The first thing you should know is that there is a difference between itemizing on a Schedule A for things like state and local income and property taxes, medical expenses, and contributions and listing expenses on a Schedule C which is where you put the income and expenses for your freelance business. A number of people have asked what they are going to do if they can’t itemize their business expenses. The answer is that they can take the same expenses as they could before for their business. They may or may not be able to itemize any more on their Schedule A depending on their particular circumstances.
The second thing is that effective tax year 2018, there will be a new passthrough rule that will enable many freelancers to take a 20% deduction of their Qualified Business Income on their Schedule C’s. An individual taxpayer will qualify for this deduction for qualified business income (or pass-through entity deduction). This deduction will not change the amount of self-employment tax they pay but it will reduce the income tax paid.
What is a pass-through? A pass-through is any entity that passes through the income to the taxpayer. What qualifies? Schedule C income, S-corporation income and partnership income. A freelancer can be a single member LLC or simply a sole proprietor.
What is Qualified Business Income (also now known as QBI)? Look at the last line on Schedule C. If there is a positive number on that line, that will be the number that will qualify for the 20% deduction. If there is a negative number, there is no pass-through deduction.
How will this work: as with so many things in the tax bill, we are not exactly sure where the deduction will be taken or if it will be taken in the same place depending on which of the pass through entities you are. We’ll know when the IRS issues the tax forms for 2018.
Are there are any limits on this deduction: Yes, for most freelancers, the 20% deduction is the lesser of 20% of qbi or 20% of taxable income. Taxable income is not adjusted gross income on page 1 of the 1040. Taxable income is the amount after the standard itemized or deductions are subtracted from the adjusted gross income and appears on the top of page two.
Some people think that there will be a reasonable compensation calculation which will limit the deduction to the amount above that reasonable compensation figure.
What is thought as of now is that all passthrough’s of earned income qualify up to taxable income of $157,500 for a single person or $315,000 for married filing joint people. If the threshold amounts are exceeded, reduced amounts of deductions are allowed for taxable income up to $207,500 for single people and $415,000 for married filing joint people. How the computations will be done on this is not yet available.
For whom do the threshold amounts matter? Here is where more lack of clarity comes in. If you are a specified service activity and earn above the threshold amounts (and phase out), you won’t be able to take the deduction. What is a specified service activity? It means activity in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
What this means is that if you are in any of the named fields and your taxable income is more than the threshold amount or the phaseout amount, you are out of luck and don’t qualify for the deduction.
The lack of clarity is in the part which I’ve underlined where the business’s principal asset is the reputation or skill of one or more of its employees. At this point, we don’t know what that means.
What about a writer? Isn’t her principal asset her skill and reputation? Same with artists. Don’t photographers fall under the same thinking? And psychotherapists? One would think their livelihood also depends on their skill and reputation. It looks like these and a lot of other people may not be able to take the deduction above the threshold (and phaseout) amount.
Will this be disputed? I would think so. At this moment, before there are private tax letter rulings, tax court rulings, or even better explanations from the IRS as to what falls under this provision, this explanation is being held by various accountants.
What must be understood is that when tax bills pass, there can be years of uncertainty about certain things. This tax bill was passed without lengthy congressional hearings so that we don’t even have congressional intent as to what this phrase means.
Further there are additional limitations of the 20% deduction to percentages of W-2 wages, if paid, when taxable income is above the threshold amount (or phaseout).
These provisions expire after 2025.
It is not yet clear if each state will allow this passthrough deduction. If they have not done so before, each state will have to issue their instructions on this for the 2018 tax season.
Besides the pass-through provisions, filing Schedule C’s for the 2018 tax year as a freelancer will remain the same as before. Filing the rest of the tax returns as an individual person or as married filing joint people will change in many ways especially regarding itemizing on a Schedule A or taking a standard deduction and taking exemptions.
In this article, I’ve tried to cover the things that are most relevant for freelancers as freelancers. The other information is widely available and not covered here.