I’ve written about how the Tax Cuts and Jobs Act (now known as PL117-95) is going to change the way we think about businesses and income. (Here’s one link– there are about 15 such posts.)  Today, we’ll talk about how this new tax law changes the sort of business entity we maintain.

For years, most financial advisors recommended that their clients set up LLC’s (partnerships or S-type entities) instead of the C corporations we used to recommend. (Of course, except for Wyoming, they didn’t exist until the 1990’s.) OK. I realize some of you have no idea of what I speak.

Folks with side businesses (some of which grow into full-time pursuits) normally operate as sole proprietorships. These folks report their income and expenses on Schedule C of their 1040. And, they are obligated to pay employment taxes (Social Security and Medicare) on their net profits (15.3%) , which would be reported on Schedule SE. And, starting this year, through 2026, 20% of their net profits will NOT be subjected to income taxes- if their adjusted gross income is less than $ 315K ($157,500 if single). (There are more wrinkles, but you should check my blog out to find  all the other conditions. I’m just trying to compare entities today!)

More sophisticated businesses or individuals or folks who have partners would form an LLC (limited liability corporations) or partnership. (A partnership would also be formed when two or more individuals operate a side business- or a full-time pursuit.) These folks report their income and expenses on Form 1065, a separate form from the 1040 for personal income taxes. Such entities may pay salaries or wages to employees- but NOT to the partners who are owners in the firm. These folks receive their profits as “flow-throughs”; the net profit is taxable to them as individuals (via the business K-1 and reported on Schedule E, page 2 of the 1040 personal tax return). And, that profit is also subject to employment taxes (15.3%). Like the sole proprietorships, these folks also have that 20% pass-through tax holiday, if their income is below the limits ($157,500 for single taxpayers, $ 315K for marrieds- or $157,500 each, if they are filing separately).Some LLC’s have filed various forms notifying the IRS that they wish to operate as corporations and be taxed as S entities. Other firms incorporate and notify the IRS they wish to operate as S entities. S used to stand for “small”, but many large firms operate under the S configuration. These firms pay all staff- AND owners- salaries (and those shareholders must be earning “reasonable compensation” [look that up in my index, if you don’t know of what I speak]). Their revenue and expenses are reported on Form 1120S and the net profits are apportioned among the stockholders (reported on the business K-1) and are taxed as part of Schedule E for the taxpayer. Like the LLC’s above, these folks get 20% of their profits tax-free, if their income is under the limits stipulated above.Finally, many firms develop C (or regular) corporations. These businesses do not pass through any income or tax-free dividends to the stockholders. Instead, the businesses are taxed as separate entities and any transfer of cash or benefits to the stockholders arrives in the form of taxable dividends. As of 2018, the tax rates for corporations have changed. Net profits will be taxed at 21% (no more 15% tax rate for those with smaller (almost non-existent) profits).

Now that we got those preliminaries out of the way, let’s consider why there may be new questions we must answer to choose among entities. We’ll consider four separate scenarios. (Even though I’ll be using a single taxpayer example, you can basically double the numbers for married couples filing together and get the same results.  And, as long as I’m saying this- even if you NEVER considered it before, you now MUST consider the Married, Filing Separately [MFS] status, because this 20% pass-through credit has income limitations- and filing separately may be the way to not lose the benefit for some higher-income couples.)

Scenario 1: Business nets $ 25000 (not including any salary or self-employment taxes)
Scenario 2: Business nets $ 75000 (not including any salary or self-employment taxes)
Scenario 3: Business nets $ 157,499 (to keep the $ 157,500 threshold on the other side and not including any salary or self-employment taxes)
Scenario 4: Business nets $ 314,999 (not including any salary or self-employment taxes)
Scenario 5: Professional Business nets $ 314,999 (not including any salary or self-employment taxes)

What we see from the above chart is that S entities generally provide the best net compensation schemes for the taxpayer. However, our scenarios have not included state taxes, because each state is different.  More importantly, there are jurisdictions like Washington, DC, New Hampshire, and Tennessee that tax S entities on their net income (and then tax the individuals for the pass-through income; in essence the businesses are taxed as if they are C corporations, with pass-through dividends to the shareholders ). Which clearly would affect our decisions as to the type of entity (and, if we can, where we wish to form our business that) we wish to employ for our businesses.

Moreover, as the income from the business increases, the difference between partnerships, proprietorships, and S entities tends to disappear- at least as it applies to net revenue passing through to the taxpayer/shareholder.

(Now, I will also tell you that we have developed a set of scenarios that works to reduce taxes for these businesses (making $ 100,000 or more).  As opposed to sharing these concepts publicly, we only share the concepts with our clients who have two (or more) year contracts with our firm.)

No matter what- remember that changing one’s business type must be effected no later than 15 March to have the IRS approve that change for the entire calendar year.

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