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If you are self-employed or work as a freelancer, the tax changes proposed by the Trump administration this week may have a big impact on how you opt to pay yourself — and whether or not you want to take the step of incorporating your business.
If legislation is passed in accordance with this sweeping tax reform proposal — forged by the White House and Republican leadership — the top rate for federal corporate taxes would drop dramatically, as CNBC reports:
The framework … calls for lowering the corporate rate from 35 to 20 percent. It would also bring down the rate for so-called pass-through businesses to 25 percent; currently, they are taxed under the individual code.
For freelancers and most people who are self-employed, what is important is the pass-through rate.
A huge potential tax benefit
The key to the proposed tax changes for freelancers and other self-employed people lies in how “pass-through” income is dealt with as it moves from a partnership, S-corp (the simplest kind of corporation you can form) or a limited liability company (LLC) to the individual or individuals who own the partnership or company.
President Donald Trump’s tax plan would set a top rate of 35 percent on personal income. However, owners of partnerships, S-corps and LLCs could benefit from the much lower 25 percent rate on pass-through business income.
That rate would only apply to money paid as profits from the business, not as a salary. Strictly speaking, companies are supposed to pay the people who work for them before distributing “profits” to owners. So if you are the owner of the company and work for it, there is an expectation that you’ll pay yourself a “reasonable” wage — which will be taxed at the normal, and potentially higher, personal income tax rate.
But once you’ve paid yourself that “reasonable” salary, remaining income could qualify for the lower pass-through rate.
Example under the proposed rules: Say you’re the sole owner of an LLC, which in turn owns a website with profits of $500,000 per year. You could choose to pay yourself an annual salary of $100,000, which would be taxed at your normal rate. You’d also be subject to Social Security taxes, Medicare and unemployment taxes on that income. However, the remaining $400,000 of profit would be taxed at 25 percent, with no additional employment taxes.
If you’re in the 35 percent tax bracket, paying 25 percent on your $400,000 profit rather than 35 percent would save you $40,000.
The tax reform devil is in the details
Incorporating or forming a pass-through business to lower your tax burden sounds great, but the reality is a little more complex. According to an analysis by the Tax Policy Center — a joint venture of the Urban Institute and Brookings Institution — the big challenge will lie in how the government determines what is allowed as pass-through income.
The report further suggested that so many self-employed people might set up these pass-through entities that it could force the government to consider a much stricter way of vetting them. In a report that came out early this year, the Tax Policy Center warned:
Current-law rules are difficult to enforce, leading to significant avoidance of payroll taxes; with the much larger rate differential under the revised Trump plan, avoidance would be much more prevalent.
In April, U.S. Treasury Secretary Steve Mnuchin said that the administration would deal with this issue by putting rules in place so wealthy people can’t create pass-throughs “and use that as a mechanism to avoid paying the tax rate that they should be on the personal side.”
At that time, Mnuchin also responded to a direct question about how new provisions would apply to freelance or contract workers as follows:
As it relates to the definition of contractors and things along those lines, those will be the details we will be working with Congress on as we turn this into a bill that will get signed by the president.
Trump’s tax reform plan might change
One other important caveat is that this remains a proposal from the president — it is not yet law. The plan will have to jump over significant legislative hurdles before it gets back to him to be signed into law. In the meantime, it might be worth reviewing other reasons to incorporate. If some form of the president’s plan makes it into law, you might have an extra reason to incorporate soon.
Stacy Johnson contributed to this post.