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This New Tax Break Will Be a Lot More Popular Than Most Think

Dan Caplinger, The Motley Fool

Headlines have trumpeted how big corporations have made out the best from the latest tax law changes passed in December. With the corporate tax rate falling by 14 percentage points to 21%, many of the largest companies in the U.S. economy are reporting billions in future benefits from tax reform.

By comparison, the provisions under which many small businesses could benefit have largely gone unrecognized. Although the concept of a 20% deduction for profits on businesses set up as pass-through entities might not be as obviously advantageous as an outright tax-rate cut, it could make a substantial difference for a surprisingly large number of taxpayers.

Metal clockwork gears with one having Tax Reform engraved on the side.

Image source: Getty Images.

1 in 6 taxpayers could see benefits

One reason why many policymakers largely dismissed the deduction for pass-through business income was that they saw it as having little impact on the vast majority of people. After all, most people earn their income from traditional employment. Out of the roughly 150 million taxpayers who file tax returns, almost 125 million reported income from wages, salaries, and similar employment sources, according to the most recent available IRS data. When you consider that many taxpayers are retired, it's apparent that even a larger majority of working taxpayers rely on employee income for their livelihood.

Yet hidden among those ranks, you'll find a huge number of people who benefit from pass-through business income. The same data reveals that almost 25 million people filed Schedule C attachments to their tax returns, which is the accepted way to report pass-through income for most people. That's about one out of every six taxpayers, and most of them stand to gain from being able to deduct a portion of their income.

To understand why this number is so large, consider who uses Schedule C:

  • Most small business owners who set up their businesses as partnerships or limited liability companies and don't elect to get taxed as corporations.
  • Couple-owned family businesses and single business owners who elect to have their businesses disregarded as a separate legal entity.
  • Those who establish businesses as sole proprietorships.
  • Independent contractors who aren't treated as employees but otherwise have interactions with their primary clients that very closely resemble the employer-employee relationship.
  • People working popular side jobs where workers aren't treated as employees, such as driving for car-sharing services.

It's those last two groups that are driving a huge demographic shift in the employment world, and tax reform could hasten the move from traditional employment to the gig economy. Since tax reform became law, interest among workers has skyrocketed to figure out ways to qualify to be independent contractors rather than employees in order to take advantage of the deduction. The loss of employee benefits is a huge offsetting negative that will prevent most workers from making the shift, but the financial incentive that tax reform creates should still spur more such moves in future years than would otherwise have taken place.

How much impact could pass-through deductions have?

There are limits to taxpayers' ability to claim the deduction, particularly for those who are in particular occupations. Yet for the most part, those limitations apply only to higher-income taxpayers.

When you look at the amounts of money that most taxpayers claim when they file Schedule C, it's a lot smaller than you might expect. Overall, taxpayers claimed about $332 billion in business income on their returns. That works out to an average of about $13,400 in net business income per return.

A closer look at the returns shows that those businesses already do a good job of claiming deductions from their gross revenue. The typical business had an average of almost $60,000 in gross receipts, but taxpayers were usually able to deduct the costs that went into the materials and production of the goods and services provided, as well as the operating expenses of the business.

A 20% tax break on an average of $13,400 in income would produce a $2,680 deduction, saving taxpayers between $268 and almost $1,000 under the new tax rates in effect for 2018. That's not life-changing money, but it's a nice windfall for those who might not have thought that tax reform would do them any good.

Save what you can

Over the next year, you'll have ample opportunity to look at ways in which recent tax law changes have affected your situation. Often, you'll find that contrary to popular opinion, there will be ways you can turn the new laws into tax savings even if you're not a business tycoon.

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