- August 8, 2019
- Posted by: Brian Post
- Category: Accounting Advice, Tax Planning Resources
They say in life that there are only two certainties, death and taxes. While we may not be able to avoid these things, we can definitely take the appropriate steps to help minimize one of the two. In the beginning of the year, we are all fortunate enough to have to deal with the stresses of an accountant’s favorite two words: Tax Season. While the subject of taxes is fresh in everyone’s mind, it is a great time to make sure that your business is set up in the most tax efficient manner so that you benefit from recent tax laws. The beginning of the year is also the time to make changes because there are deadlines that must be met in order for your business to reap the benefits for 2020 tax return filings. What we will dive deeper into with this article is the different types of entities, which ones are considered pass-through, and the benefits each offers.
There are many different types of entities that a business owner can choose to set their company up as and it is always best practice to consult your tax advisor on which one is the best for your particular situation. The following are the most common entity types and how income is reported:
Sole-Proprietorship* – A sole proprietorship is a single owner operator and the profits of the business are reported on Schedule C of Form 1040. Profits are distributed through owners draws.
Limited Liability Company (LLC)* – An LLC is an entity designed to protect small business owners. Single member LLCs report their income on Schedule C of a 1040 and multi-member LLCs are treated as partnerships and report their income on Form 1065. Profits are distributed through owners draws. LLCs may elect to be treated as a C-Corporation or S-Corporation for tax purposes.
Partnership* – Any business that has 2 or more business owners is treated as a partnership. Partnerships report their income on Form 1065. Profits are distributed through owners draws or guaranteed payments.
C-Corporation – This type of entity is incorporated and stands separate from the owners. A C-Corporation reports the income of the entity on Form 1120. Profits are distributed in the form of qualified dividends and owners take normal W-2 wages.
S-Corporation* – Another incorporated entity is an S-Corporation. S-Corporation income is reported on form 1120S. Profits are distributed through shareholder distributions and owners are required to take a reasonable salary. Deadline to make an S-Election effective for 2020 filing is 3/15/2020.
*Indicates a pass-through entity
Pass-Through Entity Benefits
The majority of small businesses in the United States are set-up as pass-through entities with LLCs being the most common type. Pass-through entities provide many benefits to the business owners and with the tax law changes that took place for 2018 filings, the benefits have become more attractive.
Section 199A Qualified Business Income Deduction
To summarize why this is beneficial to pass-through entities, business owners may receive up to a 20% deduction for qualified pass through income on their personal returns. While there are limitations to qualify for this deduction, it can be something that saves you from paying more taxes to Uncle Sam!
As mentioned, the section 199A deduction has many ins and outs and can be a complicated topic when it comes to understanding the benefits of structuring your business as a pass-through entity. Please click here to read the most recent article by Dan Gordon about this tax law change and to get a full overview of how you can reap the rewards of the QBI deduction as a business owner.
Avoid double taxation
For most small business owners, it is advantageous for the entity to be set-up as a pass through even with the corporate tax rates being reduced to a flat 21%. As a pass-through entity, profits pulled out through owners draws or shareholder distributions are not taxed. Only the profits are taxed! In a corporate structure, the dividends pulled out are still taxed at qualified dividend tax rates up to 20%. If we also assume there is a 3.8% additional Net Investment Income Tax, this would create a minimum effective tax rate of 39.8% once personal tax rates are reduced by the corporate level tax already taken on the dividends.
Pass-through profits will utilize personal tax rate brackets that range from 10-37% and will be reduced by the QBI deduction. If we also assume the Net Investment Income Tax applies of 3.8%, the effective tax rate for a pass-through entity can be as low as 33.4% in the highest tax bracket! For most small businesses that I deal with in the pest and lawn care industries, an S-Corporation is usually the most beneficial for owners. As always, keep in mind that some companies choose to reinvest profits, distribute all their profit to owners, or stockpile cash. Therefore, I still recommend discussing your tax situation with your tax advisor to pick which entity is correct for you.
Here is a chart that helps provide some key attributes of the different types of entity structures and some of the additional benefits that they provide.