How the Tax Reform Law Impacts Your Business Entity Selection
May 8, 2018
The Tax Cuts and Jobs Act of 2017 Dramatically Changed How Businesses Approach Tax Planning, Including Business Entity Selection
The Tax Cuts and Jobs Act of 2017 dramatically changed how businesses approach tax planning, including business entity selection. Businesses large and small, including publicly traded funds like KKR, are rethinking entity selection to address the impact of the new law.
Business owners should evaluate whether it is now advantageous to reconsider their existing business structure in light of the new law. In addition, entrepreneurs looking to launch a new business should keep in mind that, while the types of entities have not changed, the “old” advice for entity selection may no longer hold true.
Businesses can be organized in several different legal structures: corporations, partnerships, limited liability companies, and sole proprietorships – and a host of variations within those options. Each type of entity has its own advantages and disadvantages, which must be carefully taken into consideration when forming a new business. Existing entities should also periodically review their existing structure to verify that it still makes the most sense.
The sole proprietorship is the simplest legal structure, and there are no formal rules to follow. The downside is that the business and the owner are one and the same. Therefore, the owner is responsible for all of the obligations, including debts and liabilities, of the business. In addition, any business income or losses are reflected on the owner’s personal tax return. Given the potential liability, a sole proprietorship is not recommended for businesses involved in risky activities.
A partnership is very similar to a sole proprietorship, with the exception that it has more than one owner (partners). Similarly, the partners pay taxes on their shares of the business income using their personal tax returns. It is important to note that in a general partnership, each partner is personally liable for all of the business debts and claims, not just their share. Limited partnerships offer some additional protection in that only the general partner is liable for partnership obligations, and the limited partners are shielded from such liability.
Limited Liability Corporations
The limited liability company or LLC falls between a partnership and a corporation in terms of complexity. It has advantages over a partnership because it provides limited liability for business owners. This means that LLCs limit personal liability for business debts and court judgments against the business and shield an owner’s personal assets.
In addition, LLCs also offer flexibility. Owners of an LLC can also choose how the entity will be taxed. For instance, they can elect to be taxed like a partnership, in which the owners pay taxes on their shares of the business income using their personal tax returns, or like a corporation, in which the tax obligations of the business are generally separate from the owners.
LLCs must typically register with the state, file annual reports, and observe other business formalities. However, unlike corporations, they are not required to hold regular meetings of the board of directors and to keep written meeting minutes.
A disregarded entity LLC or an S-corp is often preferred by sole business owners, or businesses anticipating heavy early losses.
Corporations come in several forms. S-corporations (s-corps) are more like LLCs, in which taxes “pass through” to individual business owners. In a C-corporation, the tax obligations of the corporation’s business are distinct, and owners of corporations pay taxes only on profits that they actually receive in the form of salaries, bonuses, and dividends.
Corporations are more complex than LLCs with respect to both taxes and legal formalities. As noted above, income is subject to double taxation. Corporations are also required to adopt bylaws, formally define the roles of officers and directors, and keep detailed records. As a result, they can be costlier to operate.
C-corps are often preferred by venture capital investors, foreign investors and those with an expectation of significant retained earnings.
Changes Under Tax Reform Law
For many businesses, the key considerations when selecting a legal structure are personal liability protection and taxation. The Tax Cuts and Jobs Act maintains the key tax difference between traditional corporations (which are often subject to double taxation) and pass-through entities like S-corps and LLCs; however, it significantly reduced the corporate tax rate and created a new deduction for pass-through tax entities. The new tax law reduced the C-corp tax rate to 21 percent, reduced the top individual rate to 37 percent, which can make C-corps more advantageous than before. It also gives qualifying business owners a 20 percent deduction on their share of pass-through income, which offsets this somewhat for pass through entities like LLCs and partnerships.
The above changes make the analysis that accompanies entity selection more complex. While the lowered tax rate for C-corps is certainly attractive, it is generally only really beneficial in certain situations, such as if the company retains or reinvests a large majority of its income.
Finally, it is also important to keep in mind that the corporate tax rate is intended to be permanent, as written. Meanwhile, the new deduction for pass-through entities is scheduled sunset in 2026.
Key Takeaways for Businesses
As highlighted above, the tax reform law dramatically shifted the legal landscape. Thankfully, the business structure you chose on day one is not set in stone.
Of course, since every business is unique, it is best to go over your options under the new tax law with an experienced corporate tax attorney. To discuss your options, contact Scarinci Hollenbeck today.
If you have any questions regarding the changes, please contact us
If you have any questions or if you would like to discuss the matter further, please contact me, Jeffrey Cassin, or the Scarinci Hollenbeck attorney with whom you work at 201-806-3364.
Jeffrey K. Cassin will be speaking at a Meadowlands Chamber of Commerce event on Tuesday, May 15th, wherein he will discuss the matter of business entity selection under the new tax law changes. You can learn more about the event by clicking “Reconsidering Business Entity Selection In Light of Tax Law Changes”.