The recent passage of the sweeping tax overhaul has left many businesses and entrepreneurs trying to figure out how the changes will affect them. Specifically, the Tax Cuts and Jobs Act approved by congress late last year has them wondering whether they should structure their business as a C Corp or a pass-through entity.
What the Tax Cuts and Jobs Act Does
The new tax cuts and jobs act introduces a flat 21% federal income tax for C Corps for tax years beginning in 2018. The previous rate was up to 35%. Pass-through entities receive a 20% tax deduction. Although these are substantial breaks, there are some things you need to know about both before deciding.
Highlights of the Pass-Through Deduction
As is usually the case with tax bill changes, there are advantages and disadvantages of being a pass-through business. For taxable years beginning January 1, 2018 and before January 1, 2026, you can generally deduct 20% of your qualified business income from a pass-through entity such as a partnership, sole proprietorship or S Corp.
Having said this, there are also limits, with deductions phasing out at $157,500 for single taxpayers and $315,000 for couples filing jointly. The biggest impact, though, is on the QBI, or qualified business income. Here are some key points on QBI and how it relates to S corps:
- It excludes investment-related income or loss such as interest and dividend income or capital gains or losses.
- It excludes whatever payment is made to the taxpayer as reasonable compensation for their services.
- It excludes certain service businesses, such as accounting, engineering, health, law, and financial services, etc., where the principal asset of the business is the reputation or skill of one or more of its employees.
- It excludes any amount paid to an individual by the S Corp that is treated as reasonable compensation for services provided.
While some see the answer as shifting payments from wages to income to increase QBI and, thus, increase the amount of the 20% deduction, the IRS has seen this technique before. And it does not look kindly on people paying themselves less than the going rate for services they provide to a pass-through.
Highlights of the C Corp Deduction
At first glance, a 14% reduction in the tax rate seems reason enough to structure a business as a C Corp. But while 21% is attractive, there remains the specter of double taxation at the business and dividend levels. If an entrepreneur intends to take the bulk of profits out of the business instead of reinvesting them, a C Corp doesn’t offer much of an advantage. When is setting up as a C Corp a good idea? If your business regularly sees a profit, but you sock all the money away to fund future growth strategies.
The Bottom Line
It’s a tricky decision. One of the key advantages of forming a corporation in any scenario is your ability to minimize personal liability. That is unaffected by the new tax cuts and jobs act bill. So, focusing solely on the new tax laws isn’t helpful, as which way to go will depend on your business’ specific needs and practices.
There are many factors you’ll need to consider and they’re all highly dependent on your company’s individual circumstances. Contact us at 702-870-7999 to get in touch with your accountant to learn more about how these changes will affect your business in 2018 and beyond.