If you own a business, chances are good that you put a lot of thought into the type of business entity you originally organized under and haven’t given the whole thing another thought since. But with the passage of the Tax Cuts and Jobs Act last December, business owners are suddenly wondering whether their current set-up is offering them the greatest tax benefits. This is especially true for owners of pass-through entities.
A pass-through entity is a sole proprietor, partnership, S-corporation, farming activity or rental that passes through its income directly to its owners. Small business owners rarely gave consideration to establishing as a C Corporation until now that Congress has lowered the corporate tax rate to a highly attractive 21 percent.
Should You Reconsider Your Business Structure?
Most people’s eyes glaze over when they start hearing the details of tax laws, so we’ll keep it simple, especially since it really comes down to whether you benefit most from being a C-Corp, with its reduced tax rate, or a pass-through.
Whether your business is a sole proprietor, partnership, an S-Corp or any other type of pass-through business activity, 2017’s tax reform means that you can take a 20 percent deduction for qualified business income. However, if you fall under the category of a “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” (referred to in the tax code as a specified services business) that deduction phases out for higher-income taxpayers. Those types of business activities don’t qualify for the deduction once the taxpayer’s taxable income exceeds $415,000 for married couples filing jointly and $210,500 for others. So unless you want to reorganize as a C-Corp, this new benefit leaves higher-income taxpayer’s out in the cold. One way or another the new deduction is only in effect until the end of 2025, unless Congress acts to make it permanent or extend it.
By contrast, any business that is organized as a C-Corp automatically received a huge bonus with the passage of the tax reform act, as the top rate dropped to a new low of 21 percent from its previous high of 35 percent. That might make it appropriate for businesses to consider switching to a corporate structure, especially since, unlike the pass-through deduction, the 21% corporate rate change does not have an expiration date.
If you are one of the overwhelming majority of small businesses that are currently set up as a pass-through entity, you may think that your decision is clear and that you should reorganize. But there’s a good chance that the benefit you would derive isn’t worth the cost or trouble. Every situation is different, and we encourage you to take a deep breath and a closer look before taking action.
Here’s who benefits
To determine whether your pass-through business would derive a benefit from restructuring, start off by assessing your taxable income. As mentioned earlier, if your business activity is a specified service business and your taxable income is too high you won’t benefit from the new pass-through deduction. However, businesses that are not specified service businesses can still qualify a taxpayer for the pass-through deduction even for high-income taxpayers based upon the wages paid by the business activity and the qualified assets the activity is using during the year.
Thus depending upon whether or not the business activity qualifies for the pass-through deduction and how much, liability and other issues then a restructure to a C-Corp might make sense for you, especially if you tend to hold onto the money in the business. If you automatically turn your money around and spend it, then remaining a pass-through entity makes more sense.
Other considerations
If you’re still not sure as to whether restructuring works to your advantage, it’s a good idea to sit down and figure out roughly what you’d save by switching. After you do that, consider what the costs would be. If you’re going to spend as much or more on your accountant and lawyers’ fees as you’d save with the switch, then it’s probably not worth it. By the same token, if the cost of reregistering with the state and paying these professionals a one-time fee for switching over (plus the increased annual costs of tax reporting for a corporation) pales in comparison to what you’d be saving, then it makes sense to make the change.
One other thing to think about, and that’s whether your business has any risk of being sued. If you’re organized in a way that leaves you open to liability, then you should use this opportunity to make a switch and protect your assets.
If you’re still not sure, you may want to wait until the IRS and Treasury Department weigh in with their guidance. There’s always a chance that they’re going to make their own revisions to what Congress has passed.
Sonu Shukla, CPA writes for CountingWorks, an accounting news and advice website. Reach his office at [email protected].
About Sonu Shukla, CPA, CFP
Sonu Shukla is a Certified Public Accountant as well as Certified Financial Planner. He believes in proactive tax planning and has the skills, education and experience to demonstrate passionately planned financial strategies. His firm tailors highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out. Located in Orlando, FL, he services all of Florida.
