Do you understand how your business is organized as an entity and how that affects the amount you pay in taxes? Do you know how the new tax code passed into law at the end of 2017 changed the way your entity is taxed? You may have organized your business structure in one way originally, but are you certain that this is still the most effective structure for your business?
A Quick Overview of Corporate Entities
First, a quick recap of the most common types of business entities:
- A sole proprietorship is owned and run by one natural person, and there’s no legal distinction between the owner and the business entity.
- A partnership is an association of two or more persons to carry on a business and can take different forms (like limited or general partnerships). A partnership passes income and losses to the individual partners who are responsible for reporting that information on their tax returns.
- A Limited Liability Company (LLC) is a business entity that offers the option, depending on the number of owners, to be taxed as a proprietorship, a partnership, an S corporation, or a C corporation.
- An S Corporation is a corporation that pays no corporate-level tax on its profits. Instead, it passes most items of income or loss to shareholders who are responsible for reporting that information and paying tax on that income on their tax returns.
- A C corporation is what most people think of when it comes to “corporation.” A C corporation pays corporate taxes to the IRS. Shareholders also pay tax at their individual income tax rates for dividends or other distributions from the company, which is why they are considered to be “double taxed.”
Each of these types of corporate entities is affected in different ways by the tax code, and the new tax code has added some fresh wrinkles to the job of figuring out which corporate entity structure is best for your business. Below are just two of many examples:
The new Tax Cuts and Jobs Act and Corporate Entities
The new Tax Cuts and Jobs Act of 2017 created a new playing field for what corporate entity you might choose. In general, the basic tax difference between C Corporations (which subject earnings to “double taxation”) and pass-through entities such as S Corps and Sole Proprietorships (that “pass-through” earnings to a person or persons to be taxed once) remain the same. However, some of the changes enacted into law will require a much closer analysis of the impact of this basic difference in your specific business. This is why it’s a good idea to delve back into your corporate entity in 2018.
Though there are many smaller changes in the new tax law, the fundamental ones are the dramatic reduction in the corporate tax rate and the addition of a new, complex deduction for pass-through tax entities. To add another level to this complexity: the corporate tax rate is considered “permanent,” meaning there is no automatic sunset for this provision, in contrast to the new deduction for pass-through entities, which is scheduled to phase out in 2026.
Corporate Tax and C Corps
Under the previous tax law, corporations were taxed at a graduated rate which reached a maximum of 35%. Investment income, such as long-term capital gains and most dividends from U.S. corporations, were taxed at separate rates, with the top rate being 20%. In most situations, avoiding the corporate tax and structuring the business as a pass-through entity would usually result in a lower overall tax.
However, the new Tax Act replaces the previous graduated corporate tax rates with a flat rate of 21% and slightly reduces the individual rates so that the top marginal rate is now 37%. It keeps the same rates for investment income such as dividends. Based on this change, the effective rate for passing income through a traditional corporation and on to its owner as a dividend drops, making the choice between a traditional corporation and a pass-through entity much closer, especially given some of the other changes under the new Tax Act, such as the elimination of the exemptions and most itemized deductions for individuals and the effective elimination of those deductions that remain for many because of the increased standard deduction.
Pass-Through Entities and the QBI Deduction
In consideration of how this dramatic reduction in corporate tax rates could have a negative impact on “pass-through” entities in the new Tax Act, there is a special deduction for “qualified business income.” The QBI deduction is 20% of the income earned by the owners of pass-through entities, so their effective tax rate drops from 37% to 29.6% and thereby keeps approximately the same rate differential between traditional corporations and pass-through entities as under old law. However, calculating QBI and how it can benefit your business can be complicated, especially given phase-outs of the deduction and safe harbors from those phase-outs, and what types of businesses do and do not qualify for it, and so on.
You need a partner to assist you with corporate entity planning. You need a plan that works for your particular business and your situation. Financial Gravity can help you determine a strategy that will maximize your benefits under the new tax rules. Speak with a Financial Gravity team member: Let’s Talk!