In December of 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA), which brought about drastic changes to the tax treatment of both corporate and pass-through entity structures. Such changes include:
- Reduction of the corporate tax rate from 35% to a flat rate of 21%
- Deduction of up to 20% of qualified business income (QBI) from qualifying domestic partnerships, S corporations, sole proprietors, trusts or estates
This tax reform has led individuals to take a step back and contemplate which entity structure would provide them the greatest tax savings.
Reduction of Corporate Tax Rate
The substantial reduction of the corporate tax rate may lead to increasing popularity of the corporate entity structure. This decision is ultimately dependent on anticipated earnings. If an entity’s earnings are expected to grow, this structure may be beneficial due to the fact that the tax rate will never exceed 21%. The reduction of the corporate tax bracket alleviates the effects of double taxation and passes on the tax savings to the individual taxpayer.
Section 199A Deduction – Qualified Business Income (QBI) deductionS
In addition to the reduction of corporate tax rates, the TJCA introduced Section 199A, the qualified business income deduction. Individuals who participate in a trade or business, whether as sole proprietors, partners, or shareholders in a pass-through entity, may be eligible to receive a deduction of 20% on QBI flowing to their individual tax returns. This is most beneficial for individuals who are in a higher tax bracket, as it can lead to a tax rate reduction on QBI earnings from 37% to 29.6%
There are, however, limitations set in place that can reduce or disallow the deduction in its entirety. For example, individuals with taxable income greater than $315,000, married filing joint, or $157,500 for all other taxpayers who receive income from a specified service income are excluded from the deduction. Such specified service income entities include CPA firms, legal practices and more. The deduction is further limited to one of the following:
- 50% of the wages paid by the entity
- The sum of 25% of wages paid and 2.5% of the purchase price, or unadjusted basis, of the assets used to produce the QBI
Ultimately, when determining which entity structure is best for the taxpayers, it is crucial to consider the potential tax consequences. The more tax savings, the more money the businesses are able to reinvest in the growth of their businesses and ultimately sustain long-term growth.
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