The Tax Cuts and Jobs Act expanded business-owning clients’ options for choosing a business entity. Federal Insurance Contributions Act (FICA) taxes, reform’s 20-percent qualified business income (QBI) deduction and tax rate reductions also make the choice more complex.
“The QBI deduction and the business owner’s opportunity to reduce taxable income by up to 20 percent does have a lot of owners evaluating how they’re taxed, especially with the new corporate flat rate of 21 percent,” said Gene Bell, an enrolled agent, CFP and an Avantax Wealth Management advisor in Bellingham, Wash. “The initial confusion of the TCJA due to speculation of how the regulations were going to be implemented was onerous – and in some cases caused [entity] decisions that should have waited.”
“You can no longer make decisions based on the old rule of thumb or just because it’s what everyone else is doing,” said Gary Chan, J.D., CPA and director of tax and estate planning at EP Wealth Advisors. “It’s more important to go through modeling the financial results to see the tax advantages of one entity over another.”
Owners should first answer key questions about the business. “What’s the industry? What types of assets will the business acquire?” said Bill Smith, Bethesda, Md.-based managing director for CBIZ MHM’s national tax office. “How will the owner finance operations? How do they anticipate winding down or liquidating?” Businesses that don’t qualify for the QBI because they’re in a specified service trade or business may find a C corp attractive, or they may need to segregate the SSTB in a C corp and qualifying activities into pass-through entities, he added.
According to Philip Jackson, CPA at L.M. Henderson & Company, Indianapolis, additional questions include: Is the client considering adding others to become owners in the future? Willing to establish an amount of “reasonable compensation” in terms of wages? What type of retirement planning is the client/owner considering?
An LLC can be reported as a single-member LLC, a partnership (if having two or more owners) or as an S corp. A one-person business can typically save on FICA by using an S corp, “because as long as the owner is paid reasonable compensation, which will be subject to FICA, the remaining business profits may be distributed without being subject to FICA,” Smith said.
“Undoubtedly, the self-employment tax is often a deciding factor,” said Diana Teixeira, CPA at DHL&S CPAs & Advisors in Shelton, Conn. “ Self-employment income passed to an owner through an LLC will be subject to self-employment/FICA taxes. Income to an owner via an S corp is not. An LLC is more flexible in terms of allocation of income, losses and distributions.”
Employment taxes’ importance in a decision can be complicated, according to David Stiefel, managing principal with Bader Martin in Seattle. For example, FICA consists of components of both a Social Security tax and a Medicare tax. “There’s a limit to the amount of earned income subject to the Social Security tax, but not the Medicare tax,” Stiefel said.
“Distributions from C corps are subject to double taxation [on entity level profits, and shareholders are taxed again on dividend distributions], which may offset the benefit of the FICA reduction,” Stiefel added. “In an LLC, each member pays self-employment taxes on any member guaranteed payments and an active member’s share of business income. In a partnership, a partner pays self-employment taxes on any partner guaranteed payments and the partner’s share of business income.”
While businesses that intend to go public should be C corporations, not only such businesses should be C corps. “Only C corp stock can qualify for the tax benefits afforded by qualified small business stock,” Stiefel said, “S corps are also limited to 100 owners and cannot include certain types of owners.”