President Trump signed into law a major overhaul of the US tax system. The corporate tax rates have changed from a system of graduated tax rates up to 35% to a flat tax on corporate profits of 21%. The alternative minimum tax has been eliminated for corporations, and there is no different or special tax rate as before for “personal service corporations.”
Individual income tax rates have also changed under the new tax law, with seven new tax rate brackets being established, from 10% up to a maximum rate of 37%. The standard deduction has been increased ($24,000 for joint filers), but many personal income tax deductions have been cut back such as the state and local tax deduction and the deduction for home mortgage interest. Personal exemptions have been eliminated. The individual alternative minimum tax still remains; however, exemptions from this tax have been increased.
For small businesses which are not taxed as corporations, the new law gives these businesses a special 20% deduction against profits, and then the balance of the profits are taxed to the owners as regular income – subject to regular income tax rates and also employment taxes. Certain phase out rules apply for this new small business deduction.
Most small businesses currently operates through “pass-through” business entities, such as “Subchapter S” corporations, partnerships, limited liability companies (LLCs) or simply as sole proprietorships. These forms of business entities do not pay income taxes, but must often file a separate tax return, but then the profits are “passed-through” and reported to the owners of the business. In most small businesses, the owners of the business also work at the business as well.
Under the new tax law, small business owners must now make a decision: (1) to remain as a “pass-through” business; or (2) change over to a corporation (referred to as a “C Corporation”).
If the small business owner remains as a “pass-through” business, the owner will be able to take advantage of the new 20% deduction against profits – reducing taxable income and income taxes due; however, the balance of these profits may then be fully taxed to the owner as wage income subject to higher individual income tax rates and also employment taxes. If the business changes to a C Corporation, corporate profits will be taxed at a low flat 21% and not the potentially higher individual income tax rates going up to 37%. However, corporations will not receive the benefit of the special new 20% deduction for “pass-through” businesses. Also, while the corporate tax rate now will be low and fixed, once profits are taxed in the corporation the business owner may want to get them out – to the owner. If the corporation pays these after-tax corporate profits out to the business owner as a dividend (the common way of distributing corporate earnings to the shareholder/owners), the dividend is not deductible to the corporation and is fully taxable to the shareholder/owner, or is “double-taxed.” Not a good idea. If the shareholder/owner pays him/her a salary or other compensation, the corporation can deduct this payment, but the shareholder/owner must then pay both income and employment taxes on this salary – and at higher tax rates than the corporate rate.
Perhaps the most interesting issue is where a business owner wants to be able to retain business profits to reinvest back into the business – to grow the business! Here, if the business were in a C Corporation, rather than a “pass-through” business entity, the corporation could pay tax on profits at 21%, leaving 79% of the profits to be kept in the business and reinvested, or otherwise accumulated for the reasonable future needs of the business as it grows.
These are just some of the issues small business owners must now consider with our new tax law.