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  • The Tax Cuts and Jobs Act of 2017 changed the tax code in many different areas, and the business tax code did not escape the changes. In fact, businesses of all entity types actually gained from this new law. So, with these changes, should business owners start to look at changing their business structure so that they can pay less in taxes?

    Business Structures

    To understand the new tax laws, you need to know at least a working knowledge of business entities. For federal tax purposes, there are essentially four main business structures that most businesses fall into. There are a sole proprietor, partnership, S Corp and a C Corp. Sure, there are others, but most will fit this definition. These businesses, with the exception of the C Corp, are called pass-through entities. This means that the income earned from the business goes directly on the owners’ tax return and not tax at a business rate. Only the C Corp pays tax at a corporate rate.

    A sole proprietor is a single person business that reports their income on the Schedule C. A partnership requires a separate return and they file a 1065 return. That return pays no taxes, but a K1 form is issued to all partners, and the partners report that income on their personal income tax return. Same thing with a S Corp, except they use Form 1120S, but they will also issue a K1. Finally, a C Corp is taxed as a separate entity, and they file Form 1120.

    What about LLCs? Most people get mixed up with LLCs, as they are not a federal tax structure, but a state one. LLCs are basically a level of legal protection for a business. An LLC can be elected to be taxed as any of the above business structures if they qualify.

    Changes to the New Tax Law

    Since the three pass-through entities do not actually pay taxes themselves, there is no change to the tax rate to those business structures. However, there is a 20% deduction of income for owners of pass-through entities, which is a very large change. So, if your business income for 2018 was $50,000, you will get a deduction of your income in the amount of $10,000. Now, you will only be taxed on $40,000 of income. At an effective tax rate of 15%, that will save you $1,500 in income tax alone, not counting any self-employment taxes.

    For C Corp business structures, the tax rate dropped significantly, from 35% to 21% flat. On that same $50,000 in income, you would save $7,000 in taxes right off the bat. Does that mean you should switch immediately? Maybe. It certainly is something that you should start to look at, especially when you start making anything over $25,000 in a year. While the savings certainly is possible, in a C Corp, you also have to pay tax on money paid to you as a dividend or in the form of a paycheck. While it will work out in your favor as your income creeps higher, you need to figure out all the costs first and find a good threshold for your situation. Every taxpayer’s situation is different, so there is no universal answer here.

    While it is not always the answer you want to hear, this is a very loaded question, and every situation is truly different. Us accountants say this all the time, and for the most case, it is true. However, in this case, it is imperative that you seek professional advice, as this is something that you do not want to go at it alone. A good accountant can save you tens of thousands of dollars over the life of your business if it is structured properly, so trying to save money here is not a good idea. Contact us for a consultation to see if switching your business entity makes sense for your business.