If you have been keeping tabs on tax changes, the 20 percent deduction for pass-through businesses probably caught your attention. Now that it’s time to file your business taxes, it’s worth knowing how to maximize this deduction to lower your tax liability as much as possible. If you can’t implement these tips this year, plan to use them going forward so you can maximize the pass-through deduction in future tax years.
Do you qualify?
The potential for you as a freelance business owner to net a 20 percent qualified business income deduction applies only if you operate a partnership, S-corporation, or sole proprietorship. This deduction is available if your income is less than $157,500 ($315,000 for married filing jointly). If your income is greater than this amount and your business is considered a non-qualified business you may be subject to limitations on this deduction.
Non-qualified businesses include those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and investing and investment management
The deduction is not based on the definition of “business income” most of us are used to. Instead, it uses "qualified business income" (QBI) to calculate any deduction to which you may be entitled.
There is an income-based limitation on the amount of the deduction.
Some types of businesses, referred to as a Specified Service Trade or Business (SSTB) in the new tax law, are not eligible for the deduction once certain income thresholds are met.
Strategies for maximizing your deduction
To maximize the pass-through deduction for your freelance business — if not on your current tax return, then for your 2019 taxes — remember:
SSTBs (as defined above) don’t fully qualify for the pass-through deduction unless the owner’s taxable 2018 income is equal to or below the threshold amount ($157,500 for individuals or $315,000 for married individuals filing jointly). That's indexed for inflation for tax years that begin after 2018, and SSTBs don’t qualify at all if the taxpayer’s taxable income is above $207,500 ($415,000 for married individuals filing jointly). As such, you may want to increase your retirement contributions if it will keep you in the qualifying income range.
For 2019 and beyond, consider shifting taxable income into a different tax year if you estimate your taxable income to be near the applicable threshold range (which in 2019 is $160,700 to $210,700 for singles and head of households, $160,725 to $210,725 for married taxpayers filing separately, and $321,400 to $421,400 for joint filers.) You can do this by invoicing after the end of the year for work completed in the same tax year or purchasing equipment that you can deduct from your business income before the end of the tax year in which you plan to claim the deduction.
If you own an SSTB and have a high taxable income that disqualifies you for the pass-through deduction you may want to consider incorporating and/or changing your business entity type to gain alternative tax advantages for the coming tax years. Be sure to seek the advice of a tax professional before making changes to the structure of your business so you know how it will affect your taxes.
You should also determine if either of the following additional limitations to the pass-through deduction apply to you:
If 20 percent of your business’s income is greater than 50 percent of its W-2 wages; or
If 20 percent of your business’s income is greater than the sum of 2.5% of your business’s depreciable property and 25% of its W-2 wages.
It is wise to calculate where you may land in terms of qualifying for the pass-through deduction by calculating both of the scenarios above to make sure that your deduction will not be limited by the wages or asset threshold as applies to your business.
An important note: The above limit does not apply if you have taxable income below the income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).
Real estate considerations
If you are the owner of a qualified real estate-related business, you may also qualify for the pass-through deduction. However, the deduction is subject to a limit of 2.5 percent of the cost of your allocable share of depreciable real and personal property (this doesn’t include inventory or land). The cost of these assets may be included during the useful life of each asset or 10 years — whichever is longer.
Another important point: To qualify for the 20 percent QBI deduction on rental real estate businesses, the property must be directly owned by an individual or eligible pass-through entity (as described at the beginning of this article). In addition, each real estate enterprise must also receive at least 250 hours of total documented “rental services” activity to qualify for the deduction. This 250 hour requirement doesn’t require that the owner perform all such services (i.e. advertising, rent collection, employee supervision, operation and maintenance, etc.). You can count any rental services that you outsource to an agent, employee, or independent contractor.
The new pass-through deduction may save you 20 percent on your tax bill, depending how the rules of this deduction apply to your situation. Keep the tips above in mind and be sure to check with a tax professional about your specific tax obligations and how you can make the most of this potential tax saving.
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He offers a free consultation to members of Freelancer’s Union and a monthly email newsletter covering tax, accounting and business issues to freelancers on his website, www.cpaforfreelancers.com — which also features a new blog, how-to articles, and a comprehensive freelance tax guide.
Jonathan is happy to provide an initial consultation to freelancers. To qualify for a free consultation you must be a member of the Freelancers Union and mention this article upon contacting him. Please note that this offer is not available Jan. 1 through April 18 and covers a general conversation about tax responsibilities of a freelancer and potential deductions. These meetings do not include review of self-prepared documents, review of self-prepared tax returns, or the review of the work of other preparers. The free meeting does not include the preparation or review of quantitative calculations of any sort. He is happy to provide such services but would need to charge an hourly rate for his time.