How the New Tax Break For Self-Employed and 1099 Employees Works

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The tax law that was passed late last year brought a lot of changes. One of them is very good news for self-employed workers, freelancers or anyone who is paid as an independent contractor and receives a 1099-Misc at the end of the year.

In an effort to boost small businesses, the new tax law added a special deduction for “pass-through” entities starting in 2018. This deduction allows sole-proprietors(self-employed or independent contractors) to deduct 20% of their business profit from taxable income. The business income deduction is in addition to regular business expenses and your itemized or standard deductions(now $12,000 for individuals).

For example,  say you are self-employed and earned $100,000 after your business expenses plus $20,000 in wages and your Adjusted Gross Income was $112,935. To figure out your taxable income, first you’d subtract your deductions. Using the standard deduction of $12,000, your taxable income would come down from $112935 to $100,935. Previously, that’s where you would stop deducting, calculate your tax, and subtract any tax credits.

Under the new law for self-employed workers, however, you’d be able to take another deduction worth up to 20% of your business income. Based on the $100,000 of business income, you’d deduct $20,000 from the previous $100,935 number bringing your taxable income down to $80,935. This means major income tax savings for self-employed and independent contractors. It’s important to note that this will only affect your income tax. You’ll still need to pay the self-employment taxes on the full amount of your business income.

Is it that simple?

If your taxable income is less than $157,500 filing as single or $315,000 filing married, in most cases it’s as simple as that. You can take the 20% business income deduction.

However, the deduction is also limited to 20% of taxable income. Which means your deduction amount will be the lesser of 20% of your taxable income or 20% of your business income. In order to receive the full benefit of the tax break, you’d need income that was not considered business income, for example, wages from a working spouse, retirement distributions, etc.

But, If your taxable income is higher than those amounts, the law gets more complicated. The 20% deduction starts to phase out for any self-employed individuals who work in most professional services as described below:

“Any trade or business involving the performance of services in the fields of health, law, 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 or owners; or any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.”

Architects and engineers are specifically exempt from this restriction and may claim the 20% deduction regardless of their income.

When your income is above the $157,500/$315,000 limits, the 20% deduction is gradually reduced until your taxable income reaches $207,500 single/ $415,000 married. Once you reach that upper limit, you can no longer take any portion of the deduction if you are a professional service provider as described above.  If your business does not fit the service description above, you may still be eligible for the deduction at higher income levels, but more restrictions apply.  The 20% deduction can also be taken advantage of by LLC’s, Partnerships, and S-Corporations if other conditions are met.