Archives for January 2018

A reader writes in, asking:

“How does the new tax law affect the decision of how a small business should choose to be taxed?”

As a bit of background, for a business with one owner, the three taxation options are:

• Sole proprietorship (or LLC taxed as such),
• C-corporation (or LLC taxed as such), or
• S-corporation (or LLC taxed as such).

And for a business with multiple owners, the taxation options are:

• Partnership (or LLC taxed as such),
• C-corporation (or LLC taxed as such), or
• S-corporation (or LLC taxed as such).

Sole Proprietorship/Partnership Taxation

As before:

• Income from a sole proprietorship or partnership is taxed at normal individual income tax rates, and
• Sole proprietorship income (as well as partnership income if the partner is active in the business) is subject to self-employment tax (i.e., a tax of roughly 15%, to replace the Social Security and Medicare taxes that would be paid by the employee and employer if this were wage income instead).

What’s new is that those individual income tax rates are now, in most cases, lower for a given level of income than they would have been prior to the new law.

In addition, income from such businesses will also qualify for the new deduction for pass-through business income (subject to phaseouts), which makes sole proprietorship/partnership taxation somewhat more advantageous than previously.

C-Corporation Taxation

C-corporations are taxed at their own rate (now a flat rate of 21%, whereas before they had progressive tax brackets like individuals). Then, when they distribute income to shareholders in the form of a dividend, the dividend is taxed at 0%, 15%, or 20% tax rates depending on the taxpayer’s level of taxable income. The dividend may also be subject to the 3.8% tax on net investment income.

Previously, C-corporation tax treatment was not usually advantageous because of this double taxation (i.e., taxation of income at the corporate level, plus taxation of the dividend paid to the shareholders). While the new flat 21% tax rate means that C-corporation income over $50,000 will now be taxed at a lower rate than previously, the overall concept of double taxation still applies. And the net result is that C-corporation tax treatment will still be undesirable for most small business owners.

S-Corporation Taxation

Profit from an S-corporation:

• Is taxed at individual income tax rates,
• Qualifies for the new deduction for pass-through business income (subject to phaseouts), and
• Is not subject to self-employment tax.

In other words, it’s the same as income from a sole proprietorship or partnership, but without self-employment tax.

However, S-corporations are required to pay their owner-employees a “reasonable” level of compensation (i.e., wages/salary) before there can be any profits. And such wages:

• Are taxed at normal income tax rates,
• Are subject to regular payroll taxes (i.e., Social Security and Medicare taxes that are essentially the same thing as paying self-employment tax), and
• Do not qualify as pass-through income for the new deduction.

In other words, the wages themselves are not very tax-efficient. So the savings from S-corporation taxation only kick in once there is enough income from the business to pay a reasonable level of compensation to owner-employees and still have a sizable profit left over.

So, in short, for people whose income level is such that they would be in or below the 24% tax bracket (and therefore unaffected by the phaseouts for the new deduction for pass-through income) sole proprietorship/partnership taxation is now somewhat more appealing relative to S-corporation taxation, because all of the sole proprietorship/partnership income would qualify for the deduction, whereas the wages that the S-corporation would have to pay to the owner-employee(s) would not qualify for the deduction.

Of note, however, is that the opposite conclusion may apply for people in the phaseout range (as well as for non-service business owners who are past the phaseout range). That is, S-corporation taxation may be relatively more advantageous, because it would be advantageous to have the business pay wages to somebody (i.e., the owner-employee), to minimize the impact of the wage-related limit for the deduction.

More than ever, discussing the matter with a qualified tax professional is likely to be advantageous.