It seems like you just got your business taxes handled for 2017, and now you must start worrying about 2018 taxes. That’s because the tax reforms signed into law last December under the Tax Cuts and Jobs Act will most definitely affect your business taxes—and possibly your company’s legal structure as well.
And you might be wondering how to avoid a hit like that in the future. Maybe it’s time to change your business legal structure.
If you’re self-employed and operating as a sole proprietor, I suggest exploring if a change in legal structure might provide some tax relief for your business.
Sole proprietors can rack up an exceptionally hefty tax bill because they’re required to pay self-employment (Social Security/Medicare) taxes in addition to their federal, state, and local income taxes. By transitioning to an S Corporation status, you might reduce your self-employment taxes.
When operating as an S Corporation, you’re allowed to split your profits into two distinct payment types:
- Your salary
- S Corp distributions.
You pay the 15.3 percent Social Security/Medicare tax only on the salary portion of your revenue.
So, if your company made $100,000 in profit and you paid yourself $50,000 in salary and the other $50,000 in distributions, the 15.3 percent self-employment tax would apply to only the first $50,000. Pretty sweet, right?
But don’t get carried away and think you can pay yourself something ridiculous like $5,000 in salary and $95,000 in distribution. The IRS pays attention and will take notice if any shareholder who is employed by the business isn’t receiving a “reasonable compensation” as their salary. Be sure you’re paying yourself the market rate for services you provide to your S Corporation—it’s far better to do it right from the start than to have to explain yourself and risk repercussions later.
When’s the Best Time to Make the Change?
The tax benefits you might receive by changing your business structure will begin upon the date you incorporated. They are not applied retroactively, so the earlier in the year you change your structure the more of your business income will be subject to the advantages.
For instance, if your corporation receives a filing date of May 1, 2018, you’ll still need to file your taxes as a sole proprietor from January 1 up until that date. From May 1 through December 31, 2018, you’ll file your taxes as a corporation for the remainder of the year.
How Will 2018 Tax Reform Affect Your Small Business?
Sole proprietorships are the most common form of business organization in the United States because they are easy to form and offer the owner complete control of the business. Profits are passed through to the owner, and business income and expenses are reported on the individual’s tax return. The same pass-through taxation applies to partnerships, S Corps and Limited Liability Companies (LLCs). But thanks to the new tax laws making some dramatic changes in pass-through taxation rules, we may soon see an increase in the number of C Corps across the nation.
Historically, corporate tax rates have been like individual tax rates and vary depending on profits and income. In 2017, for instance, individual tax rates ranged from 10% to 39.6%, and corporate rates ranged from 15% to 39% (the exception being personal service corporations, which were taxed at 35%). Under the new tax law, however, C Corps will be taxed at a flat rate of 21%—good news for most C Corps.
But for S Corps, LLCs, partnerships and sole proprietorships, paying taxes just got more complicated. Under the new law, these businesses will be taxed at individual rates, minus a deduction of up to 20%. The goal of the new deduction is to lower the tax rate for these businesses—but taking the deduction is not as simple as it sounds.
First, the business owner is entitled to take a deduction equal to 20% of the “qualified business income (QBI)” earned from the business. What counts as QBI? Basically, QBI is income from sales minus expenses (including any salary paid to yourself). QBI does not include interest or dividend income or capital gains from the sale of a property. In other words, a lot of your business income is excluded from QBI, resulting in a smaller deduction.
The deduction is also limited to the lesser of 20% of qualified business income, or 50% of the total W-2 wages paid by the business. (The wage limit does not apply if the taxable income is below $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.)
Finally, certain service businesses and professionals such as doctors, lawyers and tax advisors are excluded from being able to take the 20% deduction.
Becoming a C Corp
To avoid the complexity of the new rules about pass-through taxation, many business owners might be swayed to reorganize and change to C Corp status so they can take advantage of the flat 21% corporate tax rate. While this can potentially be a big savings, it’s important to understand what making the switch involves.
Here are a few pros and cons of forming a C Corp.
- Liability protection: Because the C Corporation is legally an entirely separate entity from the owners and shareholders, owners and shareholders cannot be held responsible for any debts of the company, or lawsuits brought against the company. In other words, your personal assets will not be affected by the actions of the corporation.
- Getting investors: A corporation can sell stock or shares, either common or preferred—and there is no limit to the number of shareholders. If you ever plan to go public, you’ll also need to be structured as a C Corp. This structure also allows you to offer employees a stock option plan.
- Taxes: Because the corporation is a separate entity, the profits and losses of the corporation are retained for the corporation. Unless you or your shareholders receive dividends, you will not be taxed on the company’s income. In addition, many business expenses and employee benefits are tax deductible.
- Perpetual Existence: A corporation can continue to exist indefinitely even if a shareholder or owner leaves, becomes disabled, dies, or sells off the share.
- Higher costs: Corporations pay many state and federal filing fees. Each state also has its own set of regulations that may require paying for expert help.
- Increased paperwork: By law, a corporation is required to file many documents either at inception or annually. These may include articles of incorporation, corporate bylaws, corporate minutes, certificates of good standing, and more.
- Double taxation: Owners of the corporation pay a double tax on the earnings of the company and shareholders must pay taxes on the dividends received.
Making the switch involves forming a new corporation and then transferring ownership, employees, and bank accounts to the new company step by step. In addition, you’ll need to file articles of incorporation with the office of your Secretary of State, draft a series of corporate ordinances, elect corporate directors and officers, and hold annual board meetings.
In many states, you may be able to convert to a C Corp quickly. These are states that permit statutory or streamlined conversions. Check with the Secretary of State’s office in the state where your business is located to find out if yours is a statutory state.
Other Tax Reform Changes
Here are a few more things to know about how tax reform will affect a business’s deductions and credits:
- The Section 199 deduction for qualified domestic property activities (most often claimed by manufacturing firms) is repealed.
- The new law revamps the rules for net operating losses (NOLs). These losses can no longer be carried back for two years. Instead, they can be carried forward indefinitely (instead of for 20 years), up to a limit of 80% of taxable income.
- You can no longer deduct entertainment expenses directly related to or associated with conducting business, such as taking a client out to lunch or to a ball game.
- You can no longer deduct transportation fringe benefits you provide to employees, such as mass transit passes, commuter vehicles and parking passes.
- The deduction for on-site eating facilities, such as cafeterias, will drop from 100% to 50%, and it disappears completely after 2025.
- You’ll be able to deduct 100% of the cost of equipment purchases up to $1 million. This applies to any equipment purchased after September 2017. You can also spread this deduction over 5 years, rather than taking it only in the year the equipment was placed in service.
- The deduction for business interest expenses will be capped at 30% of adjusted taxable income, in most cases. However, if your business has had annual average gross receipts of $25 million or less for the past three years, it’s exempt from this rule.
Beyond the Tax Benefits
Besides the potential tax benefits, changing from a sole proprietorship to an S Corp (or LLC or C Corp) also helps protect your personal assets because your business becomes a separate legal entity. This means your company (and not you personally) is responsible for all its liabilities and debts.
Is A Change in Legal Structure Right for You?
Clearly, the new tax rules are complex. Every business has its own unique financial situation, so there’s no definitive answer whether a change in legal structure will benefit you. To make sure you’re making an informed, educated decision, I recommend consulting with a tax advisor or CPA to discuss your specific circumstances.