Probably the most asked question right now when it comes to tax planning is “What business structure should I have?”
The answer might not be so simple, after the sweeping changes from the 2017 Tax Cuts and Job Act, put in place starting 1/1/2018. This is also known as the Trump Tax Plan.
When it comes to business structures, there are generally two decisions the business owner and his or her tax strategist need to make
#1 What is the best entity or entities?
#2 Where should the entity (entities) be formed?
In today’s blog, we’re going to focus on the first question. But please don’t just assume you know the answer for #2. Nexus rules have gotten more complicated. WHERE you form your business structure is just as important as what type of business structure you should have.
The right business structure has become more complicated now due to the Trump Tax Plan.
If you have a business, one of your biggest taxes could very well be self-employment tax. That’s 15.3% of your income that is subject to self-employment tax. One of the easiest ways to avoid that tax is to have a corporate structure (either S or C).
For most businesses, then, it comes down to a question of an S Corporation (or LLC electing to be taxed as an S Corporation, LLC-S) or a C Corporation (or LLC electing to be taxed as a C Corporation, LLC-C).
The S Corp has ease of use and a possible Section 199A, 20% income deduction. The C Corp has a flat rate of 21% possible and even more importantly, if you’ve set it up right, you can sell the company down the road and pay ZERO taxes. Yep, you read that right. NO taxes.
There are 5 critical factors to consider before you decide what type of business structure you need:
- What will be your estimated profit from this company?
- What is your exit strategy from this company?
- Do you need (or want) an aggressive employee benefits plan that covers owners as well as employees?
- How much personal income do you need from the business entity? Do you plan to invest the excess and if so, what in? Growing the business or other ventures?
- And finally, the big one. Will the Sec 199A deduction be available for your business? That opens up a whole other can of worms, all of which have to be determined based on your personal tax level.
This is actually the single biggest mistake I see with tax planning right now, post Trump Tax Plan. Decision making is still done primarily at the business level, but when it comes to taxes, the Trump Tax Plan created a brand new dynamic.
Tax planning HAS to come from the owners up to the business level. If you ask me what is the best structure, I’m going to ask about the owners and their personal tax situation. What is his or her personal taxable income? Do they have other similar business and real estate ventures? Will the business create passive income streams for one or more of the owners? If so what kind and how much? Will the new business be a “specified service trade or business” under the new definition?
If your personal taxable income is over the income threshold, there are some additional hurdles to go through. If you have a specified service trade or business (according to the IRS definitions), then you also need to look at a second income threshold.
Here are the numbers:
First income threshold: $315K if you’re married, filing jointly and $157.5K if you file with any other status.
The second income threshold (only applicable for service companies) is $415K if you’re married, filing jointly and $207.5K for everything else.
For service businesses, if your taxable income (this is the TOTAL taxable income) is over the second threshold, you can’t take advantage of the 20% income deduction.
Between the two thresholds, the amount you can deduct phases out and is subject to the wage limitation rules. Those are 50% of W-2 wages paid or 25% of W-2 wages and 2.5% of qualified depreciable property.
For service businesses, it’s become more desirable to use C Corporations. Again, though, you need the right circumstances. For example, if you make over the second income threshold and you use every penny you make to live on, it won’t work. The C Corp works if you’re paying off business debt or stockpiling cash for growth, safety net or other purposes. But if you want to just pull it right back out, there is no point.
The C Corp has a flat rate of 21% and at the $415K married, filing joint level, your tax rate is 35% with no 20% income deduction possible. Living below your means can mean a BIG tax savings! (The difference of 14% applied to $400,000 is $56,000 in tax savings.)
If your income is below the income threshold, you’re usually better off, at least tax wise, with the flow through entity, an S Corp. That way you get the 20% income deduction. However, if you want to maximize employee benefits and you and your family are the only employees, the C Corp may provide better savings.
There is a lot to consider these days when you’re selecting the right business structure. One of the critical items is whether the Sec 199A deduction is available for your business. Make sure you understand the intricacies of the deduction. It takes 2 modules to cover this in our Business Coaching. There is that much nuance!