With swarms of tax reform proposals flying around Washington like Harry Potter and his classmates on broomsticks, there are more things to consider when setting up a new company or deciding now to change how your company is taxed.
The Trump goal is to kick start the economy and rebuild the manufacturing sector. Businesses that are manufacturers have substantial sales and so many moving parts that usually they will go with a C Corporation. The Trump proposals are to lower the corporate tax rate from 35% to 15% and to reduce certain corporate deductions. The actual rate will be decided by the tax writing committees of Congress in frenetic negotiations often in the middle of the night after too much coffee and adrenaline, throwing around a billion here, a billion there. .
A 15% rate would be a huge benefit to US Corporations, which are burdened in international competition with the highest corporate tax rate in the world among the largest industrial nations. This makes the total costs of goods produced by US Corporations more expensive in a competitive world market.
There are unintended consequences of a 15% corporate tax rate on pass through entities such as S Corporations and limited liability companies. If you are an owner of a limited liability company that is either a partnership or a single member LLC, all of the profits of the LLC are passed through to your individual return under current law. When you report the profits personally, you could be taxed at a federal and state rate of 45% or higher. If instead, you could be taxed at a 15% rate and leave most of the earnings in the company to pay for future growth with a C Coporration, then the C Corporation all of sudden looks like a better tax choice than an LLC if not at the 15% rate. This is completely contrary to what has been the conventional wisdom for several years. It goes back to a time remembered by a dwindling band of gray haired tax practitioners whose fading memories barely recall when you could save taxes by incorporating a business as a C Corporation.
Why has the C Corporation fallen out of favor as compared to the pass though entities such an S Corporation or LLC for new small businesses? Under the law before Trump tax reform, a C Corporation pays a double tax, often at a combined federal and state rate of 40-45% (depending on the state rate) on profits at the corporate level and then a second tax at a rate of 30 to 45% when the shareholder takes the earnings out of the C Corporation as dividends and not as salary. The flow through S corporation and LLC avoids this double tax and without the double tax, the owners of the S Corporation and LLC, particularly on the sale of the business, end up paying a lot less taxes as compared to what happens with a C Corporation-where 55% or higher of the proceeds from the sale of business go to taxes.
One proposal is that if the rate for C Corporations is 15%, then the rate on business earnings for LLCs and S Corporations would also be at 15%. This would be a big tax cut for small business owners, the main source of new jobs.
But, it also greatly complicates the personal tax return when everyone is screaming for tax simplification. Under this approach, you would have to keep track separately of business profit income that would be taxed at 15% as opposed to personal salaries and investment earnings which would be taxed at a much higher rate. With this approach, business owners would be motivated to reduce their salaries (taxed at 30 to 45%), maybe reducing their contributions to social security, and to increase business profits (taxed at 15%). Also, if you want to cut your personal tax rate, incorporate your country western dance teaching “business” or your cat sitting “business”.
So, what are you to do before we know what the new tax law will be?
Conversion of a C Corporation to an S where you are thinking of selling the business soon will usually still be advantageous. That is because you avoid the double tax on the sale, which can take more than 55% of your profits, if you sold the business more than five years after the effective year you filed your S election.
If you do not plan a sale soon or are starting a new small business, you could start it as an LLC rather than a C Corporation, as is usually done now. But what if it turns out to be better later after tax reform to be a C Corporation? Typically going from an LLC to a C Corporation does not usually trigger a tax. However, going from a C or S Corporation to an LLC can often trigger a tax.
If you have an existing business that is a pass through entity and after Trump tax reform becomes law, and then you decide you want to be a C Corporation, you could make that choice when you know what the new rules are.
As in all tax planning, run the numbers and consult your tax advisors. With tax rules, there are exceptions to the exception to the exceptions, some, all or none of which may apply to you. Contact me for a review of your tax structure and options at firstname.lastname@example.org.