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The Tax Cuts and Jobs Act ushered in numerous tax changes for 2018. While many of the tax changes generally apply to larger business entities, a few apply to small businesses. The change getting the most attention is the 20 percent reduction of taxable income for pass-through businesses. This part of the new tax law is causing many Americans (an estimated 25-35 million) to want to form a business entity. That’s more than the total number of people alive today who have incorporated!
“These changes make tax analysis extremely important when forming a business. The corporate tax rate has come down significantly (from 35 percent to 21 percent), but so have the tax rates for pass-through entities,” according to Rocket Lawyer On Call® attorney, Jim Green. “Companies should consider how they are currently structured and if changes should be made to maximize deductions.”
It’s important to talk to an attorney or tax professional to understand your options.
So, what is a pass-through entity?
Small businesses have been called the “backbone” of the U.S. economy for a good reason. In fact, over 90 percent of registered businesses are small with only one or two owners and zero (or few) employees. Often, these businesses are “pass-through” entities, meaning that the owners claim their business income on their personal tax returns rather than as a corporation. Pass-through businesses include sole proprietorships, Limited Liability Corporations (LLCs), S-Corporations (S-corps) and partnerships.
Types of pass-through businesses explained:
This is the simplest type of business, which the IRS defines as an unincorporated business owned by one person. It is not a legal entity, such as an LLC. Income and losses are reported on the individual’s personal tax returns.
Limited liability corporations (LLCs)
This is a legal business entity in which members of the company are generally not held personally responsible for the company’s debt or liabilities. An LLC may be formed of one person or more. Many business owners form this type of entity to protect their personal assets. Regulations may vary by state.
S-corps share company profits, losses, deductions and credits with its shareholders. The shareholders are then taxed through their own individual tax returns. S-Corps may consist of one to 100 members.
Partnerships are formed between two or more people. Profits and liabilities are shared, but not necessarily in equal proportions. Partnership categories include general, limited liability, and limited partnerships. Regulations may vary by state.
2018 small business tax changes: 20 percent reduction of taxable income
While this change may be exciting for small business owners, tax laws can rarely be called uncomplicated. There are exclusions and thresholds which need to be considered before you can assume that you might benefit from this tax advantage.
But, as briefly as possible, the pass-through deduction allows certain filers to deduct 20 percent of pass-through income. The result is that many business owners may experience a lower tax rate than they would have in previous years. Twenty percent could be enough to push many filers down to a lower tax bracket.
Many 2018 tax filers will be able to claim this deduction. However, there are limitations and exclusions. For example, some job classifications have restrictions including doctors, lawyers, athletes, artists and financial service providers.
On the other hand, some professional services are included such as engineering and architecture services, as are certain real estate incomes. If you’re confused, you’re not alone. You may be considering restructuring your business or changing your job classification to avoid this exclusion. However, it’s not a change you should make without professional assistance from a tax attorney or an accountant.
Thresholds for eligibility are set at $157,500 for individual taxpayers and $315,000 for married taxpayers. Figuring out if you meet the threshold is not simple. Factors that contribute to whether you are eligible include qualifying business income and qualifying property. Again, you’ll want to talk to a tax professional about whether you meet these thresholds or not.
Should I become my own business or incorporate in 2018?
If you are already a sole proprietor or self-employed, in many cases, you can benefit from forming a business entity. Or, if you are considering starting your own business, you may, at the minimum, consider forming an LLC to protect your personal assets.
Learn more about the potential advantages of incorporating your business:
Protection of personal assets
While your personal assets are not 100 percent protected, they are more protected than if you do not form a legal business entity.
Easier to sell your business
You cannot sell or transfer your small business if the business is you. If you form an actual entity, the business can be sold or transferred.
Depending on the entity type, business tax rates can be lower than personal tax rates, plus you can write off numerous business expenses. Incorporated businesses may also have more success at getting funding from third parties.
Client and investor confidence
Clients and investors tend to put more confidence towards incorporated businesses. Incorporating can help to demonstrate your legitimacy and can help others take you more seriously.
Navigating 2018 business tax changes: Who can help my small business?
Nearly everyone can benefit from working with business tax professionals to ensure that you not only set up your business entity properly, but that you are also prepared to maximize your tax advantages. Since local tax laws vary, you’ll want to select professionals who are familiar with your industry and your local area.
Here’s a look at who can help you:
Often tax attorneys work with CPAs to help you with tax issues. You’ll want to consult with a tax lawyer when you are starting a new business and especially if you are having any type of conflict with the IRS or state tax agency, such as an audit. If you are facing a possible tax crime situation, you can benefit from the protection of the attorney-client privilege. It is also prudent to acquire the services of a tax attorney, if you are planning on conducting any type of international business.
Certified public accountant (CPA)
CPAs often hold degrees in business administration, finance or accounting. They are also required to meet mandatory ongoing educational requirements yearly. Many recommend that you hire a CPA for life-changing events such as starting your own company.
Skilled accountants can help you set up your chart of accounts and your accounting software, as well. Accountants can help you determine how you are going to track your sales and expenses, and most can be contracted to help you reconcile your accounts monthly. While they are not tax attorneys, many accountants know about local and federal tax laws.
Enrolled agent (EA)
Enrolled agents may represent taxpayers before the IRS. This is an IRS-authorized role and ongoing education is required. They are considered tax preparation experts and are often more affordable than CPAs.
For some small business owners, 2018 may be called the year to incorporate. Whether you’re starting a new venture or already self-employed, it is important to talk to a lawyer about the best option for you.