The Tax Cuts and Jobs Act (TCJA) provided for some significant changes for business taxpayers. Among them, the TCJA introduced a flat 21% federal income tax rate for C corporations, which under prior law, profitable C corporations paid up to 35%. Such substantial changes has many businesses rethinking their entity type.
In addition, the TCJA also cut individual income tax rates, which applies to pass-through entities and sole proprietorships, including LLCs (treated as partnerships for tax purposes), partnerships, and S corporations. However, there was not much of a top rate drop for these going from 39.6% to only 37%.
So, what’s the optimal entity choice for your business? Here are some considerations before talking with your tax advisor.
Tax Basics for Entities
Prior to the new TCJA laws, most small businesses were set up as sole proprietorships or pass-through entities to avoid the double taxation of C corporations. C corporations pay entity-level income tax and the shareholders pay tax on the dividends, as well as on capital gains when they sell the stock. Pass-through entities do not pay federal income tax at the entity level.
C corporations are still potentially subject to double taxation, however, the lower current 21% tax rate helps make up for it. But it’s not that simple and is further complicated by another tax provision that allows noncorporate owners of pass-through entities to take a deduction equal to as much as 20% of qualified business income (QBI), subject to various limits. That deduction, however, is available only through 2025, unless Congress extends it.
Other Factors to Consider
Deciding on the best entity choice for your business depends on many factors. Remember the TCJA is somewhat temporary, unless Congress decides otherwise, so one form of doing business might be more appropriate at one time (for instance when you’re starting a business), and another form might be better after you’ve been in business for a few years. Here are some examples:
- If a business consistently generates losses, there’s no tax advantage to being a C corporation. C corporation losses can’t be deducted by their owners. In this case, you would be better off as a pass-through entity because losses would pass through to the owners’ personal tax returns.
- If you are a profitable business that pays out all income to the owners, operating as a pass-through entity would most likely be better if significant QBI deductions are available. If not, there’s probably not a clear entity-choice answer in terms of tax liability.
- If you are a business that’s profitable but holds on to its profits to fund future projects, operating as a C corporation would be most likely be beneficial if the corporation is a qualified small business (QSB). This is because a 100% gain exclusion may be available for QSB stock sale gains. But, even if QSB status isn’t available, C corporation status is still probably be the best choice — unless significant QBI deductions would be available at the owner level.
Remember that taxes are only one factor. There are many others that will make a difference too.
For example, one frequently noted advantage of some entities is that they allow a business to be treated as an entity separate from the owner. I.e., properly structuring a corporation can protect you from business debts. While this structure type may seem beneficial, there is extra work you will need to do to ensure that the corporation is treated as a separate entity. Your state will have some additional requirements, such as filing articles of incorporation, electing a board of directors, adopting by-laws, holding organizational meetings, and keeping minutes.
The Best Long-Term Choice
The TCJA has extensive effects on businesses. Choosing your business entity type is certainly easier when starting up a business. Changing your type of entity can be a bit more complicated. Either way, it’s important you contact us to as to the best way to set up your business with the least amount of tax impact for years to come. We can help you consider the pros and cons of the various types and plan for success.