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Article by: Jeffrey Skolnick, CPA, M.S. Taxation

You’ve embarked on your career as a small business owner / entrepreneur. You are extremely excited by the products or services you sell or provide. Your self-esteem is high, after all you’re the head honcho. Everything is going well and then it happens. Overwhelm sets in. You had no idea how much paperwork business owners need to deal with. Regulations, how to advertise, handling employees, income taxes, payroll taxes, sales taxes, insurance premiums, record keeping and bookkeeping. In addition to the issues just mentioned, every time you go on the internet you see an advertisement for something that looks like you should have in your business. How can you keep all these things straight and still find time to actually sell your products and services? You start to panic and as I mentioned overwhelm sets in.

I have worked with many business owners in precisely this position. They come to me paralyzed by business management decisions that are taking so much time that their sales have fallen. At this point they may even start thinking about selling new and different products. Some are angry, some are in tears. It’s total chaos! In reality they are just individuals dealing with being overwhelmed.

The first thing I tell them is to step back, take a deep breath and relax. The key to relieving the stress and anxiety of this situation is organization. I know it sounds overly simple but let me explain how this removes the paralysis and begins the process of relieving your stress.

DEFINE YOUR GOALS

The first step you must take is to define your goals. I know you’ve heard this one before. There is a reason why you’ve heard this so often, it’s true. Whether you realize it or not you do set goals. Some individuals may have just a rough idea of why they are in business and what they are trying to accomplish. The most organized individuals will write down their goals. Actually, putting pen to paper (or in today’s world, typing in word), changes your mindset. Some business owners will even use vison boards and a variety of other tactics to cement their goals in place. If that’s you, great, but that may not be for everyone. Whether that is you or not, however, you still need to set some goals. I believe your goals will usually be uncovered by answering a series of questions. Some examples would be:

• Is your business going to be your main source of income or a side hustle? 
• How much do you need your business to net and how many hours are you willing to put in to make that happen?
• How soon do you need to reach your goals?
• How do you supplement your cash flow while you are initially building your business (in other words, before you’ve reached your goals)?

DESIGN A PLAN TO ATTAIN YOUR GOALS

Once you clarify your goals, the next step is to formulate a plan that will be your roadmap to success. 

The 2018 Tax Cuts & Jobs Act

Article By: Jeff Skolnick, CPA, M.S. Taxation

The 2018 Tax Cuts & Jobs Act contains a very generous deduction for owners of Pass-Thru Entities.  There are a number of rules that limit this deduction based on various factors which include occupation, taxable income, entity structure and proper recordkeeping.  That being said, this is a deduction well worth understanding.  The remainder of this article will break this provision down and explain it.

New Code Section

The new tax law adds a new section to the Internal Revenue Code.  The new section is 199A. Qualified Business Income. This code section allows a 20% deduction for Qualified Business Income of a Pass-Thru Entity.  As I mentioned before there are a number of limitations that may apply.  Think of the 20% deduction on Qualified Business Income as the first hurdle.

Pass-Thru Entity

The new code section applies to pass-thru entities; therefore it makes sense to define the term pass-thru entity.  Pass-thru entities are generally sole proprietorships, partnerships and S corporations.  The reason I did not mention LLCs is that LLCs for tax purposes are considered disregarded entities meaning they have no tax standing on their own.  The default tax position of a single member LLC is a sole proprietorship, the default position of a multiple member LLC is a partnership.  The only real difference between a single member LLC and a sole proprietorship or between a multiple member LLC and a partnership is that the LLCs enjoy protection from legal liability in essentially the same manner as corporations.  Lastly LLCs can also choose to be taxed as S corporations.  While obviously 100% of a sole proprietorship’s income would be eligible for the deduction, partners and S corporation shareholders pick up their ratable share of the associated entities income and deductions.  For example a 50% shareholder in an S corporation that had qualified business income of $250,000, W-2 wages paid of $100,000 and qualified property of $1,000,000 would use $125,000, $50,000 and $500,000 respectively on his/her return.

Qualified Business Income

Qualified business income is defined in the new law as the “net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer”.  This is basically the net income line (income less all applicable expenses). There are, however, certain items that are not counted as qualified items.  The term qualified business income excludes short-term and long-term capital gains and losses as well as dividend income and interest income (unless earned in a trade or business).  The law also considers Real Estate Investment Trust (REIT) dividends, qualified publicly traded partnership income and qualified cooperative dividends as qualified business income but these are more specialized situations and this ebook will not focus on these items. I only wanted to mention them to provide information that rules do exist on these types of income.

Qualified business income does not include W-2 wages or guaranteed payments to partners.

How the deduction works

This new deduction, as I mentioned earlier, is calculated by first taking 20% of Qualified Business Income (the first hurdle) followed by a number of other hurdles which I will now cover.

Taxable Income Limitation

I have labeled the taxable income limitation as hurdle number 2.  The reason for this is that there are a couple of other provisions which kick in at certain taxable income levels. First of all while the 20% limitation on Qualified Business Income is hurdle number 1, if 20% of taxable income less capital gains and qualified cooperative dividends is less than Qualified Business Income than this lower limitation amount is used.  Again qualified cooperative dividends are a specialized area which I am not going to delve in to here. If you see the term you know this section applies. I also mention the term so people realize that qualified cooperative dividends are not the same as the qualified dividends everyone is used to seeing on Form 1099-Div. Qualified dividends are considered capital gains for this code section.

Example 1

Scott, a single taxpayer, has qualified business income of $100,000 and taxable income of $160,000 of which $10,000 is long term capital gain income.  Hurdle number 1 is 20% of qualified business income or in this case $20,000.  Hurdle number 2 is 20% of taxable income less long term capital gain income ($160,000 – $10,000 multiplied by 20%), or $30,000.  The deduction in this example is limited to $20,000 based on his qualified business income.

Example 2

Scott, a single taxpayer, has qualified business income of $150,000 and taxable income of $100,000, none of which is related to long term capital gains.  Hurdle number 1 is 20% of qualified business income or in this case $30,000.  Hurdle number 2 is 20% of taxable income, or $20,000.  The deduction in this example is also limited to $20,000 although this time based on taxable income.

Specified Service Trade or Business

What I consider to be hurdle number 3 is the exception for what the code section calls “specified service trades or businesses”.  Code section 199A defines these businesses based on the definition shown in another code section (1202(e)(3)(A)).  Code section 1202 defines these businesses as any “trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees”. 

In order for the specified service trades and businesses to utilize the deduction of this new code section fully the taxable income of the taxpayer(s) must be at or below $315,000 for married taxpayers filing a joint return and one half or $157,500 for everyone else.  Once the taxpayer(s) exceeds the taxable income limitation the deduction phases out. In the case of taxpayers with a threshold of $315,000 the deduction phases out over the next $100,000 of taxable income.  In the case of a taxpayer with a threshold of $157,500 the deduction phases out ratably over the next $50,000 of taxable income.

In each of the examples that follow there were no capital gains. In addition when the taxpayer exceeds the applicable limits ($315,000 for married taxpayers filing jointly and $157,500 for everyone else) hurdle 4 (explained later) also kicks in. For purposes of examples 3 through 7 assume there is enough W-2 wages and/or Qualified property that hurdle 4 does not come into play.  Again I will explain hurdle 4 shortly, however I do not want to further complicate these examples at this time.

Example 3

Scott, a single taxpayer, has qualified business income of $100,000 from a specified service business and taxable income of $150,000.  Hurdle number 1 is 20% of qualified business income or in this case $20,000.  Hurdle number 2 is 20% of taxable income, or $30,000.  Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $20,000 and because Scott’s taxable income is below $157,500 he is allowed the full $20,000 deduction even though his qualified business income was earned in a specified service business.

Example 4

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $300,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $60,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income is below $315,000 she is allowed the full $50,000 deduction even though her qualified business income was earned in a specified service business.

Example 5

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $500,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $415,000 ($315,000 plus the $100,000 phase-out) she is allowed no deduction.

Example 6

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  Kathy’s deduction is therefore limited to $50,000 multiplied by 55% (again she loses out on 45% of this deduction).  The allowable deduction is 55% of $50,000 or $27,500. Please keep in mind that in addition to the three hurdles listed here Kathy would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.

Example 7

Scott, a single taxpayer, has qualified business income of $150,000 from a specified service business and taxable income of $190,000.  Hurdle number 1 is 20% of qualified business income or in this case $30,000.  Hurdle number 2 is 20% of taxable income, or $38,000.  Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $30,000 and because Scott’s taxable income exceeds $157,500 but is below $207,500 part of his deduction will be phased out.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $190,000 less $157,500 equals $32,500.  $32,500 is 65% of the $50,000 phase-out.  Scott’s deduction is therefore limited to $30,000 multiplied by 35% (again he loses out on 65% of this deduction).  The allowable deduction is 35% of $30,000 or $10,500.  Please keep in mind that in addition to the three hurdles listed here Scott would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.

Other limitations based on taxable income

The last hurdle (what I call hurdle number 4) applies to all businesses; remember hurdle 3 only applies to specified service trade or businesses. Once the threshold limits of $315,000 and $157,500 are reached the code section states that the deduction will be the “lesser of 20 percent of the taxpayer’s qualified income or the greater of 50 percent of the W-2 wages with respect to the qualified trade or business or 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.”  That certainly is a mouthful and I will now explain it in English. 

The first part discussing 20% of qualified business income is the same number we’ve been using from earlier.  This is the calculated figure after leaping over hurdles 1 and 2.  The newly introduced complication is the greater of 50% of W-2 wages (a number very easily attained from the payroll tax filings of an entity) or 25% of W-2 wages plus 2.5 % of the unadjusted basis of qualified property.

Qualified Property

The code section defines qualified property as property held by, and available for use in the qualified trade or business. The unadjusted basis is used (original cost without any reduction for depreciation). The only other limiting factor on property is that property no longer qualifies as of the later of 10 years after the date it is placed in service or the last full year that the property is depreciated.

Example 8

Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Kathy’s business paid $60,000 in W-2 wages and has no qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $0).  Hurdle 4 therefore limits the deduction to $30,000.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $30,000 calculated by hurdle 4.  $20,000 multiplied by 45% equals $9,000. Kathy’s deduction is therefore limited to $50,000 less the $9,000 phase-out or $41,000.

Example 9

Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Kathy’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000).  Hurdle 4 therefore limits the deduction to $40,000.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $40,000 calculated by hurdle 4.  $10,000 multiplied by 45% equals $4,500. Kathy’s deduction is therefore limited to $50,000 less the $4,500 phase-out or $45,500.

Example 10

Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return.  Scott’s business paid $800,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $400,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $200,000 + $25,000).  Hurdle 4 therefore limits the deduction to $400,000.  The deduction is calculated by using the first 2 hurdles ($90,000) and the $400,000 calculated by hurdle 4. Scott’s deduction is $90,000.  Notice there is no phase-out since Scott’s taxable income exceeds $207,500.

Example 11

Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return.  Scott’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000).  Hurdle 4 therefore limits the deduction to $40,000.  The deduction is calculated by using the first 2 hurdles ($90,000) and the $40,000 calculated by hurdle 4. Scott’s deduction is $40,000.  Notice there is no phase-out since Scott’s taxable income exceeds $207,500.

How to take the deduction

Another great thing about this deduction is that it is available to both those who itemize and those who do not itemize their income tax deductions.

CONCLUSION

This is a deduction that will be very beneficial to many that own sole proprietorships, interests in partnerships, S corporations and LLCs.  There are a few limitations that must be followed and in some instances action such as restructuring your business type (for example from a sole proprietorship to an S corporation) may be required.  While this article is intended to provide a certain level of knowledge regarding this new provision it does not replace the expertise of a professional or further research if you are a professional.

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Obviously being an income tax accountant I hear certain questions over and over again.  One of the most common questions I receive is from small business owners wondering what issues are considered “red flags” by the IRS and would increase the chances of being selected for audit.  I am going to narrow this article to those red flags connected to sole proprietors (those who file Form Schedule C with their income tax return).

Am I more likely to be audited because I am a sole proprietor?

The quick answer unfortunately is yes.  There are a few reasons for this answer.  The first is that employees usually work for 1 or 2 companies during the year and when they receive their Forms W-2 at yearend most will not overlook any employment and what the employee reports to the IRS is the same as what the IRS has received from the various employers.  When individuals run a sole proprietorship they may receive many Forms 1099 at yearend and if the taxpayer does not have accurate books and records they may miss a Form and report less income than the IRS has reported under their social security number.  If the IRS thinks you are underreporting income this is a red flag.

As I have discussed in past articles owners of sole proprietorships are entitled to many deductions that individuals who do not own small businesses are not.  There may be large write offs of automobile expense, wages paid to members of the family and other items which for employees would fall to itemized deductions and only become deductible once certain thresholds are met (2% of Adjusted Gross Income for certain miscellaneous deductions and 10% for medical deductions).  While these deductions may all be legitimate, they may also be scrutinized.

Lastly if you are writing off losses that may be considered hobby losses that can cause the IRS to take a look at your return.   Generally if your small business makes a profit 3 out of 5 years (2 out of 7 for horse breeding) then you are considered to be running a business with the expectation of making a profit.  That is not to say that if you do not meet these criteria that you cannot deduct the loss, you just do not meet the “safe harbor” test and must be able to provide reasons why your business is legitimate and why you expect to earn a profit.

Conclusion

This article discusses very generally why running sole proprietorships make your return more likely to be audited.  Keep in mind even if you are audited if you have books and records that support your income and deductions you nothing to fear.  I would always suggest that any individual running a sole proprietorship be in contact with a tax professional because the rules are quite extensive and running afoul of them may get your return more attention than you would like from the IRS.