One of the most fundamental choices that a small business owner must make is the form of entity in which the business will operate.
Should it be a limited liability company (LLC) or a corporation? And there are essentially two varieties of corporation–the regular so-called C corporation and the S corporation. There are other forms of entity, to be sure, including an unincorporated business that operates as a sole proprietorship if there is only one owner or a partnership if there are more than one owner.
But since sole proprietorships and general partnerships do not provide limited liability protection to their owners, the typical universe of choices usually considered by business owners are the three big ones–the LLC, the C corporation, and the S corporation.
Before the Tax Cuts and Jobs Act, a C corporation was hardly ever even in the discussion for the choice of entity for a small business. The reason? Profits earned by C corporations and distributed to shareholders get taxed twice (the well-known concept of “double taxation”)–first, by the corporation itself, and, second, by the shareholder who receives the distribution.
Now, however, one cannot simply dismiss out of hand a consideration of a C corporation for the choice of entity for a small business, because the highest corporate rate has been reduced under the Tax Cuts and Jobs Act from 35% to 21%.
If a particular business has the need for the retention of funds within the corporation, and the shareholders are willing and able to forego current distributions of corporate profits, then a C corporation with its relatively low maximum income tax rate of 21% (vs. the highest individual income tax rate under the new law of 37%) may make sense. As is often said, the facts of your particular situation matter. You will need to run numbers to see if a C corporation may make sense for your particular business. What’s interesting is that before the new tax act, one would hardly ever even thought about a C corporation as a possible business form.
One glaring negative with a C corporation (in addition to the continuing “double taxation” problem on the distribution of profits) is that a C corporation is not a pass-through entity, and, thus, a C corporation does not qualify for the 20% pass-through deduction now found in Section 199A of the Internal Revenue Code, thanks to the new Tax Cuts and Jobs Act.
The new 20% pass-through deduction is complex. Explaining it in the context of this blog post is not really feasible. But the important takeaway for anyone thinking of setting up a new business in Tennessee is this–if you’ve narrowed your choice down to either an LLC or an S corporation, you really must get deep in the weeds of your own financial facts to make the right and best decision.
Key points that one must consider in making the decision are (1) the level of gross profits of the business and (2) the level of wages paid by the business.
For example, if your business has gross receipts of $1 million, you have no third-party employees, you are married and file a joint return, and you operate the business as an LLC, then the possible 20% deduction would be $200,000, but since the profits allocated to you as the sole owner are $1 million (which is in excess of the cap on getting the deduction for an owner of a pass-through business who files a joint return of $415,000), you can only deduct up to 50% of your wages paid—but you pay no wages. So, no deduction for you.
But what if you had the same $1 million in profits but operated as an S corporation. You can pay yourself wages if you operate as an S corporation, so assume that you pay yourself $250,000 in wages and you receive the remaining $750,000 in a profit distribution. Since profits are now $750,000 (after the payment of wages), the 20% pass-through deduction can be no greater than $150,000. But your wages are only $250,000, so 50% of that amount is $125,000. Since 50% of wages is less than 20% of profits, the amount of your deduction is the $125,000.
But look at this–same business, but you get a $125,000 deduction if you operate as an S corporation but no deduction if you operate as an LLC.
There are other tax issues at work here, too. If the $250,000 is reasonable compensation, then you will save 2.9% on the remaining $750,000 in self-employment taxes, or $21,750.
All things being equal, you would probably choose to be an S corporation rather than an LLC in this case.
But, here’s the thing–you must look at your own individual facts. In some cases, you might reasonably choose to be an LLC rather than an LLC.
The new Tax Cuts and Jobs Act and the 20% pass-through deduction in it are going to make choosing the right form of entity even more challenging going forward.