Should You Consider a Change in Business Entity?
The new tax law makes major changes to the taxation of businesses. Owners should reconsider their choice of entity based on the new deduction for pass through entities and the 21% C corporation tax rate.
Let’s assume you own an S corporation – a true S corporation – not a limited liability company (LLC) that has elected S corporation status. You’ll see why I am making that assumption in a few paragraphs. LLC’s have some additional options.
As an S corporation owner, you can choose to keep your S corporation status or revoke the status and become a C corporation. Why might you want to revoke your S election? C corporations now have a 21% corporate tax rate as well as dividends that are taxed at 15% or 20% for its owners. If your combined tax rate for your company as a C corporation is less than the personal tax rate you pay on your S corporation profits, you should revoke your S corporation status.
Evaluating the math on this isn’t as simple as it first appears. Adding the 21% to the 15% C corporation rates gives you what looks like a 36% tax rate, which is lower than the 37% top individual tax rate under the new tax law. However, the math isn’t this easy for a couple of reasons.
First, depending on your personal income, you might pay 20% on the C corporation dividends not 15%. Also, depending on your income, you may pay an additional 3.8% Medicare surcharge on your personal tax return for the dividends.
Second, adding up the C corporation rates doesn’t reflect the true impact of the double taxation. Below is an example of a company with $100K net profit, showing how the taxes work as a C corporation versus an S corporation.
You might think the C corporation rate would be 43.8%, but it’s actually not that far from the highest personal tax rate. The main assumption in this example is that the owner is paying federal taxes at the highest rates. Another assumption is that the business is eligible for the pass through tax deduction. You have to do the math with real tax rates for the owners to make the right decision.
Given my caveat about running real numbers, I am mostly finding that keeping the S corporation status works almost all of the time.
If you own an LLC with multiple owners, that is treated as an S corporation for tax purposes, you can not only choose to be a C corporation, but you can also choose to be treated as a partnership. The tax treatment as a partnership is similar to S corporation treatment, but slightly different. Guaranteed partner payments are treated the same as S corporation owner salaries for the purposes of the new pass through tax deduction.
I am finding that remaining an S corporation is generally the right course in this situation as partnership treatment means paying self-employment tax (Social Security and Medicare) on all profits, while S corporations only pay Social Security and Medicare on owner salaries. Again, you have to run the numbers to know for sure.
Finally, if you are the sole owner of an LLC treated as an S corporation, you can choose to be treated as a sole proprietor for tax purposes. This means you no longer file a separate tax return for the business. This choice becomes really interesting, and I’m not finding clear answers. Here’s an example of an analysis examining the choice to become a sole proprietor for tax purposes.
This example shows that the S corporation still works for this owner. However, as the profit of the company changes, so does the math. Once the profit gets significantly over the Social Security earnings cap, becoming a sole proprietor becomes more attractive, particularly if the S corporation owner is taking a salary in excess of the Social Security cap. This happens because the new 20% deduction applies to all of the sole proprietor’s income, but only to the profit after salary for the S corporation.
Does that mean taking a lower salary makes the 20% deduction more valuable for an S corporation owner? Yes it does. So why take a salary at all? The IRS gets an opinion here, and there are a couple of other factors to consider in addition.
First, the IRS requires that S corporation owners take fair salaries relative to what they could make as non-owner employees. Yes, you can exercise some judgment here, but the IRS looks at the fair salary issue in every S corporation audit. As I noted in a prior post, pigs get fat and hogs get slaughtered. Lower your salary with great caution.
Second, lowering your salary reduces your Social Security credits. If you are within 10 years or so of retirement, lowering your salary could reduce your eventual Social Security benefits.
Finally, pension contributions for S corporation owners are normally a percentage of owner salaries. Reduce your salary and you reduce your maximum pension contribution.
The math works on reducing the salary of an S corporation owner for income tax purposes, but balance that against the other three factors. Again, please run real numbers to determine if switching to sole proprietorship status from an S corporation is the right course for you.
As you can see, there are no clear answers when you reconsider the best entity type for your business. That’s good – at least for me – and it is all about me 😊. E-mail me and I’ll send you information on where you can send your contribution to my yacht down payment. The new tax bill confirms the benefit of bribing your Congressman.
If you have any questions, please contact me at firstname.lastname@example.org or call (703)818-8284.
Thanks for reading!
Frank Stitely, CPA, CVA