I'm not a tax expert, so please use my remarks as a research starting point rather than taking them as gospel. Here are a couple of tricks (ok, basic tax techniques for small business owners) as I understand them. I haven't used these personally, just read about them while trying to plan ahead. Please accept any corrections from wise commenters (such as SeattleCPA!).
1. Pass-through income deduction. This is part of the new tax plan that was passed last year. 2018 is the first year it's in effect. It applies to anyone who owns a sole proprietorship, or any other form of business that has "pass through" income - business income that gets treated as personal income. The new tax law allows you to deduct 20% of that income and pay no income tax on it.
2. Declare 40% of remaining income as dividends. I have been told that the IRS allows sole proprietors and LLC owners to classify up to 40% of income as dividends. Dividends get better tax treatment than ordinary income.
3. Solo 401(k) plan. This is the self-employed person's version of a corporate 401(k) plan. It is used if you don't have any employees, the business is just you. If this is your case, maybe you would benefit more than from an SEP. If so, you can contribute $18,500 per year, plus 20% of your taxable self-employment income (I think you first deduct from the self-employment income another 7.65% for self-employment taxes).
Example: sole proprietor, $50,000 of income (meaning, revenues less expenses for 2018 are $50,000 before any deductions or taxes).
1. Use pass-through income deduction. 50,000 x 20% = 10,000 deduction. Income goes down to 40,000.
2. Declare 60% as ordinary income, 40% as dividends. 40,000 x 60% = $24,000 ordinary income. $40,000 x 40% = $16,000 dividends. You pay 15.3% employer/employee payroll tax (FICA, OASDI) on the ordinary income, but zero payroll tax on dividends.
3a. Determine basis for 401(k) calculation. 24,000 x 7.65% = 1836. $24,000-1836 = $22,184 ordinary income less employer portion of payroll tax; basis for 401k calc is 22,184.
3b. 22,184 x 20% = 4,437.
3c. Max 401k contribution = 18,500 + 4,437 = 22,937.
3d. Ordinary business income = 24,000 - 22,937 = 1,063.
I think the result would be something like:
1,063 Ordinary business income
12,700 standard deduction
You don't owe any income tax on ordinary income at all!!!
12,700 - 1,063 = $11,637 amount of dividends sheltered from tax by standard deduction
16,000 -11,637 = $4,363 business dividends subject to tax
Supposing this person also had $400,000 in proceeds from sale of a primary residence, in which the house cost $120,000 but had depreciated $20,000 and had sales expenses of $25,000:
400,000 - (120,000-20,000) - 25,000 = 275,000 capital gains
275,000 -250,000 = $25,000 amount of capital gains subject to tax
(tax code allows deduction of $250,000 capital gains from sale of house that the owner lived in for the majority of the year in 3 of the last 5 years, aka a primary residence)
$04,363 taxable business dividends
$25,000 taxable capital gains
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$29,363 taxable amount subject to the income tax rate for dividends and capital
If I understand correctly, dividends and capital gains up to $37,700 (the point at which low tax rates rise up to high rates in this year's tax code) get a tax rate of 0%. Meaning that our taxpayer would owe income tax of zero!
He/she still owes payroll tax though:
24,000 x 15.3% = $3,672.
Totally curious to see whether this is anywhere close to correct. Experts? SeattleCPA?