In December, Congress and the president enacted the Tax Cuts and Jobs Act to overhaul the federal tax system. I recently wrote about one aspect of the Act in a post describing how it has changed the gift and estate taxes for the next 7 years.
Of course, the Act did much more than just that. As relevant for today’s post, it also reformed how business entities’ income will be taxed by the federal government. I’ve written before about that topic and how it impacts small-business owners’ estate planning, so I thought it would make sense to revisit it in light of the new changes.
Refresher: Federal Taxation of Business Entities
Before getting to that, I want to briefly summarize again the different forms of federal business taxation. When you establish a business organization for your business—like a corporation or a limited liability company (LLC)—you can usually choose how that business is taxed for federal purposes.
There are a few different tax options available, each with its own advantages, but in general, they boil down to taxation as a C corporation or taxation as a pass-through entity. C corporations are subject to a double tax: Income is taxed once to the corporation when it is earned, and again to the owners when money is distributed as dividends.
In contrast, pass-through entities are not independent taxpayers. Instead, the owners pay tax on their entity’s income at their own individual rates in proportion to their ownership interests. Distributions from pass-through entities are not subject to a second level of tax.
What the Tax Cuts and Jobs Act Means for C Corporations
In recent decades, small businesses have tended to shy away from the double-tax regime of C corporations. However, as I explained in my post about qualified small business stock, choosing to be taxed as a C corporation does have some advantages. Which option is best for any given small business depends on that business’ unique circumstances.
The Tax Cuts and Jobs Act might lead some small-business owners to reassess their strategy in this regard. That’s because it addresses one of the big problems businesses could face with a C corporation—accelerated corporate tax rates that maxed out at 35%. The Tax Cuts and Jobs Act reduces the corporate rate to 21%.
Now, it might make sense for more small businesses to be taxed as C corporations to access the benefits of that treatment—including qualified small business stock—despite the continued double taxation.
What the Tax Cuts and Jobs Act Means for Pass-Through Entities
To counteract the advantage of a lowered corporate tax rate, the Tax Cuts and Jobs Act includes two changes that are beneficial to small-business owners—particularly when their business is taxed on a pass-through basis. First, the top individual income tax rate is cut from 39.6% to 37%. For high-income earners, this could lead to significant tax savings on pass-through and other income.
Second, the law allows many taxpayers to deduct up to 20% of the qualified business income of a pass-through entity. However, this deduction is subject to some limitations on the types of business, and is phased out as a taxpayer’s income rises. If you own a pass-through business entity, you should consult a knowledgeable professional to understand how this provision may benefit you.
Should the Tax Cuts and Jobs Act Change Your Small-Business Planning?
For some California small-business owners, the changes made by the Tax Cuts and Jobs Act may inspire them to adopt a different business-tax strategy than what they followed under prior law. In doing so, those owners must be mindful of how their business and tax structures impact their estate plans. (See, for instance, my post on estate planning for S corporations.)
To understand how your business structure or business-tax strategy may affect your estate planning, contact the Law Office of Bridget Mackay today.