The Tax Cuts and Jobs Act of 2017 changes the income tax planning for all businesses, including for small business owners. It is now more important than ever for business owners to consult with their tax advisors before setting up new business entities, and to consider restructuring their existing business entities to take advantage of potentially significant tax benefits under the new law.
Prior tax laws favored structuring businesses as pass-through entities, such as limited liability companies and S corporations, to avoid the double layer of taxation faced by a traditional C corporation. Under a pass-through structure, taxes on business profits are not paid directly by the business entity, instead, they are passed through and paid by the business owner based on his or her individual tax rate. In contrast, taxes on business profits of a C corporation are paid both at the business entity level and then again when profits are paid to the business owner as dividends.
WHAT HAS CHANGED?
Two of the biggest changes affecting businesses under the new tax act are:
- the significant reduction in tax rates for C corporations – – from 35% to 21%, and
- a new 20% business income deduction for certain qualified business income from pass-through entities.
Many professional service businesses (such as doctors, lawyers, accountants, and financial advisors) are excluded from receiving the deduction unless the business owner(s) earns less than specific threshold amounts ($157,500 for a single taxpayer, and $315,000 for a joint return). The deduction is also subject to additional wage-based limitations. To further complicate matters, the tax rate reduction for C corporations is a permanent change, whereas the pass-through business deduction is set to expire after 2025 (unless extended). For additional discussion of the deduction, including more details on specifically excluded service businesses, how the deduction is calculated and the wage limitations, see a recent post by my Fox colleagues.
WHO SHOULD CONSIDER USING A C CORPORATION?
Under the new tax act, there are a couple of situations that would likely warrant using or converting to a C corporation:
- businesses that retain significant profits for reinvestment, rather than distributing profits out to its owners; and
- professional service businesses who do not qualify for the 20% pass-through business income deduction and whose owners make more than the income thresholds (at least to assess the possibility of restructuring into separate businesses).
There are also legal and accounting costs to consider and weigh against the potential tax savings. If a current business is structured as an LLC, converting to a C corporation may be as simple as making a new tax election and amending the current organizational documents, or may involve a more complicated process of filing a conversion and creating a new set of corporate organizational documents.
Finally, as with all new tax legislation, there are still a lot of unanswered questions requiring further guidance, particularly as to the calculation and application of the seemingly simple but complex limitations applicable to the 20% pass-through business deduction. Nevertheless, business owners should be consulting with their tax advisors on the best structure or restructure of their business entities.