Earlier this year, Congress passed the Tax Cuts and Jobs Act. It affects individuals and businesses of any size.
Business Formation Facts
You can form your business with the federal government in the following six ways. Each has its own taxation implications.
Sole proprietorship: Small businesses that choose to file taxes as a sole proprietorship will report all business income and related expenses using federal form 1040, Schedule C.
Partnership: Partnerships are associations consisting of two or more people who run a business together. Businesses can opt for a limited partnership or a general partnership. Regardless of the type of partnership, it will file a separate return using federal form 1065. Each member of the partnership will report the business’s income or loss on his or her own tax return.
Limited Liability Company (LLC): This type of business is considered a hybrid in that it allows taxpayers to choose taxation as a corporation or a partnership. Often, LLCs are single-member, which are usually a “disregarded entity” when it comes to filing federal taxes. In this case, the business owner would not file a separate tax form but instead file in the same way as a sole proprietorship would.
C Corporation: The C corporation will file federal form 1120. Any owed taxes are paid as a separate entity. However, shareholders, or owners, will pay taxes at their individual income tax rates if any dividends or other corporate distributions are received. In this way, corporations could have to pay a “double tax.” Those in service professions, such as architects and healthcare practitioners, could file as a professional or personal service corporation.
S Corporation: S corporations have similar tax structures to partnerships in that most of the business’s income or losses are passed through to the owners, or shareholders. The individuals must then report this data on their personal tax returns. The S corporation will have to file federal form 1120-S.
B Corporation: The B in B corporation stands for benefit, indicating that the business has a social mission at the heart of it even though it is not a non-profit entity. B corporations have the option of filing either as a C corporation or an S corporation. The C corporation would pay the corporate tax rate, while the S corporation would pass income and losses through to the individual owners.
Corporate Tax Change
Per the new act, any registered corporation will now be subject to a flat single rate of 21% on its taxable income. As of 2018, the Alternative Minimum Corporate Tax no longer exists.
Pass-Through Entities – Section 199A Deduction
The other major tax change relates to pass-through entities – sole proprietorships, partnerships, LLCs and S corporations. They can deduct 20% of their Qualified Business Income, which is calculated by deducting all business expenses from the business revenues. If your business is an S corporation or a partnership, you must also include deductions for W-2 payroll, even guaranteed payments to any partners or a W-2 salary paid to an owner.
Illustration: Let’s say your S corporation makes a profit of $100,000, and from that, you pay yourself $40,000 as a salary. That means that your Qualified Business Income is $60,000 because you would deduct the $40,000 salary from your $100,000 profit. Now, you would apply the 20% rate to determine your deduction, which would amount to $12,000.
There are caps you need to keep in mind regarding the 20% deduction. For a single taxpayer, the cap is $157,500 of total taxable income. Married taxpayers who file a joint return have a cap of $315,000 of total taxable income. The key words are total taxable income. So, while your Qualified Business Income may be $60,000, your total adjusted income that takes into account all personal items, could be only $50,000. In this case, you would apply the 20% rate to your $50,000 total taxable income. Your deduction would be $10,000.
Special Service Business
Special service businesses have their own phaseout amounts, that can negate the 20% deduction if they are met. These are $207,500 of total taxable income if you’re a single taxpayer and $415,000 of total taxable income if you file jointly as a married couple.
How do you know if you have a special service business? If you are in an industry that depends on the respectability and ability of its practitioner to be successful, such as healthcare, law, athletics, accounting, consulting, financial services, then you are likely an owner of a special service business. These types of businesses have different thresholds and rules when it comes to the 20% deduction. Single taxpayers with a total taxable income of more than $207,500 will lose the entire 20% deduction. The cap for married taxpayers who file jointly is $415,000.
Partial deductions are possible if your taxable income is somewhere between the cap amounts of $157,500 (single taxpayer) or $315,000 (married jointly filing taxpayers) and the phase-out amounts of $207,500 (single taxpayer) or $415,000 (married jointly filing taxpayers). You must compare your partial deduction against whichever is larger of the following: 50% of total W-2 wages paid out in the tax year and 25% of total W-2 wages paid out in the tax year plus 2.5% of depreciable assets, which is calculated at the business’s cost of acquisition.
What You Need to Know
The majority of small businesses in the United States qualify for the entire 20% deduction because their total taxable income falls below the maximum ceiling amounts of $157,500 for a single taxpayer and $315,000 as a married couple filing jointly. If your taxable income is higher than these thresholds, a partial deduction will be applied instead. The percentage of this deduction will depend on wages paid and depreciating assets, so it is best to engage a CPA or other tax professional for assistance when you file. He or she will also be aware of any further changes to the tax laws.
*This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. First Home Bank does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.