Tax is one of many factors when choosing a desired type of entity for a startup. As we discussed in 2016, tax considerations can be one of the most important factors when the startup is expecting to receive funding or operate at a loss in its early years.

A lot changed late last year when Congress enacted the new tax bill. Generally, tax for corporations was reduced from 35% to 21%, and several deductions changed considerably. This post will discuss some of these changes, and what a startup should have in mind in deciding what is the right type of entity for their business. Some of the changes, such as what really qualifies for the 20% deduction for pass-through entities, are still being discussed and any conclusion should be taken with a grain of salt.

When a startup is organized as an LLC or an S Corporation, income pass-through and its shareholders are taxed individually (as opposed to at the corporate level). Before the changes, this was even more of a salient advantage, as the marginal tax rate could reach 35% for corporations, plus 20% on dividends and a 3.8% Medicare surtax versus 39.6% for individual income. After the changes, the marginal rate for corporations reduced to 21%, and the maximum marginal rate for individuals to 37%. Additionally, as a compromise to small business owners, Congress enacted a 20% deduction for “qualified business income.”

 

When does it make sense to be taxed twice?

If the founders decide to “check the box,” their entity of choice will be treated separately for tax purposes. For example, if an LLC with three owners is created and they decide to “check the box,” they will be taxed at their individual level and at the corporate level. In some circumstances, it makes sense to prefer this type of arrangement.

What situation didn’t suffer changes under the new tax law is when you don’t expect to pay any taxes in individual losses, or use said losses to offset future gains. This could be useful if the founders don’t have income at the moment, or if they are a tax-exempt entity. What is interesting after the changes is the possibility of reinvesting at a lower rate (21%) than the highest bracket for individuals. Founders and investors that don’t expect to be receiving dividends and reinvest in the business, should prefer double rather than single taxation.

 

When it does not make sense to be taxed twice?

For many small businesses, and startups that don’t plan to receive any funds, the new bill didn’t provide many changes. As an LLC or an S Corporation, founders can pay less taxes compared to when they pay in their individual level. Many don’t even reach the highest marginal rate of 37%. As only 50% of new businesses survive more than five years, the roll-over of losses doesn’t make sense for a lot of owners.

The 2017 Tax Act introduced a new benefit: a 20% deduction for “qualified business income” generated by their “qualified trade or business.” This deduction effectively reduced the maximum individual tax rate from 37% to 29.6%. Non-qualified trade or business includes most professional services, such as those provided by accountants, attorneys, financial services, and medical providers. All businesses with taxable incomes below the threshold amount ($157,500 for single and $315,00 for married taxpayers) are qualified.

Thus, not “checking the box” still makes sense for many of the small businesses, and for the startups that are founder or family financed, running as an LLC or S Corporation.

What should I worry about?

Tax planning was always a consideration in deciding which type of entity, and whether to choose the pass-through option. However, the new tax rates for corporations and the 20% deduction complicate matters. While pass-through entities that generate qualified business income receive a more beneficial tax treatment even with the rate reduction, taxing as a different entity can at times be more advantageous. Because the changes are still being studied, and have a strong impact on how much a company will owe in taxes in the future, these questions are even more relevant today.

On the other hand, only the tax cuts are permanent, and some question whether the tax bill will remain as democrats gain voter support. Conversion from an LLC or partnership to a corporation is facilitated by many states, but the opposite is not true (i.e., from corporation to LLC or partnership).

Additionally, new creative ways of tax planning are on the horizon: a pass-through entity to hold business assets, thus preventing tax liability, and a corporation to perform related services, such as the management function. The amount of tax an entity is liable for can change considerably with the right planning, making the hard choice of the type of entity even more difficult.