Everyone has questions about the sweeping tax reform that became law at the end of last year. As a coach and champion for independent consultants, I went on a fact-finding mission to answer two important questions:
- Are self-employed consultants still better off being paid on a 1099 tax basis as a business or on a W-2 tax basis through a third party?
- Is there a tax advantage to how independent consultants structure their businesses — as a sole proprietor, LLC, S corp or C corp?
Here’s what I learned after too many hours of research and talking with two CPAs and a lawyer. (Disclaimer: I am neither an accountant nor a tax lawyer, so I’m not qualified to give tax or legal advice. I’m simply trying to help self-employed consultants understand how the changes in tax law may affect them, so they — you — can have a more productive conversation with your tax professional.)
A. The answer to my first question is yes. It’s still better to be paid on a 1099 tax basis because you can still take business-owner tax deductions, possibly in addition to the new 20% deduction (more on that below), and you can still take advantage of better retirement options like a SEP-IRA to lower your taxable income. (See “Friends Don’t Let Friends W-2”TM for more information.)
B. Your taxes for last year, due this April, are largely unaffected. The majority of new tax regulations apply to money you make in 2018. So there’s nothing significant to worry about when you do your tax return for 2017.
C. Your taxes for 2018 and in coming years will either be much easier or much more complicated, depending on your income level. This is because of income thresholds that dictate eligibility for the new 20% deduction for businesses.
If you make less than $157,500 as an individual taxpayer, or less than $315,000 as married taxpayers, your taxes might be easier (see next section), but if you make more than those amounts, your taxes certainly will be more complicated.
These thresholds are pivotal to understanding the implications of tax reform. The other key factor is that as consultants we are in a personal service business. More on that in the next section.
D. Sorry to say, my second key question about how your legal business structure may affect your tax burden can’t be answered in a blog post. It’s too complicated and there are too many tradeoffs. For example, businesses with an S-corp tax treatment will trade off savings in self-employment tax against a lower pass-through business deduction, and they also have additional costs like payroll and tax-filing expenses that should be considered.
E. If you’re doing business as a sole proprietorship, and your income is below the thresholds mentioned above, you can take advantage of the 20% deduction; you do not need to be structured as an LLC or other formal entity.
Implications for Pass-Through Entities and Service Businesses Like Consulting
Most independent consultants I know have structured their business as a pass-through entity like a sole proprietorship or LLC. That way their tax information flows through to their 1040 federal tax return. This means they avoid filing two tax returns and being taxed at both the corporate and individual level. This flow-through principle is still valid under the new tax law.
What’s changed is how you calculate your business-owner tax deductions. Instead of lowering the corporate tax rate on pass-through businesses like it does for C corporations, the new tax law includes a 20% deduction for income from certain types of pass-through entities.
Here’s an example scenario of the 20% business deduction. You’re married, you run a dry-cleaning business, and you had profit before tax of $175,000. Theoretically you’ll be able to do one calculation (20% of $175k) and deduct $35,000 from your taxable income. You would do this instead of itemizing all your business deductions like rent, liability insurance, advertising expenses, etc. Pretty simple.
This example shows how it works for independent consultants too, as long as your business income is below the thresholds of $157,500 if single or $315,000 if married.
However, if you’re a successful consultant with business income above the thresholds, your tax situation will be complex. This is because the new law excludes personal service businesses like lawyers, realtors, and consultants, from being able to take the 20% deduction once they cross the income thresholds. A personal-service business is basically any trade or business where money is made by selling a service, especially if the business depends on the reputation or skill of the owner.
If your income is greater than the $157,500 or $315,000 thresholds, some serious number crunching will be needed to figure out how to best structure your business for tax savings. Everyone’s situation is unique, and no general guidelines exist yet. It’s still too new and confusing, plus clarifying amendments to the law are likely to come in the months ahead.
- Keep funneling money into a solo 401(k) or SEP-IRA to lower your taxable income. The contribution limits are even higher now than before. (Contributing to a retirement plan like this is like having a goose that lays golden eggs. See my blog post to learn why.)
- Some business expenses that used to be tax deductible no longer are, or they’ve become much more complicated to deduct like meals and entertainment. Click here for an excellent PDF summary of some of the changes. Note: this is subject to change; tax accountants are expecting (hoping for?) some clarifying amendments in the coming months.
- Be particularly alert if you’re “on the bubble” of the income thresholds that relate to qualifying for the 20% deduction. Remember, to qualify for the deduction your qualified business income (QBI) needs to be less than $157,500 or $350,000 if married. QBI is generally net income from your business, so if you’re on the bubble at the end of the year, you may want to push back the start date of your next project or delay billing for the work if you can.
- Last, the more successful you are, the more important it is to use a good tax professional. It’s a good problem to have. :-)
Closing comment: many consultants ask me to recommend tax experts, but I don’t have a good answer yet. I’m researching a national network or firm that specializes in serving self-employed professionals. My goal is to have a recommendation this summer, once this tax season is over. In the meantime, put as much money as you can into your retirement account!
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Helpful Tax Articles and Tools
TurboTax/Intuit: Key Tax Reform Changes That Could Affect Your Next Year
FoxBusiness.com: What tax reform really means for small businesses — a good simple overview.
Forbes.com: What the New Tax Deduction for Pass-Through Businesses Looks Like In Chart Form — the decision-tree flow chart is somewhat helpful. As a consultant, follow the bright blue and red boxes.
ThinkAdvisor.com: The New 20% Pass-Through Tax Deduction: An Advisor’s Guide — has a couple of good examples, including one of an employee who consults on the side.
Forbes.com: What Tax Reform Means for Small Businesses & Pass-Through Entities — filled with useful definitions but the examples are complicated.
Online Taxman.com: When to switch from LLC to S Corp
TurboTax/Intuit: Estimate your 2018 taxes at any time with TaxCaster. It’s up to date with the latest tax laws and can calculate both your current and future year taxes.