SMALL BUSINESS TIPS
A SIGNIFICANT NEW TAX DEDUCTION
NOW AVAILABLE TO SMALL BUSINESS OWNERS!
The Tax Cuts and Jobs Act, signed into law in December of 2017, placed a severe limit on the deduction for state income and property taxes. This limitation, commonly referred to as the SALT (State and local taxes) cap, restricts this deduction to a combined amount of $10,000. For reference, a family in Illinois making $400,000 with $18,000 in property taxes would have combined state income and property taxes of $38,000 but could only deduct the first $10,000. Even if your combined taxes are below the $10,000 level, you are unlikely to realize any actual savings from the deduction since you need to itemize your deductions to do so. To circumvent this restriction, a number of states have passed laws allowing pass-through businesses to elect to be taxed at the business level, rather than the personal level. This election can provide meaningful tax savings to small business owners.
How Does this Work?
If your business is a partnership or an S-Corporation, it is considered a pass-through business, meaning the business itself is not taxed at the corporate level. Instead, that income is passed through to the owners, who are then responsible for the taxes on the business profits. This is relevant because the SALT cap only applies to individual taxes, not business taxes. By electing to pay tax at the entity level, business owners can now turn their state income taxes into deductible business expenses without needing to itemize and without being subject to the $10,000 SALT cap.
Nineteen states have passed laws allowing pass-through businesses (as of 10/8/21) to make an election to be taxed at the business level, including Illinois, Wisconsin, New York and California. We are going to focus today's article on how this provision will work in Illinois, as Illinois’ flat tax rate makes it the most straight forward example.
The bill that created this provision in Illinois was signed at the end of August. We are still waiting on the state to provide more thorough guidance on how businesses will make the election, but here is what we currently know:
Passthrough businesses can elect to pay state taxes at the business level for tax years 2021-2025. (The SALT cap is set to expire in 2026). This election will need to be made each year. Once made for a given year, the election cannot be revoked.
Starting in 2022, businesses that make this election will need to make quarterly estimated tax payments towards state taxes to avoid penalties. This requirement is waived for 2021 since the first 2 quarterly payment deadlines had already passed before the bill was signed.
A business that makes the election will pay a 4.95% tax rate on its net income. The owners of the business will then receive a credit towards their personal taxes equal to the amount of taxes the business paid times their percentage ownership in the business.
Should You Make This Election?
The decision to make this election will depend on several factors, including the net income of your business, the total taxable income on your personal return, your filing status, and the state you live in. As we mentioned, because Illinois has a flat tax rate, nearly all business owners in Illinois will benefit by making this election, though the extent of that benefit may not always be worth the extra steps. The more income your business generates, the larger the benefit this election will have on you (for Illinois business owners). However, in other states the benefits are less certain due to differing methods of implementing this program.
In Wisconsin, individual taxes fall into one of four brackets depending on income, with 3.54% being the lowest bracket and 7.65% being the highest bracket. However, businesses making this election in Wisconsin will pay taxes at the fixed corporate rate of 7.9%. As a result, the federal tax savings barely outweigh the increased taxes paid to Wisconsin at lower income levels.
See the chart below that illustrates how business owners in different states will benefit from making this election,.
As these examples illustrate, the savings for businesses in flat-tax states like Illinois are fairly straightforward. The more income your business generates the larger the potential savings. This is due to the fact that Illinois tax rates do not change when you make this election, they are simply changed from a personal expense to a business expense.
On the other hand, there are additional factors at play in Wisconsin. The benefits in Wisconsin are not so obvious until higher income levels. For example, in scenario 5, a married couple in Wisconsin with $250,000 in wages and $500,000 in business profits could reduce their federal taxes by $11,123 while only increasing their Wisconsin taxes by $2,667 resulting in net savings of $8,456. And the benefits only increase as incomes rise.
The key takeaway is that the benefits for business owners in states with a flat tax rate (such as Illinois) are straightforward. The more income your business generates, the greater the savings from making this election. For states with bracketed tax rates (such as Wisconsin), the benefit is not as clear. We will need to analyze the impact of making this election on both your federal and state taxes to determine the best course of action.
The essential benefit of this strategy is that you can now capture your state income tax payment as a business expense to reduce the taxable income on your federal tax return. If you have $1,000,000 in business income you are likely in the 37% marginal tax bracket. If we push a $50,000 tax bill through your business, we can save you between $14,000 and $19,000 on your federal income tax bill.
The SALT cap has been a thorn in taxpayer’s sides for nearly four years. With the passage of these laws in different states, many business owners will now have the ability to work around this cap to deduct their state income taxes against their federal tax liability. The benefit to each individual will depend on your home state, your marital status and your income level. Please reach out to us for help determining if you would benefit from making this election.