The Tax Cuts and Jobs Act (TCJA) passed in December 2017 made significant changes to the income tax laws for 2018 and beyond. The new legislation introduced some major adjustments to business tax law, including a lower corporate tax rate, new rules for pass-through businesses, and a tax break for some industries. Many of these changes will have an impact on your 2018 small business taxes, so it is crucial that you calculate your business income correctly and take advantage of all the deductions available.
As these laws and regulations continue to be implemented in 2019, many small business owners may need to adjust and adapt to the changes. If you are self-employed and operating as a sole proprietor, this could mean considering whether or not a change in legal structure might provide some tax benefits for your small business.
A Major Deduction for Pass-Through and Corporate Entities
One of the biggest changes in tax laws affecting businesses is a significant deduction for both pass-through and corporate entities. Pass-through businesses include those structured as sole proprietorships, partnerships, S corporations, and limited liability companies. Pass-throughs comprise nearly 95 percent of U.S. businesses, all of which can now deduct 20 percent of qualified business income in calculating their federal taxes.
It is important to note that the law limits the deduction for certain service businesses. Owners of businesses such as legal, medical, or accounting practices begin to get a reduced deduction if their taxable income surpasses $315,000 for joint filers or $157,500 for single filers. Owners of service businesses with taxable income in excess of $415,000 for joint filers or $207,500 for single filers are not entitled to a deduction.
The new legislation also lowers the tax rate for C corporations from 35 to 21 percent. This change is designed to encourage companies to remain in or return to the U.S., employ workers, and generate wealth.
With the dramatic drop in the corporate tax rate and the introduction of the new qualified business income deduction for pass-through entities, more and more business owners are weighing the pros and cons of changing their legal structure to take advantage of the tax break.
Changing from a Sole Proprietor to a C Corporation
A sole proprietorship is an unincorporated business owned by a single individual. The most common structure for small businesses, it offers owners complete managerial control and entitles them to all profits. Sole proprietors are required to pay self-employment (Social Security/Medicare) taxes in addition to their federal, state, and local income taxes, which can add up at tax time. In addition, because there is no legal separation between you and your business, you can be held personally liable for the debts, losses, and obligations of the business, as well as liabilities resulting from employee actions.
A C corporation is an independent legal entity. Owners only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. Any additional profits are taxed at a corporate rate, which is usually lower than a personal income tax rate.
Changing your small business from a sole proprietorship to a C corporation will allow you to take advantage of the 21 percent corporate rate, as well as give you the benefit of personal liability protection. However, keep in mind that corporations are highly regulated by federal, state, and, in some cases, local agencies, requiring extensive recordkeeping, accounting, and tax preparation. Incorporating also makes your small business subject to other corporate tax rules, such as the accumulated earnings tax that keeps a corporation from retaining too much income.
Switching from S to C Corporation Status
S corporations are an attractive option for some small businesses. This structure provides owners with the liability protection of a C corporation, and only the wages of the S corporation shareholder who is an employee are subject to employment tax. An owner of an S corporation who wants to take advantage of the new corporate tax rate can choose to revoke its status and become a C corporation. This requires a shareholder vote with at least a 50 percent buy-in.
The change is effective on the date specified in a notice that is sent to the IRS. If no date is provided, the revocation is effective as of the first of the year of the notice if received by the IRS on or before the 15th day of the 3rd month of the corporation’s tax year. For example, if a calendar-year S corporation filed a revocation in September 2018 with no specified date, it was effective January 1, 2019.
Keep in mind that the tax benefits you might receive by changing your business structure will begin on the date the change is effective. They are not applied retroactively, so the earlier in the year you change your structure the more of your business income will be subject to the advantages.
Every business has its own unique financial situation and there are many factors that come into play, so there is no black-and-white answer as to whether or not a change in legal structure will benefit you. To ensure that you make an informed decision that’s right for your small business, consult with a tax professional or licensed CPA for guidance relative to your specific circumstances.
In light of the new tax legislation, it is more important than ever that small business owners stay up to date with the rules and regulations. Working with a tax professional will help ensure that you take full advantage of the deductions available and, just as importantly, meet your payment obligations.
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Summit does not provide tax, legal, or accounting advice. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.