Q. If you are a sole proprietorship, is it better tax-wise to now become a Corporation or LLC?
— Trying to figure it out
A. This is a very complicated question as tax professionals are still trying to determine exactly what the new tax law means for different kinds of companies.
We expect the IRS will give some clarity in time, but for now, let’s dive in.
The new tax law has a provision that allows a 20 percent deduction of qualified business income to certain pass-through businesses, said Laurie Wolfe, a certified financial planner and certified public accountant with Lassus Wherley in New Providence. The bill also has a provision that lowers the corporate income tax rate permanently to 21 percent for C corporations.
“Given your personal circumstances, either of these could result in a lower tax bill than you currently have,” Wolfe said.
She said the provision that allows the 20 percent deduction has many rules regarding which types of business can take it. There are also exceptions for those types of businesses prohibited from taking it that are tied to income level.
“The rules specifically exclude any trade or business involving the performance of services in the fields of health, consulting, law, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or workers,” she said. “It further excludes someone in the trade or business of performing services as an employee.”
The purpose of this part of the law, she said, is to prevent people from setting up business entities solely for the purpose of avoiding W-2 income and the Social Security taxes that go along with it.
In a late win, architects and engineers were excluded from this provision, with the argument being that their work is more in the line of manufacturing than personal services, she said.
For those businesses excluded, there are exceptions if their income is below a threshold. Those taxpayers with taxable income below $157,000 for singles or below $315,000 for married couples are not prohibited from taking the 20 percent deduction, Wolfe said.
Under the new tax law, sole proprietorships, partnerships, LLC members and S Corporation shareholders who are individuals, trusts or estates are eligible for this deduction, she said.
“Because this deduction covers both sole proprietorships and LLCs, the new provisions themselves were not intended to have different results among these different entity types,” Wolfe said.
Then there are additional limitations to the deduction based on the W-2 wages of the business and the property it owns, she said.
Because S Corporations are the only pass-through entities that pay wages to owners, the calculation of the deduction results in a different amount when this limitation comes into play, she said.
“Because the law was rushed to finalize, there will likely be many such errors of interpretation and hopefully fixes will be made,” she said. “Because of these likely changes, I would not rush to change your current business structure based on the results of this limitation until it is clarified.”
Moving on to C corporations, these are not pass-through entities, meaning their income does not flow through to be taxed at the individual, trust or estate level.
The C Corporation’s tax is calculated on the corporate income and the tax is paid by the corporation, Wolfe said. When dividends are paid out to the shareholders, the shareholders pay tax on those dividends.
“You may have heard of `double taxation.’ This is what that term is referring to,” she said. “The corporation pays tax on its income and the shareholders pay tax on that same income when it is distributed out to them in the form of a dividend.”
This is one of the reasons that S Corporations came into being and why so many businesses migrated to this form of entity. In an S Corporation, the shareholders pay the tax on the income of the corporation and distributions are not taxed, Wolfe said.
Another downside of the C Corporation is that losses are trapped inside the company and can only offset future income of the business, she said, while losses of pass-through entities can, with exceptions, offset the unrelated other income of the individual owner.
So why would anyone want to be a C Corporation in light of the new tax law?
“Well, if you are in a business which is capital intensive and profits are not passed out to shareholders, but rather retained in the business to invest in growing the business, the tax savings due to the lower rate avails the business of more after-tax money with which to invest,” Wolfe said.
The money is growing on a tax-deferred basis, and the anticipation is that the growth the company experiences will make up for the double taxation of any income that is passed out, she said.
Wolfe said there are other reasons that C Corporations can be beneficial. These could include self-employment tax savings and minimizing adjusted gross income at the owner level when compared to pass-throughs. There are many limitations and phase-outs at the individual level that are tied to adjusted gross income, she said.
Given that this is just a very basic conversation of what is a very complicated and everchanging area of business choice of entity, Wolfe recommends business owners seek the advice of a lawyer that specializes in business.
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