Lawmakers knew that they could not give corporations this type of reduced tax rate without providing some similar break to small businesses, which are overwhelmingly some type of pass-through entity. This is where the new 20% Qualified Business Income Deduction came into play. This new deduction for pass through entities was meant to keep an even playing field among the various types of business entities available. (You can read about the 20% QBID here, here, here, and here.) It is important for business owners to evaluate the impact these changes will have to ensure you are choosing the best option for your business.
While larger, more profitable companies are getting a substantially reduced tax rate, small corporations previously taxed at 15% will see an increase in their federal income tax rate to the flat rate of 21%. Corporations with income up to $90,400 in taxable income will see some tax increase under the new corporate tax rate structure. For smaller C corporations with taxable income of less than $315,000 per year, the possibility of converting to a different type of entity (S corporation, LLC, partnership, etc.) might be something to consider. Now that pass-through entities are eligible for a 20% reduction in taxable income, this could be a better option.
Previous to the new law, if you were classified as a “personal service corporation” and were a C Corporation, your tax rate was a flat tax of 35%, not the graduated tax rate. These businesses are typically accounting, architecture, consulting, etc. It was not beneficial for these types of businesses to be C Corporations because they didn’t receive the benefit of the graduated tax rate. Now, however, those businesses would have a flat 21% tax rate, which may warrant some changes in how we think about those types of businesses.
One final word of caution regarding the 21% tax rate hype... tax rates on your taxable income may be decreasing, but a corporation’s taxable income could be increasing in 2018 even if everything in your business stays the same. There are several changes and limitations to allowable business deductions in 2018 and beyond that could impact the amount of a corporation’s taxable income. Any type of tax planning that involves the change in the corporate income tax rates should consider all of the other changes made by the tax reform bill.
Every corporation has a unique set of circumstances and therefore should take these points under consideration as we move forward in 2018 and beyond. Changes to your business may be necessary to use the new tax laws to your benefit. Contact RLH if you’d like to discuss how your situation will look different in the coming year.