With the new tax law, many small business owners are revisiting the question of S-Corporation election. For years, most small businesses have elected to be taxed as an S-corporation, but tax rate changes have many asking if that is still the right choice. So let’s review the big picture of options available.
This is the default without any action by the small business. Although there are some minor tax advantages of being a Sole Proprietor, the negatives usually far out weigh the benefits. You have NO legal protections as a sole proprietor, therefore all of your personal assets are at risk for any business liability. Additionally, sole proprietors are historically 4 times as likely to receive an IRS audit. If you have a substantial business, anything in excess of $100k in revenue, consider an alternative.
The “go-to” for most small businesses, the S-Corporation has three primary benefits. First, you have a separate legal entity for the business, which helps when business creditors are trying to get paid. We aren’t lawyers, so consult one for your situation!
The second benefit is that all income of the business is not subject to self employment tax, as it is in a sole proprietor. Generally, only the salaries taken by the owner’s on a W-2 are subject to the self employment (FICA) tax. Earnings in excess of the W-s wages are only subject to income taxes.
Lastly, an S-Corporation pays no tax itself. The income flows through to the individual owners and taxed there. This eliminates the “double taxation” of a regular C-Corporation. Additionally, the new tax law provides a new 20% deduction against business income from flow through entities. For more information on that topic, read this article.
You must qualify for S-Corporation election, and you must file form 2553 in a timely manner. If you have questions about your situation, schedule a free consultation to see how it might make sense for you.
This is the way all of the “big” corporations are taxed. S-Corporation status is only available to certain small businesses. There are no restrictions on size, however. Even very small corporations can use this structure. Tax deductions for fringe benefits to owner employees are available for C-Corporations, which are not deductible for S-Corporations.
But, there is the double taxation. The corporation pays tax on its income, and then the owner’s pay tax on the distributions (dividends) when they are made. This adds up to a very high effective tax rate in most situations. Even though the new tax law lowered the corporate tax rate to a flat 21%, when you add in even the lowest individual tax rate adds 10% to that, and that is only for taxable income BELOW $19k. A more reasonable rate estimate would be 25%, which gives you a combined rate of 46%. Yikes!
Additionally, C-Corporations do not qualify for the new 20% deduction for Business Income from flow through entities, further increasing the effective tax rate. There are situations where a C-Corporation can make sense in a business’s tax plan, but you need to consider carefully. Schedule a free call to discuss your situation.
Partnerships aren’t used often by small businesses, in part because they are more complex, both legally and from a tax standpoint. That being said, partnerships offer tax benefits that Corporations can’t match. The primary benefit is the ability to allocate losses and income differently than the capital ownership. For corporations, dividends, income, and losses must be allocated by ownership percentage. For single or married owners this usually is not an issue. But more complex situations might desire the ability to allocate more income or losses to one partner or another.
Like an S-Corporation, the Partnership pays no tax itself. The income flows through to the individual partners, where it is taxed at the individual’s tax rate. Again, the partnership income qualifies for the 20% business deduction for pass through entities, which is very valuable to the individual partners.
So Now What?
Every business situation is different, and those situations change. With the new tax law, it is an ideal time to review your small business tax plan, especially your entity choice. Schedule a free phone consultation to discuss your situation.