The Tax Cuts & Jobs Act Affects Small Businesses
On December 22, 2017, the Tax Cuts & Jobs Act (TCJA) was passed into law, ushering in tax reform that will affect most, if not all, Americans. The changes to the tax code took effect on January 1, 2018. Of all of the provisions contained in the TCJA, one is attracting the attention of small business owners, making them consider whether they should reorganize as a C corporation.
The new reduction of the maximum corporate tax rate from 35 percent to 21 percent only applies to companies that are structured as “C” corporations. However, most small businesses are set up as either “S” corporations or partnerships, referred to as passthrough entities, which have elected to be taxed on their profits at the owner’s personal tax rate. Since the TCJA reduced individual tax rates very little, some small business owners are considering reorganizing as C corporations. The decision will depend on a number of considerations.
The first consideration is that pass-through entities are taxed only once, although at a higher rate under the new tax law, while C corporations can be taxed twice: at the 21 percent rate, and again at the owner’s individual rates if any of the corporation’s profits are paid out to the owners as dividends. If owners are not planning to pull a lot of cash out of a business but intend to reinvest most of the profits back into the company, a C corporation could be considered. Also, C corporations can still deduct all state and local taxes, while individuals are limited to a maximum deduction of $10,000 per year. This can be an important factor for companies that are generating income in multiple jurisdictions. One factor against converting, however, is an impending sale, since a sale will necessarily require a distribution to owners, triggering two levels of taxation.
Another factor to consider is that the law provides a benefit for pass-through businesses that generate less than $315,000 in annual gross income (for a married couple filing jointly). These companies will be shielded from paying the higher personal rate because a deduction of up to 20% of income may apply. There are a number of exceptions to this deduction however, including the fact that it does not apply to income from “professional services” (legal, financial, consulting, tax, and freelance services), so professional service providers may be prime candidates for conversion.
The savings should be more than the conversion expense, so it’s essential to do a full analysis first. Also, note that while the reduction to the corporate tax rate purports to be permanent, any shakeup in Congress (such as a return to control by Democrats) could give rise to further changes or reversions. It would be far more difficult to revert back to an S corporation or partnership once the C corporation conversion is complete. Most entities have to wait 5 years before they can revert to an S corporation election.
Once you decide that converting your S corporation or partnership into a C corporation is the right thing to do, the process can be simple or complicated depending on how you are currently structured. Companies already set up as corporations (with Inc., Incorporated or Corporation in their names) must file a change of status with the IRS, by filing a letter of revocation. The corporation’s employee identification number (EIN), business address, number of corporate shares, and shareholders’ resolution used to approve the revocation should be included in the letter. To be effective on the first day of the corporation’s taxable year, the company should revoke its S corporation election by the fifteenth day of the third month of that tax year—by March 15, 2018 for the current tax year—otherwise the election cannot be effective before the date of filing. Limited liability companies must reorganize completely by filing a plan of conversion (from LLC to a corporation) with their Secretary of State. Many states provide for streamlined or statutory conversions that can be completed easily. However, some states have a more complicated process. Once filed, the revocation or change of tax election would be filed with the IRS.
The Tax Cuts & Jobs Act will certainly have a profound impact on small business owners in many ways. Looking at the tax ramifications of keeping or revoking their pass-through tax status is one that should be analyzed by each business owner.
Business Insights is hosted by the Law Firm of KPPB LAW (www.kppblaw.com).
Sonjui L. Kumar is a founding partner of KPPB LAW, practicing in the area of corporate law and governance.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.
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