FAQs about the New 20% Pass-Through Deduction

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The Tax Cuts and Jobs Act, passed at the end of 2017, has a big new deduction for freelancers. Starting in 2018, freelancers may be able to take a new pass-through deduction that could shield as much as 20% of their net profits from tax. There are limitations, of course, so read on to understand this new deduction in a nutshell.

Who Qualifies for the Pass-Through Deduction?

The pass-through deduction applies to just about everyone running their own business or working as an independent contractor. For instance, an Uber driver qualifies for the pass-through deduction. So would a freelance Web developer.

Does One Need to Set up a Business Entity to Qualify for the Pass-through Deduction?

Not necessarily. There is no requirement to have a pass-through legal entity to qualify for the pass-through deduction.

In other words, the pass-through deduction is available to sole proprietors.

The deduction is also available to people who operate their business through a legal entity such as a limited liability company (LLC) or S-corporation.

How Much is the Pass-Through Deduction?

The amount of the pass-through deduction (and the method used to calculate the deduction) varies significantly based on income. Or to be more specific, the deduction varies based on taxable income.

What we are looking at is a person’s taxable income for the year (but without taking into account the pass-through deduction). In other words, the starting point is a person’s total income minus all deductions except the pass-through deduction. For married couples, we use the combined taxable income for the year, including income from the spouse.

The deduction varies across three tiers of income, so finding your income number is the important first step. Let’s now look at the rules for each of those three income tiers:

Tier 1. Your taxable income is under $157,500 (single) / $315,000 (married)

  • The rules at this income level are fairly straightforward.
  • At this income level, the deduction applies to freelancers in any industry.
  • The deduction will be equal the lower of:
    • 20% of net earnings from self-employed business, or
    • 20% of taxable income.

Example for Tier 1:

Mary is unmarried and earns $150,000 of income as a freelancer with $50,000 of various deductions. Her pass-through deduction is the smaller of 20% of her net self-employment income or 20% of her taxable income. The smaller number here is 20% of her taxable income ($100,000), which equates to a $20,000 deduction, saving her $4,800 of taxes in 2018. Pretty great news for Mary!

Tier 2. Your taxable income is between $157,500 – $207,500 (single) / $315,000 – $415,000 (married)

  • The calculation of the pass-through deduction starts becoming quite complex in Tier 2.
  • The deduction calculation now includes two additional factors:
    • Wages paid out to any employees in the business, and
    • Original cost of equipment and other tangible property used in the business.
  • Certain “service professionals” will get a much reduced deduction.

Example for Tier 2:

Theresa is unmarried and works as a self-employed architect. (An architect, by the way, is not on the list of service professionals for which special rules apply.) She earns $205,000 from her plumbing business (after business expenses). She has $22,500 of various personal deductions, which brings her taxable income down to $182,500. Theresa has no employees (it’s just her). She has one significant business asset, a work van with an original cost of $10,000. Theresa’s pass-through deduction calculates to $22,839, which saves her $7,308 in federal tax in 2018.

Another example for Tier 2:

Thom is unmarried and works as a self-employed physician. (Physicians are on the list of service professional where special rules apply.) His income and deductions are exactly the same as Theresa (in the example above). He earns $205,000 from his medical practice, has no employees, and has various business equipment with an original cost of $10,000. Thom is only eligible for a  pass-through deduction of $125, which results in tax savings of just $40.

Tier 3. Your income is over $207,500 (single) / $415,000 (married)

  • Certain “service professionals” now don’t qualify for any deduction at all.
  • For other individuals, the crucial factors in the calculation remain:
    • Wages paid out to employees in the business, and
    • Original cost of equipment and other tangible property used in the business.

Example for Tier 3.

Stephanie is unmarried and works as a freelance software programmer. She earns $500,000 from her business (after expenses). She has one employee to whom she pays $25,000 in wages. She uses computers, chairs, desks, and furniture for business purposes. These business assets have a total original cost of $25,000. Stephanie’s pass-through deduction calculates to $12,500, which saves her $4,375 in federal taxes in 2018.

Another example for Tier 3.

Simone is unmarried and works as a physician. She earns $500,000 from her medical practice (after expenses). Because health care services is a specified service business and because her taxable income is over $207,500, Simone does not qualify for the pass-through deduction.

Digging Deeper into Key Terms

Wages paid out means the amount paid to employees hired in the freelancer’s business. That means the employee is on a W-2. Amounts paid to other independent contractors or freelancers do not count towards the pass-through deduction.

The original cost of business assets means the purchase price of those items. This cost number is not adjusted for any depreciation expenses claimed. The types of assets that count for the purpose of the pass-through deduction are tangible depreciable property. Tangible means something touchable, that is to say, something physical. Depreciable means it’s a type of asset for which the IRS allows us to take a depreciation expense. Examples of tangible depreciable property include: computers, furniture, machines, and cars. Intangible assets, such as patents, liquor licenses, and covenants not-to-compete, do not count towards the pass-through deduction.

Tax Takeaways

  • Your total tax liability for 2018 could be going down as compared to 2017 as the result of the new pass-through deduction.
  • If you are going to qualify for the pass-through deduction, it may make sense to calculate your estimated taxes based on your projected 2018 tax liability. This could free up some cash flow.
  • With smart tax planning, freelancers may be able to increase their pass-through deduction. This might entail setting up an entity, such as a S-corporation, and paying wages to oneself out of the business. Or, seeking other deductions to keep taxable income in a certain tier. All these are great reasons to work with a tax accountant who can help you navigate the new rules.

 

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