In our first Tax Code Changes blog, we spoke of IRA withdrawal behavioral changes, and last week we talked about mortgage planning tips under the new rules. This week we will tackle something for the sole proprietor business owner who uses a Schedule C for business income reporting, as this applies to most small businesses in America. The new rules have opened a window of controversy over a new IRS term of art called “QBI” or qualified business income. Each pass-through business including sole proprietors will be able to deduct 20% of the net profit of their business before applying the tax when filing their personal return in 2019 for tax year 2018. The rule limits that deduction to a threshold for people in certain trades such as accountants, stock brokers and other professions that tend to use knowledge as their primary way to generate income, versus using their hands. This means that your accountant has a deduction limit, but your mechanic or carpenter does not (that`s a separate controversy to discuss on another day). The 20% deduction means that a gift shop owner that makes a $55,000 profit after paying her bills only pays tax on $44,000. If she is married with a $24,000 standard deduction (the new MFJ deduction) that would mean that only $20,000 of that income would be taxable, placing them at the very end of the 10% bracket instead of in the middle of the 12% bracket. It’s a nice savings, but its hundreds of dollars, not thousands. Without any tax planning this will all just happen, so that some people will see benefits without doing anything different. However, that same business owner could do many things to greatly reduce the tax bill, or even eliminate it! Some things are simple, like fully funding a SEP IRA (self-employed pension), or letting the business lease a car instead of owning it personally. That could add $6,000 a year to deductions and make that $55,000 of profit $49,000 instead. Then they can apply the 20% discount to the 49,000 as well! Those are easy things that stir up no controversy. However, if a business owner wanted to put money in the kids’ college funds instead of the IRS’s coffers, he could employ his kids in his business, and under the new rules the effects are stunning!
Let’s start with the disclaimer first. Your kids really have to work and do things of value for the business, not just collect checks! That being said, we find that many families do have kids helping in the family business, and without pay. “You are helping the family make money to survive”, and it is simply expected! Those business owners have a great opportunity to formally track and pay wages for that work, with two big benefits. First, if a sole proprietor hires their own kids, they do not have to pay FICA or FUTA taxes at all!! 100% of the pay goes to the kids, and they don’t pay any FICA or FUTA taxes either! No match payments for mom or dad, no match payments for the kids! Then, the wages can leave the business as an expense against the bottom line. For instance. Let’s say that our same gift shop owner has two kids in high school that take the bus from school, help out until 6:00 and go home with mom at closing time. With the new Standard Deduction for single people at $12,000, those kids could earn as much as $12,000 each in 2018 without paying any tax! Now let’s start with the $55,000 profit again, and then take $12,000 off for each child, that’s $24,000 off the profit, leaving $31,000 profit. Then, apply the 20% off, reducing the profit by an additional $6,200.00. So income is now $31,000 minus $6,200, or $24,800 going to the tax return. Then apply mom and dad’s $24,000 standard deduction and you have made the tax bill very close to ZERO! They will have $800 of taxable income in the 10% bracket, and pay tax of just $80.00!!
Of course you could argue that now my kids have all our money. But the kids could use that money to buy the groceries and all of their own clothes. You could even charge them an Uber fee! We’re sure once that cash gets home instead of going to the IRS’s coffers, you can figure that out!
From a SEP IRA, to a company car, to hiring kids and more, anyone running a small business in America that doesn’t take advantage of the services of a real tax planner, and not just a tax preparer, is likely wasting money on taxes while feeling bad about not being able to save for college and/or retirement. Find one today and start planning your tax outcomes!