Are You Using The Best Business Entity Structure? This May Have Changed Post-TCJA
The Tax Cuts and Jobs Act (TCJA) will take effect in tax years 2018 and beyond. This act has lowered tax rates for both C corporations and individual income. The most significant cuts are for C corporations. Rates for C corporations have been moved to a flat 21%, as opposed to paying up to 35% previously.
The drops in income tax rates have not been as significant: top rates have moved from 39.9% to 37%. This decrease includes sole proprietorships and pass-through entities, including partnerships, S corporations, and, generally, limited liability companies (LLCs).
The drop in rates for C corporations may lead you to believe that becoming a C corporation is always the best choice. However, simply observing rates does not guarantee the best financial outcome.
Before the TCJA most small businesses avoided being set up as C corporations because C corporations are subject to double taxation. They are required to pay entity-level income tax, and shareholders also pay tax on dividends and capital gains when they sell stock.
While double taxation is still a factor in setting a business up as a C corporation, the 21% tax rate often offsets the cost enough to create overall savings. The TCJA also includes a provision that allows noncorporate owners of pass-through entities to take a deduction equal to as much as 20% of qualified business income. However, this deduction is only guaranteed in 2025 and will end unless extended by Congress.
Deciding on how to structure your business will depend on several factors. Listed below are three common scenarios that will lead to different entity choices.
- Retention of profits to finance growth:
Usually, a profitable business that invests profits into future growth will benefit by operating as a C corporation. For qualified small businesses (QSB) a 100% gain exclusion may be available for stock sale profits. Unless qualified business income deductions are more valuable, even non-QSB businesses should generally classify as C corporations.
- Distribution of profits to owners:
Operating as a pass-through entity will probably be best for a business that distributes all profits to the owners if significant qualified business income deductions are available. Otherwise, which set-up is used probably won’t create a major difference in terms of tax liability.
- Business that generates tax losses:
A business that usually creates losses should probably operate as a pass-through entity. Pass through entities allow losses to pass through to the owners’ personal tax returns. Operating as a C corporation will not be useful as losses cannot be deducted by owners.
If you have any questions or would like help choosing between a C company or pass-through entity, we can help you. We can be contacted at 949-860-9902 or click here, and we will contact you.