We partnered with CPA-turned-blogger Caleb Newquist to get his take on the tax topics that seriously affect small businesses. Have a question for Caleb? Tell us about it here.
For a time, choosing an entity type was a snap for business owners. Your lawyer or accountant would consider a few facts, ask a couple questions, and the choice usually came down to one of two pass-through entities: an S corporation (S corp) or a limited liability company (LLC).
The owner or owners would choose one or the other, file the necessary paperwork, and that would likely be the end of it. Setting up your business as a C corporation was hardly ever considered, if at all.
With the passage of the Tax Cuts and Jobs Act (TCJA) last December, entity choice has suddenly become a challenging exercise for new and established companies. Businesses that have long existed as pass-throughs cannot ignore the allure of the new 21 percent corporate tax rate.
This post will unpack the top things business owners should consider about their entity formation under the new tax law.
The entity types that will benefit the most from the new tax law.
The TCJA has something to like for virtually every business type. Rather than go through every single form, we’ll narrow it down to two main groups: 1) pass-through entities; 2) C corporations (C corps).
Quick refresher: “pass-through” refers to all kinds of partnership types (general, limited, limited liability are the most common), LLCs, and S corps. The TCJA is great for pass-throughs primarily because of the new 20 percent deduction on qualified business income. Reminder: the deduction is temporary. It will expire in 2025 unless another law is passed to extend it.
This one is easy. The top rate on C corps plunged from 35 percent to 21 percent. Every time you hear a screech of tires, it’s probably a business owner rushing to their accountant’s office to find out if they should change their entity type to a C corp.
Unlike the 20 percent deduction for pass-throughs, this change to the corporate rate is permanent. That means the top rate will remain at 21 percent until Congress changes it.
Does it make sense to restructure?
This is the crux of the biscuit, as Zappa used to say. And like the meaning of that phrase, there are no clear answers. Unless, of course, you’re a mega, multinational corporation that is taxed as a C corp. In which case, it makes absolutely no sense to change your structure. In fact, you can stop reading here.
But 90 percent of businesses in the U.S. are small businesses organized as pass-throughs, and that means the decision is far from cut and dry. There are lots of questions you have to answer before considering whether to change your entity type and even then, it might not be a clear choice.
Which entity types will benefit from a restructure?
All right already, to make some actual sense of when you should change your entity type, here are a few crucial questions to ask yourself:
How much does your business make?
If your business is organized as a pass-through and your taxable income is above the 20 percent deduction threshold of $157,500/$315,000 (single and married filing jointly, respectively) and blows through the phase-out of $50,000/$100,000, then you might benefit from changing your business to a C corp.
What kind of business is it?
As we mentioned here, certain service businesses such as law and accounting firms, or “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners,” are ineligible for the 20 percent deduction. If this is you, then it might be advantageous to become a C corp.
What are you going to do with the money?
In this almost-too-witty New York Times overview of tax plan hacks, NYU Law Professor Lily Batchelder sums it up nicely: “If you’re wanting to save a lot of money, you might want to become a C-corp, and if you want to spend it right away, you would want to be a pass-through.”
What she’s saying is that because shareholders (i.e., owners) who receive dividends from a C corp must pay taxes on those dividends, there’s an incentive to keep the income in the corporation where the profits will be only taxed at the 21 percent rate. This helps avoid what’s known as “double taxation” and is the chief reason why most businesses did not organize as C corps before the TCJA.
Pass-through entities, on the other hand, do not pay tax on their profits. The profits “pass through” to their owners and are taxed at the individual level regardless of whether they are paid out. This way, owners don’t have to worry about another layer of tax when the profits are distributed.
What other factors should you consider?
Considering the items above along with other circumstances is important. What are those circumstances? Here are a few examples:
How much will changing your entity save you?
$500 per year? $500,000 per year? You’ll want to know, otherwise, what’s the point? All the tax acrobatics don’t make a shred of sense unless it results in a boost to your business’s bottom line.
How much will it cost to change your business’s entity type?
There will be costs associated with this change. You’ll have to re-register with the state where your business is based, and there may be additional fees—both one-time and annual—for the entity type you choose.
Oh, and do you plan to do all this work yourself? Accountants and attorneys don’t work for free, and they are counting on their clients to come knocking about just these sorts of questions. You must consider all these associated costs as well as the savings to learn where it leaves you. If you crunch all the numbers and changing your business’s entity type will save you $1,000 a year, is it worth all of the trouble?
Do you have any liability exposure?
If your entity type does not provide you limited liability, do yourself a favor and reorganize pronto.
What’s the IRS saying about all this?
As with any changes in the tax law, the Treasury Department and Internal Revenue Service (IRS) will share its interpretive guidance on how businesses should apply the law. So whatever people—including the experts—think they know, it can all change after the powers that be chime in.
So, should you change your entity type? It depends!
The TCJA has turned selecting an entity type into a business edition of Choose Your Own Adventure. You might be missing out if you don’t explore your options, but you’ll want a tax professional by your side to help you consider all the possibilities—and avoid any pitfalls along the way.
Want to learn even more about the tax reform? Check out this live recording where two tax experts break it down.
This article provides general information and shouldn’t be construed as tax advice. Since tax rules may change over time and can vary by location and industry, it’s always best to consult a CPA or tax advisor for advice specific to your business.