Here’s what you need to know about the significant changes taking place in 2013 Taxes law.
The fiscal cliff deal had two major results: First, it raised taxes on virtually everyone that earns money; second, it failed to fix the underlying budget deficit problem, leading to further “cliff-like” standoffs in the near future. Both of these results will have a direct, financial impact on business owners. While much has been written about the deal, some important details haven’t been covered that will significantly reduce the after-tax income of small-business owners. Let’s take a closer look at the key changes to the tax code and how they affect various small-business owners.
Understanding How Uncle Sam Understands Income
When talking about taxes, “earnings” and “income” are commonly used, but what exactly do these terms mean? With so many definitions and formulas, it’s difficult to keep track. For tax purposes, what we really care about is the amount of taxable income, and that’s usually what “earnings” and “income” mean when they’re used. Simply put, the IRS considers taxable income to be the money you took in during the year, minus certain reductions, deductions and personal exemptions. Two individuals could have the exact same amount of taxable income, but how they arrived at that amount could be very different. “Adjustable gross income,” which is an intermediate calculation between gross income and taxable income, is also used as a base to calculate some taxes.
2013 Tax Changes That Affect Business Owners
Self-employment tax. Self-employed (SE) business owners, like employees, enjoyed a temporary reduction on their self-employment tax, which expired in 2012. The SE tax, which is really two taxes, returns to 12.4 percent of income up to a threshold amount for Social Security and 2.9 percent of all income for Medicare. The threshold amount for Social Security has not been announced but is expected to be between $107,000 and $110,000.
Additional Medicare tax. This taxes 0.9 percent of self-employment income above a threshold amount of $250,000 for married filers and $200,000 for single filers.
Unearned income Medicare contribution. This tax increase was enacted as part of the Affordable Care Act, not as part of the fiscal cliff solution. It goes into effect in 2013 and taxes 3.8 percent of investment income, subject to certain thresholds and limitations. Money you earn from your business is not considered investment income. The threshold for this tax is $200,000 for single filers and $250,000 for joint filers. The 3.8 percent tax applies to the lesser of your total investment income or your adjusted gross income over the threshold. This means if you earn below the thresholds, you won’t have to pay this tax.
Income taxes. Rates for individuals earning over $400,000 and couples earning more than $450,000 have increased. For every dollar earned over these amounts, 39.6 cents in federal income taxes will be due.
Personal exemption. This exemption reduces your taxable income by $3,900 for every member of your household. A couple with two children could reduce their taxable income by $3,900 x 4 = $15,600. In 2013, this personal exemption will start to phase out for couples with an adjusted gross income of $300,000 (and reach zero for couples earning above $422,500) and single filers with an adjusted gross income of $250,000 (and reach zero for earnings above $372,500). By phasing out this exemption, people earning above the thresholds will have a larger base from which they must calculate income taxes.
Pease provision. This is an extremely complex provision that puts a cap on deductions for tax filers with adjusted gross incomes above $300,000 (if filing jointly) and $250,000 for single filers. The formula used is complicated and has many variables. The net result will be thousands of dollars in additional income tax for people subject to Pease.
