If you are a sole proprietor or an informal partnership, you might be asking yourself “how do I best take advantage of the 2018 tax cut?” Forming a business entity like an LLC or an S or C Corporation can give your business protection from lawsuits and in many situations prove beneficial in reducing your tax liability.
Many accountants and lawyers will take a one-size-fits-all approach and advise all their clients to form an LLC, or an S Corporation. But the 2018 tax law resets all thinking on entity formation.
First let’s look at the big changes:
- C Corps tax rate reduced to 21% from 35%
- Sole props, LLCs, partnerships and S Corps all get a 20% tax cut.
- Services businesses (accountants like us and others) are capped at $156k and 315k on the tax cut. Everybody else is uncapped!
Before we delve more into the tax law, let’s revisit some of the advantages of incorporating (LLC, S or C Corp):
- Pay less self employment tax as S Corp or C Corp.
- Get protection from lawsuits as corporation is an entity separate from yourself.
- C Corps are best entity if your business is in expansion mode and you don’t plan to distribute dividends to yourself. The tax cut makes this even more attractive.
Your business is unique, and the decision of which one to choose should be based on a variety of factors specific to your situation. Let’s get into some of the most common entities.
The Limited Liability Company (LLC) is a popular choice for many reasons. An LLC gets the protection of liability like a corporation, but has flexible tax statuses: single member LLC can be sole props or even elect to be S corps/C corps just ask multiple member LLCs can be partnership or make the S or c election. Unless your are a sole prop LLC, the LLC itself is not taxed, and all of the profits and losses are passed through to the individual owners. With the new Tax Cuts and Jobs Act of 2017, most LLCs now qualify for a 20% business tax deduction on Qualified Business Income. That can result in huge savings. Another major benefit of an LLC is that appreciated assets can be distributed to individual owners without triggering a capital gains tax, making it the preferred entity choice for real estate companies. But there are also major drawbacks to the LLC. All of the business income is subject to self-employment taxes that fund Social Security and Medicare, and selling the business can result in higher taxes for certain assets held within the business.
The S Corporation (S Corp) is another popular candidate, made even more attractive with the new 20% deduction mentioned above. The S Corp is a corporation under state law, but it is taxed like an LLC under Subchapter S of the tax code, meaning that income and losses are passed through to the individual owners. The S Corp also has favorite capital gains treatment when the shares are sold, but distributions are not taxed like dividends in a C Corporation. However, the S Corp is not available to many businesses because there are restrictions on the number and type of owners, and the corporation can only have one class of stock.
The C Corporation (C Corp) is what most large businesses choose. It is the only entity that has a special entity tax, which results in “double taxation.” The income of the C Corp is first taxed at the entity level, and then it taxed again as a dividend when distributed to the owners. The double taxation is what turns many people off to the C Corp, but with the new 21% corporate tax rate, it is once again an entity that many businesses should consider. C Corporations have benefits that the pass-through entities do not. One of those benefits is that certain employee fringe benefits are only available to C Corporations. Another one is the tax-free reorganization potential when merging with other corporations. There is also a huge potential capital gains savings with a C Corp for smaller companies that sell after five years.
This blog is for information only and is not intended to be relied upon for any specific legal advice. Washington Tax Services does not provide legal advice or legal services. Attorneys on staff at Washington Tax Services are engaged solely as tax professionals and do not represent clients on legal matters.