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One important step when starting a new business is choosing a business or entity structure. Do you want to own the business yourself or have it owned by a separate legal entity? The first option would be a sole proprietorship (for one owner) or a partnership (for more than one owner). The result of the second option is usually either a corporation or a limited liability company (LLC).
Many factors go into making this decision. Every business is different, as is every person wanting to start a business. Where there is a single owner, factors to consider include, but are not limited to, the need for liability protection, how the business will be financed, and the exit strategy. Where there are multiple owners, additional factors involve how management and financial rights will be shared and transferred.
Another important factor is taxation—in particular, federal income taxation. Although the choice of entity should not be based solely on which structure provides the lowest federal income taxes, how a business is to be taxed is still a consideration. Therefore, many small business owners may be wondering how the Tax Cuts and Jobs Act (H.R. 1) impacts them. This law enacts sweeping changes to the Internal Revenue Code. Here are three of the many changes that may be of particular interest to small business owners regarding their choice of entity.
Sole proprietorships, partnerships, S corporations, and LLCs are “pass-through” tax entities. The business’ income (and losses) pass to their owners, who report their share on their individual tax returns. One change that impacts the owners who have chosen a pass-through entity is the reduction in the individual income tax rates. Effective starting in 2018 (but expiring in 2025), individual taxes range from 10% to 37%. (Previously they ranged from 10% to 39.6%.)
The standard deduction has also increased.
Note: This reduction may be offset in some cases by the elimination or limitation of many personal deductions.
The new tax law allows individuals owning pass-through entities to deduct 20% of “qualified business income”. (This is subject to certain caps and exclusions.)
An incorporated business that has not elected S corporation status (which is known for tax purposes as a C corporation) will pay taxes on its income. The same is true for an LLC whose members have decided to have it taxed as a C corporation. The owners of these corporations and LLCs should be interested to note that under the H.R. 1, the corporate tax rate is a flat 21%. (Previously there was a maximum rate of 35%.)
In addition, the alternative minimum tax on corporations was repealed.
There are a significant number of changes in the Tax Cuts and Jobs Act beyond the three outlined above. You should obtain the advice of tax and legal experts to determine whether a change in entity type is desirable. If you have decided to make the change (either due to H.R. 1 or for any other reason), CT is here to help you comply with the requirements of the relevant state business entity laws.
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