LLC vs. Corporation Post Tax Reform: New Calculus

When you are ready to form your new small business, you probably have reviewed with your small business attorney various entity choices. The small business attorney likely discussed possible legal entities such as corporations, partnerships and limited liability companies (LLCs).

          Related articles:

Forming a New Business: Corporations vs LLCs
Traps for the Unwary: LLC Taxed as S Corp 

Which entity is the best form for your business depends on many variables such as structure, liability, management as well as tax considerations. You have likely heard that there was a big change to the United States tax code starting in 2018 under the Tax Cuts and Jobs Act. Many of the tax reform provisions affect small businesses. In this article, we discuss how these changes may affect the calculus in deciding which legal form your want to choose for your startup business.

Small businesses generally would organize as passthrough entities such as S corporations to avoid a high corporate tax rate and double taxation under the old regime. For example, in most cases, a startup would form as an LLC and then decide whether to be taxed as a partnership or as a S corporation.

          Related article: Starting a LLC: Tax as a Corporation or Partnership 

The drastic reduction in the corporate tax rate introduced by the recently enacted tax reform from 35 % to 21 % may require small business owners to evaluate whether their entity form remains the most beneficial. And some may even consider whether to structure their businesses as C corporations. Small business owners should think about the following considerations and discuss them with their small business attorney and tax adviser.

Tax rates have changed

C corporation’s income is now taxed at a flat 21% rate. Previously, corporations were subject to tax at graduated rates of up to 35%. Whereas any entity with a pass-through status, income flowing through an individual partner is subject to tax at a maximum 37% rate.

State and local taxes deduction

The new tax law caps the state and local tax deduction (known as the SALT deduction) at $10,000. And that assumes that the taxpayer itemizes deductions. In the meantime, C corporations can fully deduct state and local taxes.

Qualified Business Income 20% deduction

The tax rate for small business pass-through entities used to be the same as your individual tax rate. The recent change in tax law introduced a new 20% deduction for qualified business income (the “20 % QBI deduction”) earned by flow-through businesses to reduce the tax liabilities of the members.

This 20% QBI deduction only applies to QBI, which is defined as domestic, net business income. QBI does not include certain types of income such as wages, guaranteed payments, certain investment income and income from certain service-based businesses.

Those are just a few, but not the only limitations placed on business owners in allowing them the QBI deduction to be claimed. However, provided that certain tests are met, the 20% deduction can lower the effective tax rate owners of small businesses pay from a high of 40% (assuming the highest federal rate plus depending on whether the 3.8 % tax on net investment income applies) to a low of 29.6% which is still higher than the C corporation’s 21 % tax rate.

The inevitable? double taxation

C corporations are, of course, subject to two levels of taxation—one at the corporate level on earnings and one at the shareholder level, for instance, on dividends paid out to shareholders.
If your dividends are qualified they will be taxed at a rate of 0%, 15%, or 20%, depending on the adjusted gross income of the taxpayer. If your dividends aren’t qualified, they will be taxed at your marginal tax rate, according to the 2018 tax brackets.

The calculation can significantly change if the business does not issue any dividends. For example, there may not be much to distribute after payment of salaries to the owners and other employees. Or possibly you have decided to reinvest the profits in the business, and simply not make any distributions. If you do not anticipate that your business will make distributions to its owners, then a C corporation structure may result in significant income tax savings.

Crunch the numbers

In light of these and other considerations, some entities may consider converting into another form. As the factors above make clear, there is not a “one size fits all” answer to the choice of entity decision analysis in the wake of tax reform. Speak to your small business attorney and your tax adviser to review and discuss the specifics of your situation.