Many accountants and tax professionals wonder if they could save their clients a lot of money just by helping them change business entities. The short answer is, yes you can – under the right circumstances. Entity selection can usually be done at any time it is deemed beneficial, but the three stages that are typical triggers are the creation of a business, a change in ownership structure, or when circumstances change.
Let’s look at when it might be advantageous to change, especially in terms of tax savings, outside of key moments.
Reasons for making an entity change
Making an entity change is something that needs to be taken into account not only for tax savings, but also when there are other factors involved. Some of these factors may include setting up a a partnership structure where there is an unequal distribution among the owners, if there is a desire to eventually go public or if the owner is considering opting out or withdrawing from the business and wishes to transfer the wealth to the children.
However, most of the time, lowering taxes is the main driver of an entity change. With higher taxes on the horizon with proposals from President Biden and the House Ways and Means Committee, now is the time to prepare to help your clients. Here are some “weak points” of the new tax proposals:
- Increase in corporate tax rate
- Higher individual rate increased
- Increase in the capital gains tax rate
- New social security tax on income over $ 400,000
- Expanded Net Investment Income Tax (NIIT) Coverage
- Phased out / capped deductions (including QBID) for high income taxpayers
These higher tax rates will give you the opportunity to save money for a business by changing the type of entity. For clients whose businesses do not make more than $ 400,000, the changes are unlikely to be a big factor in the decision. But for companies with large net profits, the changes can shift the balance towards corporate entities to better manage the timing and effect of higher tax bills. Additionally, taxpayers with low cash flow requirements may find that highly profitable businesses would be better off transitioning to C corporation status.
As an example, let’s take a look at a $ 1.3 million business case study. Your clients are married, filing jointly, with a Schedule C company that has a payroll of $ 475,000. They only need $ 150,000 in cash to maintain their standard of living and would have to pay themselves a salary of $ 70,000 if they were an S corporation.
Moving from an entity from a Schedule C corporation to a C corporation would save them significant savings. And these only get bigger with the possible changes that exist. Of course, that doesn’t mean that all of your Schedule C clients will be better off at making this change – it’s only effective on a case-by-case basis.
For example, if your business owners needed $ 750,000 in cash to maintain their lifestyle rather than $ 150,000, Company C ceases to be viable under current law because the corporate tax. the large dividend and loss of QBID would offset any savings from the downturn in the company. tax rate.
Under the Biden plan, however, Company C would remain an option. This is in part due to the large tax increase that would be incurred if the company remained a Schedule C. But it is also the result of the company preventing taxpayers from triggering the higher capital gain rate in the future. individual level (which at $ 1 million) and protecting the unnecessary $ 550,000 under a lower rate, even with the increased corporate rate.
A similar scenario – or with an even larger tax difference – would exist under the ways and means plan. Company C would protect the initial income from the individual rate of 39.6%, as well as the NIIT that would be taxed on business income. In addition, the dividend payment would only be subject to a 25% tax (compared to a rate of 39.6% included in the Biden plan).
Advantages and disadvantages of each type of entity
Each type of entity comes with various positive and negative points. Here’s a quick recap of what to keep in mind for your customers, starting with the good things about each type of entity.
Potential positive points of sole proprietorships and one-person LLCs:
- Possibility of directly deducting eligible expenses related to the business
- Simple organizational structure
- Does not require the filing of an additional tax return
Potential benefits of partnerships:
- Better access to capital
- Ability to share tasks and responsibilities between partners
- Greater flexibility in operational allocations
Potential positives of S companies:
- Additional corporate liability protection
- Reduced self-employment tax
Potential positives of C companies:
- Additional corporate liability protection
- Eligibility for a lower tax rate
- Possibility of deferring dividends (and taxes on these dividends) to future years
These are the most likely reasons why your customers might want to move from one entity to another. But remember, it’s not all about the positives. There are also negative points for each. Below is a brief summary of the negatives to keep in mind.
Possible negative points of sole proprietorships and one-person LLCs:
- All income is subject to self-employment tax and personal income tax.
- There is unlimited liability if the business is not covered by an LLC.
Possible negative points of partnerships:
- There is potentially unlimited liability, with each partner being responsible for all debts of the company, including those attributable to other partners.
- General partners are subject to income tax and self-employment tax on net profit.
Possible negative points of S companies:
- Payroll is required on an ongoing basis after the S corporation choice has been accepted by the IRS, including employment tax returns.
- It is recommended that you run a reasonable compensation analysis to support the owner’s compensation calculation.
Possible negative points of C companies:
- Shareholders are subject to double taxation on dividends.
The additional complexities of the decision: consequences and side effects
There are other complexities to consider beyond the simple positive and negative aspects of each entity. Indeed, every decision you make has additional consequences and has side effects. Take, for example, determining the type of company best suited to an entity’s needs:
- S companies that have moved from status C are subject to an entity-level tax on any integrated unrealized gains that existed at the time of conversion if any of the assets are sold within five years of conversion.
- The AC company that chooses S status must include in its final C tax year the integrated gain attributable to the LIFO inventory.
- An S corporation that was previously a C corporation will have to account for gains and accrued profits as C corporation. Shareholders of S corporation will be required to treat distributions as taxable dividends if distributions from S corporation exceed amounts taxed to shareholders but not distributed until the accumulated E&P is fully distributed.
- Conversely, an S corporation that revokes its election and becomes a C corporation will have a period of at least one year after conversion to distribute tax-free amounts previously taxed but not distributed at the time of conversion.
Overall, choosing an entity type is a huge decision no matter where your client is in the process. Your job is to go through the options and consider what is most important to the individual situation. With big tax changes on the horizon, now is the time to start thinking about changing entities.