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January 26, 2018

The Tax Cuts Jobs Act: Should You Change Your Business Entity Structure?

Q&A – A Few Highlights On What the Tax Cuts and Jobs Act Means for Your Business

By:  Alexander Kelly, Esquire

President Trump signed The Tax Cuts and Jobs Act of 2017 (“Tax Reform Act”) into law on December 22, 2017, a little less than two months after it was first introduced in the House of Representatives. It is the largest overhaul of the United States Tax Code since 1986 and has massive implications for individuals, business, and policy. Many businesses are asking what it means for them and whether or not they should change their entity structure. This Q&A highlights a few of the most common questions businesses have been asking. The Tax Reform Act and the implications for businesses depend greatly case-by-case, so be sure to consult with a qualified attorney before making any decisions for your business.

Q:        I have read that the Tax Reform Act is a net tax cut for pass-through entities, is that true?

            A:        Yes and no. According to the Congressional Budget Office (CBO), over the next ten years, pass-through entities and individuals can expect to see $1.125 trillion in net benefits compared to only $320 billion for C-Corporations. However, the law makes the corporate benefits permanent while individual and pass-through benefits reduce over time becoming net tax increases beginning in 2027. You should consider how long you intend to be pulling money from your entity before selecting which structure you want to use.

            Q:        I’ve been counseled in the past that taxes should drive which business structure I choose, is that still the case?

            A:        In the past, that advice would have generally been correct as the prior tax structure imposed a “penalty” on C-Corporation distributions. By way of example, in the past, the maximum effective tax rate of a C-Corporation was 48%, a whopping 10% higher than the highest rate for an LLC. Now, that penalty gap has been essentially closed meaning that you and your attorney should be focused more on your business plan than the potential tax liabilities when determining the best structure. Below see an illustrative comparison of the old tax law implications and the new tax structure, assuming the top tax rate:

Old Tax Law                                                                                                                             

Entity Type LLC (or other pass through entity) C-Corporation
Income $100,000 $100,000
Entity Tax Rate 39.6% or $39,600 35% or $35,000
Distribution Tax 0% or $0 20% or 13,000
Received After Tax $60,400 $52,000
Effective Rate 39.6% 48%

New Tax Law 

Entity Type LLC (or other pass through entity) C-Corporation
Income $100,000 $100,000
Entity Tax Rate 37% or $37,000 21% or $21,000
Distribution Tax 0% or $0 20% or $15,800
Received After Tax $63,000 $63,200
Effective Rate 37% 36.8%

            Q:        What if my company will hire employees and pay wages or use significant capital?

            A:        In this case, using an LLC would likely remain the best option as you can take advantage of the 20% profit ‘haircut.’ Basically, the ‘profit haircut’ reduces the qualified income for entity taxation from the full 100% to only 80%. This was done in order to incentivize job creating pass-through entities by reducing the tax burden on income. By way of example, if your LLC brought in $100,000 of income, the profit haircut would be employed so that the tax rate would be 37% on only $80,000 and not the full $100,000. Thus, the entity rat tax would be $29,500 as opposed to $37,000 due to the profit haircut. In this example, the business should go through the tax and business analysis with its attorney and accountant.

The upshot is that the new tax reform significantly changes the inquiry you must go through when determining entity choice. These decisions should always be made with the input of legal counsel and accounting expertise.

 

PK Law’s Corporate and Real Estate Group represents individuals, partnerships, companies and corporations engaged in a broad range of businesses and industries.  PK Law’s corporate, real estate and tax attorneys have extensive experience in a variety of business transactions, real estate matters and corporate matters and work cohesively with PK Law litigation, estate planning and labor and employment attorneys to ensure all aspects of their clients’ legal needs are managed.