Is your current entity type the best option for your company when it comes to reducing its tax exposure? Many businesses are missing out on potential ways to reduce their business' tax footprint because of their current entity type.
Most business owners do not think about their business type once it's set up because they have more pressing matters to deal with related to their business' operations. Quite often a lack of awareness of the tax benefits that different entity types provide is the biggest reason why owners are reluctant to make a change. Every business type comes with its own positives and negatives when it comes to its tax exposure, so it's important to find the one that fits your company the best and periodically review its effect on your tax rate.
Since the Tax Cuts and Jobs Act went into effect, the biggest tax reform in American history, it's more important than ever to re-examine your company's entity type and be aware of the complexities and drawbacks that each present.
A lot of tax code changes have taken place over the last few years, one of which is President Trump's decision to cut the corporate tax rate from 35% to 21%. This tax code change is the largest percentage point reduction of the top marginal rate in history! While Congress was reworking the tax code, it realized that many small businesses operating as pass-through entities would be subjected to higher federal income tax rates compared with the new 21% corporate income tax rate. To account for this, Congress provided a 20% deduction for pass-through entities known as the Qualified Business Income Deduction (QBI). This deduction provides significant tax savings for those operating as S Corporations, Partnerships (LLCs), Sole Proprietorships and owners of rental real estate.
The QBI deduction for pass-through entities in conjunction with the reduction of the corporate tax rate to a flat 21% makes the pass-through entity an enticing option for many small- to medium-sized businesses. Pass-through entities, such as sole proprietorships, partnerships and S corporations, historically have provided a way to avoid the double taxation that C corporations are subject to at the dividend and entity levels. Pass-through entity types are taxed only once, at an individual tax rate, but it can be as high as a 37% rate. Thankfully, if the entity qualifies for the full 20% QBI deduction their effective tax rate is closer to 30%. The QBI deduction is currently scheduled to end in 2025, but obviously this can change as the political winds shift, so it's a good idea to keep your own business' circumstances in mind and adjust accordingly.
It's hard to know which entity type will result in the lowest tax burden without also looking at your business' operations, the possible impact an owner's exit strategy may cause, and any number of unique circumstances that are specific to your business. Depending on the size of the company and how it's structured, these additional factors can be just as important.
•Mark Gallegos, CPA, MST, is a senior tax manager at Porte Brown LLC headquartered in Elk Grove Village