The Tax Cuts and Jobs Act (TCJA) made historic changes to the federal tax code. While all types of business entities have received a significant tax break, some have fared better than others.
Depending on your business, it may be to your advantage to rethink your current business structure. Keep in mind, though, that there are factors to consider other than simply which tax rate is lowest.
Should I change my sole proprietorship or partnership to an LLC or S corporation?
If you currently do business as a sole proprietor or partnership, you may wonder if, in light of the TCJA changes, you should switch to a limited liability company (LLC) or S corporation. Actually, all of these business entities are treated fairly equally under the tax code. Income from any of these entities is passed through to your individual income tax returns. Changing your business structure to an LLC or S corp won’t necessarily affect your tax liability in any meaningful way.
The good news is that owners of pass-through entities can now take a deduction equal to as much as 20 percent of qualified business income (QBI). Personal service businesses—like law firms and medical practices—are subject to limits on QBI, with deductions disappearing once total taxable income hits $415,000. At that point, these business owners lose the benefit of the 20 percent deduction.
Note that there may be other fine reasons to restructure your business as an LLC or S corp. One such reason might be a desire to separate your business assets from your personal assets, in order to protect the latter from creditors. Your tax accountant can help you decide whether this would be the right move for you.
Should I change my pass-through business to a C corp?
If you currently operate your small business as an LLC or S corp—or even as a sole proprietorship or partnership—it makes sense that you would now consider changing it to a C corp. The TCJA dropped the top corporate tax rate for C corps from 35 percent to 21 percent. Meanwhile, the QBI deduction mentioned above reduces the effective tax rate on pass-through income to just 29.6 percent.
Further complicating matters is the fact that the QBI deduction is set to expire in 2025, unless Congress extends it. For now, the corporate tax break remains in place indefinitely.
Easy choice, right? Who wouldn’t prefer the 21 percent tax rate without an expiration date? Well, it’s not quite that simple. Under the TCJA, C corps are still potentially subject to double taxation because they are considered separate legal entities from their shareholders.
Double taxation works like this: corporations pay taxes on their earnings annually, just like individuals do. But when corporations pay out dividends, the shareholders who receive them must pay additional taxes on them even though the earnings have already been taxed once.
In the end, a C corp may or may not be the best structure for your entity. For example, if you’re an owner or part owner of a profitable pass-through entity that holds onto profits to fund future growth and you don’t distribute those profits, then switching to a C corp might make a lot of sense for you.
On the other hand, if your business consistently generates tax losses, there’s no tax advantage to operating as a C corporation. Same for a profitable business that pays out all income to the owners. In these two cases, operating as a pass-through entity generally will be better.
The TCJA offers you some unique choices for your business structure. It pays to consult a qualified tax accountant for advice about making the best decisions for your business.