $157,500 for single taxpayers. The pass-through deduction for these higher income freelancers depends largely on how much wages they pay out to employees and the cost of equipment and other assets used for business purposes. This calculation starts getting much more complex, so anyone above these income levels should consult a tax advisor because there are significant tax planning opportunities.
To learn more, please read: Frequently Asked Questions about the new Pass-Through Deduction.
2. More earnings will be subject to Social Security taxes in 2018.
For the year 2018, Social Security tax will apply to the first $128,400 of net earnings from self-employment. This is up slightly from the 2017 limit of $127,200.
As a reminder, the 15.3% self-employment tax is composed of two parts: a Social Security tax of 12.4% and a Medicare tax of 2.9%. The Social Security tax is capped, while the Medicare tax applies to all net earnings from self-employment.
New Business Loss Limitation
3. Higher earning freelancers will see their losses roll forward, rather than be used to offset other forms of income earned that year. Through 2017, freelancers who have a net loss on their self-employment business are able to use that loss to offset against other forms of income, such as W-2 wages. Starting in 2018 those losses can no longer be used to offset income and lower taxes due in that year if a person has gross income over $250,000 (or $500,000 for married couples). Instead, those losses have to be carried forward into future tax years where they can be used to offset future income that the freelance business eventually generates. This change will most likely impact married couples where one spouse is a wage earner and the other spouse is an entrepreneur. This could also impact freelancers with a day job and running side-business.
Changes to Business Deductions
4. Entertainment expenses will no longer be deductible starting in the year 2018. The Tax Cuts and Jobs Act eliminated this deduction. That means, starting immediately, client entertainment will not be tax deductible.
For tax year 2017, freelancers can still deduct half of the expenses for entertainment, amusement, or recreation on their 2017 tax return. To qualify for the deduction, the entertainment must be directly related the freelancer’s business.
5. Buying a car got more favorable under the new law. A new car bought for work purposes can now produce a tax deduction of up to $18,000 in the first year that the car is used for business purposes (assuming the car cost $18,000 or more, if less than the deduction would be equal to the purchase price). That’s the upper limit for depreciation expense for the year 2018. In 2017, the upper limit was $11,160, so the increase in the deduction amount is significant.
6. Pre-owned cars qualify for the deduction too. It used to be that you needed to buy a new car to get the maximum depreciation deduction. Congress relaxed the requirements to allow both new and used cars to qualify for the maximum deduction. And the date of this change is unusual – the change took effect on September 27, 2017. So if you bought a pre-owned car last year and started driving it for business, you might already qualify for the higher car deduction on your 2017 tax return.
7. Write off up to $1 million of asset purchases. Freelancers are currently allowed to deduct $510,000 of computers, equipment, furniture and other business assets on their 2017 tax return under what’s called the section 179 deduction. For most freelancers, that is already more than enough. But for those with large capital expenses, they will be happy to know that this deduction has been increased to $1 million for 2018.
8. Interest expenses associated with any business debt will continue to be deductible for 2018. Congress was debating whether to limit how much interest businesses can deduct. One idea Congress had was to limit the deduction for interest paid to the amount of interest income earned by the business. In the final version of the Tax Cuts and Jobs Act, Congress decided to limit the interest deduction only for businesses with gross revenues over $25 million for the year.
9. When selling self-created assets (such as a patent or invention), that sale will be treated as an ordinary gain subject to the ordinary tax rates starting with the year 2018. For 2017, certain types of self-created assets were treated as capital gains, potentially subject to the lower long-term capital gain tax rate. The list of self-created assets that will no longer qualify for capital gain treatment going forward are:
- Models or designs (whether or not patented),
- Secret formula or process,
- Literary, musical or artistic compositions,
- Letter or memorandum, or
- Similar types of self-created property.
10. Settlements related to sexual harassment will not be tax-deductible in 2018 if the settlement is subject to a non-disclosure agreement. Congress got the #metoo message.
Freelancers are undoubtedly among the most impacted by the new tax law effective 2018. We highly recommend anyone with self-employed income to consult a tax advisor, as there are important tax planning opportunities for 2018.
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