Following the enactment of the Tax Cuts and Jobs Act, many businesses are wrestling with whether to change their company structure.
The issue is whether to shift to a C corporation, which pays business taxes, or to remain a pass-through company, which pays taxes through the owners’ individual returns.
Although taxes are not the only concern when choosing a company structure, they can be a deciding factor. The new tax bill cut the maximum corporate tax rate to 21 percent, down from a top rate of 35 percent.
But most small businesses don’t qualify for that reduced rate. That’s because pass-through entities, which include LLCs, sole proprietorships and S corporations, are taxed at the owner’s personal rate. And while personal tax rates also dropped, they can still be as high as 37 percent.
But the math isn’t that simple. Many pass-through firms are eligible to deduct 20 percent of their income, effectively reducing their top rate, although the deduction phases out for service businesses and others generating more than $157,500 in individual income.
Immediate tax savings are not the only numbers that should factor into calculations. Owners should also consider how soon they expect to sell. Pass-through entities offer tax advantages at the time of sale, while gains from the sale of a C corporation may be subject to both corporate and individual taxes.
If you do switch from an S corp to a C corp, you’ll have to wait five years to switch back again. Then, for five years after you return to an S-corp, gains tied to the C-corp’s assets will be taxed twice upon a sale.
The new law gives some businesses tax breaks, but the calculations aren’t simple. Deductions available to some businesses are not available to others. Other factors such as dividends, losses and estate planning may also impact your decision. There’s no one size fits all answer. Consult an attorney and accountant to review the new tax rules and the specifics of your business operation.