Congress has just passed the most sweeping reform to the tax code in more than 30 years. As a freelancer, managing your own taxes and understanding the implications for your business can be challenging, especially when the rules change.
This FAQ is designed to help you navigate the changes, but it should not be considered professional counsel. We suggest that all freelancers educate themselves using publicly available information and also enlist the guidance of a qualified accountant for more in-depth and situation specific questions.
– The tax policy drops the corporate tax rate from 35% to 21%. This will impact the small percentage of freelancers who structure themselves as C-Corps.
– For freelancers who operate as pass-through entities (sole proprietorships, LLCs, or S-Corps), a 20% pass-through deduction has been introduced to even the playing field for small businesses. This deduction allows you to deduct 20% of your revenue figure before subtracting expenses and calculating your net income. There are income ceilings, which limit some workers’ ability to take this deduction.
– From a pure tax standpoint, most freelancers won’t see any added benefit to being one versus the other. According to Zhanna Kelley, CPA, “Freelance taxpayers in higher income brackets may benefit from forming an S-Corp. S-Corp status allows you to classify divide your net income between wages (W-2) vs. dividends (K-1). You save because you’re not required to pay Social Security and Medicare taxes (FICA) on the portion considered “dividends.” Says Kelley, “Just be sure to give yourself a reasonable salary for the W-2 portion of your earnings to avoid IRS scrutiny of the division. Also, for taxpayers in New York City and other locales, net income from S-Corps is subject to another tax, which offsets the benefit. You need to determine if the tax benefits of an S-Corp will outweigh the costs of forming and maintaining S-Corp status as well as the local tax.”
Pay attention to the pass-through provision
The most important policy change for freelancers to focus on is the new pass-through deduction. Many small businesses operate as “pass-through entities” in the form of sole-proprietorships, LLCs or S-Corps. In these cases, the business owners or freelancers pay individual tax on earnings but there is no double taxation in the form of corporate taxes.
Since the new tax policy lowers the corporate tax rate from 35% to 21%, a new pass-through provision was introduced to give an economic boost to small businesses (which do not pay corporate taxes), too. So, how does it work?
Under the new policy, freelancers operating as pass-through entities can deduct 20% of their revenue from their taxable income. The provision is taken “below the line,” which means that while it lowers your taxable income it will not impact your adjusted gross income (AGI).
Here’s a very simplified look at the calculation:
If your taxable income is below the $157,500 threshold ($315,000 for joint-filers), you can deduct 20% of the pass-through income generated by your business. The catch: This deduction may not be greater than 20% of your taxable income.
Example: If your taxable income is $60,000, you may deduct 20% from that, which resets your taxable income to $48,000. Looking at federal taxes only for the sake of simplicity, at a 22% tax rate, you would pay $10,560 in federal taxes versus $13,200.
Limitations for high-earning and professional services freelancers
If your earnings put you above the $157,500 threshold, things get a little more complicated. This ceiling was designed to discourage high-income business owners from creatively gaming the system to reduce their personal tax obligations.
If you earn between $157,500 and $207,500, you are only eligible for a fraction of the deduction. In those cases, the deduction will be limited to whichever is greater: 50% of the W-2 wages paid by the business or 25% of W-2 wages + 2.5% of “qualified property.” Put another way, you will only receive a fraction of the pass-through deduction.
If you’re a single taxpayer earning income above $207,500, you are not eligible for the deduction at all.
Professional services limitation
Professional services freelancers (consultants, lawyers, accountants, etc.) are not allowed to claim the deduction if they make more than $157,500 as a single taxpayer or $315,000 if filing jointly.
Should you incorporate?
The pass-through deduction was designed to create parity between small business owners (many of which operate as LLCs) and large businesses (C-corps), the latter of which benefits from the reduced corporate tax rate (from 35% to 21%). As such, in theory, most freelancers will not need to incorporate, as the net tax obligation will be the same no matter if you’re a single member LLC, partnership or an S-Corp. (You can read a more lengthy breakdown of that here.)