Does it pay to be highly successful? From a personal and professional viewpoint, sure. You get satisfaction from helping your clients and customers and achieving milestones, as well as financial rewards. But from a tax viewpoint, success has its downside. Federal tax rules may penalize your efforts. Higher income tax rates aren’t the only things applied to owners who are very profitable. There are additional tax costs, all of which contribute to a significant tax bill. While taxes won’t dampen the drive for success, they do cut into what can be pocketed. Understand how these additional tax costs work.
Added tax costs overview
Owners of pass-through entities—sole proprietorships, partnerships, limited liability companies, S corporations—pay tax on their share of business profits on their personal returns. This means the income tax rate paid on business income can be as high as 37%, depending on net profits, other income, and personal deductions. For 2023, this tax rate applies when taxable income is $578,125 or more for joint filers, $578,100 for heads of households, and $693,750 for singles. Of course, with graduated tax rates, only the amount over the threshold is subject to the top rate; other income is taxed according to the lower tax rates of 10%, 12%, 22%, 24%, 32%, and 35%. The tax rate on long-term capital gains for most individuals is 15%. Some pay no tax; others pay 20%. Owners with long-term capital gains may be pushed into paying 20% on because of their business income. The 20% rate applies in 2023 to joint filers with taxable income of $553,851, $523,051 for heads of households, and $492,301 for singles. Bottom line: When business income that owners must report is added to other personal income, many owners are subjected to the highest rates for ordinary income (e.g., salary; business income) and capital gains.
Additional Medicare taxes
There are 2 Medicare taxes:
- 0.9% tax on earned income exceeding a threshold amount based on filing status (see below). For S corporation shareholders, the tax applies to salary and taxable fringe benefits (W-2 wages). For sole proprietors, partners, and members of limited liability companies, the tax applies to net earnings from self-employment.
- 3.8% net investment income tax on the lesser of net investment income or the amount that modified adjusted gross income (MAGI) exceeds a threshold amount (see below). This applies to income from pass-through entities in which an owner does not materially participate (i.e., is not involved in day-to-day activities).
The threshold amounts for both Medicare taxes are not adjusted annually for inflation. They are:
- $250,000 for joint filers
- $200,000 for singles and heads of households
- $125,000 for married persons filing separately
Bottom line: These extra Medicare taxes add to a tax bill but do not add to your Medicare coverage and are tax not deductible.
Bar to QBI deduction
Owners of pass-through entities may be able to claim a 20% deduction of their net income (with various adjustments). However, the deduction is barred to those with taxable income over a set amount. For example, for 2023, the full deduction applies for an owner who files a joint return and has taxable income of no more than $364,200. The deduction phases out and cannot be claimed once taxable income exceeds $464,200. The threshold for other filers is $182,100, with the end to any deduction when taxable income exceeds $232,100. For those with a specified service trade or business (SSBT), which is business involving the performance of services in the fields of fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business principal asset is the reputation or skill of one or more of its employees or owners, there’s an even greater limitation. Those with taxable income under the start of the phase out, no worries. For those SSBT and taxable income over the threshold, the maximum deduction is reduced according to a formula based on the extent to which the owner’s adjusted gross income exceeds the lower income threshold. This excess is divided by $100,000 for joint filers and $50,000 for all other filers. All these numbers and all these limitations are very confusing. You can see some examples in a Congressional Service Research report. Bottom line: Highly profitable owners of pass-through entities will get little or no QBI deduction.
“A fine is a tax for doing something wrong. A tax is a fine for doing something right.” ~ Anonymous There’s potentially another added tax cost for small business owners with significant income: Audit exposure. Remember when funding was provided last year to hire additional IRS agents, Treasury Secretary Yellen promised audit rates wouldn’t increase for those with income under $400,000? Translation: Audit rates likely will increase for successful entrepreneurs. Be careful. Read more on pass-through entities in earlier blogs here.