Forming a business?

February 6, 2021

The Entire Landscape has Changed Post-TCJA

Especially When It Comes To Business Entity Choices.

Choosing the appropriate type of entity for your business has many factors that should be considered. Tax treatment is one of those considerations, and I have to say, unfortunately there are some business consultants out there doling out the same old advice and assertions that they were using prior to the Tax Cuts and Jobs Act of 2017.

Almost everything in life has a good side and a bad side. The same holds true for business entities. One of the major goals of TCJA was to achieve more parity between the different business structures, see Publication 5318, Tax Reform: What's New for Your Business.

Tax Rates

Corporate (C-Corp) income tax rates were lowered from 35% to 21%. Dividends received by shareholders are still taxed at 20%, plus an additional 3.8% for taxpayers subject to the Net Investment Income Tax (if your income is over $200,000 Single or $250,000 Married).

Sole Proprietors, Partners and S-Corp (Flow-Through Entities) may be eligible for a qualified business income (QBI) deduction – also called Section 199A – for tax years beginning after December 31, 2017. The deduction allows eligible taxpayers to deduct up to 20 percent of their qualified business income (QBI).

It is important to note that the QBI Deduction does not apply to amounts received as reasonable compensation from an S corporation or amounts received as guaranteed payments from a partnership.

Greg Cook, EA, CPA Accredited Tax Advisor desk plate

There is also an Additional Medicare Tax of .9% still in effect that applies to wages (W-2 Income) and self-employment income from either Schedule C or Fm 1065 K-1 Partnership if your income is over $200,000 Single or $250,000 Married.

Distributions from S-Corps are subject to the 3.8% NII Tax mentioned earlier under C-Corps. Also, shareholders of S corporations who work in the business are required to pay themselves reasonable compensation, which is taxable at ordinary income rates. Again, this compensation is not eligible for the QBI Deduction.

Did TCJA achieve the parity it sought? I'm going to provide a real-world comparison of these four different entities and the tax outcomes for the same hypothetical taxpayer under each.

Choice of Entity

What about a Limited Liability Company (LLC)? If there is only one member in the company, the LLC is treated as a "disregarded entity" for tax purposes (unless another tax status is elected), and an individual owner would report the LLC's income or loss on Schedule C of his or her individual tax return.

The default tax status for LLCs with multiple members is as a partnership, which is required to report income and loss on IRS Form 1065. Under partnership tax treatment, each member of the LLC, as is the case for all partners of a partnership, annually receives a Form K-1 reporting the member's distributive share of the LLC's income or loss that is then reported on the member's individual income tax return.

An LLC with either single or multiple members may elect to be taxed as a corporation through the filing of IRS Form 8832. Further, the member(s) can file Form 2553 to Elect to be treated as an S-Corp.
Real World Examples

A Married Taxpayer owns 100% of an LLC that Makes $800,000 Profit in Tax Year 2020

Background: The business has $10 million in sales, Cost of Goods Sold and Operating Expenses of $8.7 million, Employee Payroll (excluding owner) of $500,000, with the business showing a profit of $800,000. The owner is married and pays Health Insurance Premiums of $12,000 for him and his wife.
entity sole proprietorship

Sole Proprietorship

Under this entity, the taxpayer paid Federal Income Tax of $157,896, plus Self-Employment Tax of $38,500, plus Additional Medicare Tax of $4,399, plus Alabama Income Tax of $31,073 and Business Privilege Tax of $100 on his Single Member LLC, for a total of $231,968 in taxes. The owner received a QBI Deduction of $148,790, and received Above-the-line Deductions for One-Half of his Self-Employment Tax of $19,250 and Health Insurance of $12,000.

The Good - Not required to file a Balance Sheet with the Tax Return, accounting for every penny going in and out of the business. Of course that is something that you always want to do, but do you really want to have to do it on your tax return every year? No requirement to track and report Basis. One Tax Return. The simplest form of business. Will draw the highest possible Social Security Benefits in the future.

The Bad - The wife is not covered for Social Security Disability. However, she can draw Social Security Retirement Benefits based on the husband's earnings history and she becomes vested in those benefits after ten years of marriage, even in the case of divorce.
entity partnership

Partnership

Under this entity the husband made the wife a General Partner with 10% ownership, the taxpayer paid Federal Income Tax of $156,613, plus Self-Employment Tax of $47,662, plus Additional Medicare Tax of $4,399, plus Alabama Income Tax of $31,137 and Business Privilege Tax of $100 on his Partnership LLC, for a total of $239,911 in taxes. The owners received a QBI Deduction of $147,874, and received Above-the-line Deductions for One-Half of his Self-Employment Tax of $23,831 and Health Insurance of $12,000.

The Good - The wife now has Social Security Disability Coverage and may draw SS Benefits in the future based on her earnings rather than one-half of the husband's benefits. Note: As this is the only entity structure that requires more than one owner, it therefor creates an "apple & oranges" comparison. Ownership interests of 99% and 1% would bring the taxes down, but serve no apparent business purpose. Ownership interests of 49% and 51% to make the business Woman (Minority) Owned would make the tax outcome way worse.

The Bad - Two Tax Returns Required, 1 for You and 1 for the Business (doubles chance of audit). You must have a partner (requires two or more owners) to be a partnership. Adding the wife as a General Partner requires Self-Employment Taxes to be paid on her income. Adding her as a Limited Partner will avoid the SE Tax, but cause you to pay Net Investment Income Tax on her K-1, her portion of any Section 179 Deductions would be lost, and that percentage of the QBI Deduction would be forfieted. May make the wife personally liable for business risks.
entity s-corp

S-Corp

Under this entity the taxpayer is 100% shareholder and paid himself a reasonable salary of $100,000. The taxpayer paid Federal Income Tax of $169,909, Payroll Taxes on his W-2 of $15,300 ($7,650 Employer & $7,650 Employee portions), Net Investment Income Tax of $20,609 (on his K-1 Distribution of $692,350), plus Alabama Income Tax of $25,519 and Business Privilege Tax of $110 on his S-Corp LLC, for a total of $231,447 in taxes. The owner received a reduced QBI Deduction of $138,470 because it cannot be claimed against his W-2 income.

Although this option is the WINNER by $521, I promise you that the small tax savings will be lost to increased tax filing fees from your preparer due to the Balance Sheet and Basis Tracking & Reporting requirements. Would you give up a third of your future Social Security Benefits to save $500? The taxpayer went from 3 pages attached to his personal return (Sch C, 2 pgs. & Sch SE, 1 pg.) to a 35 page stand-alone Corporate Tax Return. He now files Sch E with his personal taxes to report the K-1. He must also file Form 8960 (instructions are 20 pages, which include 7 pages of worksheet calculations) with his personal return to pay Net Investment Income Tax on the K-1 Distribution.

The Good - Prior to the Net Investment Income Tax (that was introduced in 2013) and the more recent TCJA, many owners tried to pay a less than reasonable salary to themselves to avoid paying Social Security Taxes. There may be a sweet spot if your business is generally expected to show a profit of $137,700 to $249,000, but at the profit level of my example it just doesn't work.

The Bad - The Self-Employment Taxes are replaced with a Net Investment Income Tax on the K-1 Distribution. The Taxpayer will draw one-third less Social Security at retirement and for the balance of his and his wife's lifetime. Two Tax Returns Required, 1 for You and 1 for the Business (doubles chance of audit). Required to file a Balance Sheet with the Tax Return accounting for every penny going in and out of the business. Must track and report Basis in the Company with both Tax Returns. Required to create & maintain Board Meeting Minutes.

Note to Tax Preparers: There is a potential $5,000 Preparer Penalty for preparing an S-Corp Tax Return Fm 1120S where the client does not pay themselves Reasonable Compensation for the services they provided their S Corp.

Note to Taxpayers: When you pay Self-Employment Tax or Social Security Tax, you get something in return for your money. When you pay Net Investment Income Tax, you support Gender Studies in Pakistan (or whatever our government officials decide to spend our tax dollars on).
entity c-corp

C-Corp

Under this entity the taxpayer is 100% shareholder and paid himself a reasonable salary of $100,000. The Corporationr paid Federal Income Tax of $145,171, Alabama Corporate Income Tax of $35,945, and Business Privilege Tax of $1060 on the Corp LLC. After paying out taxes of $182,176, the Corporation paid a Dividend of $509,114. The Taxpayer paid Personal Federal Income Tax of $88,114, Payroll Taxes on his W-2 of $15,300 ($7,650 Employer & $7,650 Employee portions), Net Investment Income Tax of $13,646 (on his Qualified Dividend of $509,114), plus Alabama Income Tax of $24,746, for a total of $323,982 in taxes. The owners received a reduced QBI Deduction of $138,470 because it cannot be claimed against his W-2 income, received no deduction for Health Insurance and no deduction for one-half of his Employment Taxes.

The Good - If the owner's goal is to leave profits in the company for reinvestment and leave the company to his heirs at death, this may have an advantage. I can't count the times a new business owner told me they thought they didn't have to pay tax on businesses profits unless they pulled the profits out of the company. In all 3 of the other entities you will pay income tax whether you pull the profits out or not.

The Bad - Double Taxation (Corporation and Personal). Two Tax Returns Required, 1 for You and 1 for the Business (doubles chance of audit). Required to file a Balance Sheet with the Tax Return accounting for every penny going in and out of the business. No QBI Deduction. The Taxpayer will draw one-third less Social Security at retirement and for the balance of his and his wife's lifetime. The Alabama Business Privilege Tax increased from $100 (Sole Proprietor & Partnership) and $110 (S-Corp) to $1,060 (C-Corp). Required to create & maintain Board Meeting Minutes.
0
Sole Proprietor
Taxes Paid
0
Partnership
Taxes Paid
0
S-Corp
Taxes Paid
0
C-Corp + Pers.
Taxes Paid

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For more important tax information for small to medium size businesses.

Other Considerations

Tax Planning is Never One-Size Fits All!

There are many factors that can have a drastic impact on your outcome when it comes to choice of entity. The first that comes to mind is when there is business real estate involved. As a Sole Proprietor, you cannot charge rent to the business, however, with the other 3 choices where the entity is separate from the individual, that's not the case. But paying rent can wreck the QBI Deduction, cause NII Tax and other problems. And finally, I can tell you that over the course of the last thirty-five years I've known a lot of clients that grumbled about paying into Social Security. But I've had a lot of them thank me later on for encouraging them to do it.
"The various outcomes in my analysis of this hypothetical can change radically with different unique facts and circumstances."
February 6, 2021
Greg Cook
Gregory J. Cook
Gregory J. Cook, EA, CPA
Accredited Tax Advisor