Pass Through Business Entities Have Lower Income Taxes in 2018
Lowering taxes on businesses was one of the main objectives of tax reform. Here are a few of the major changes to pass through business entities like C Corporations, Sole Proprietors, Partnerships, and S Corporations.
1 – The Corporate Tax Rate is Lowered to a Flat 21%
The Tax Cuts and Jobs Act of 2017 (TCJA) permanently lowers the corporate rate paid by most corporations to 21%, beginning in 2018.
Previously, the graduated corporate rates were 15% / 25% / 34% / 39% / 34% / 35% / 38% / 35%. Because the rates changed as taxable corporate income increased, a corporation’s marginal income tax rate could be 35% but the effective rate could be much lower. In fact, the Treasury Department found that the average tax rate paid by profitable corporations with over $10 million in assets was 22% for 2007 through 2011.
Many corporations use a fiscal year. Corporations using a fiscal year can use a blended rate for the fiscal year including January 1, 2018.
Corporations pay income tax, employment taxes, estimated taxes, and sometimes excise taxes. Corporations can deduct expenses such as employee compensation, equipment, advertising, and state and local taxes.
When corporations share net income with their shareholders, shareholders pay tax on the dividends they receive. That’s why corporate profits are often said to be subject to double taxation. At the individual taxpayer level, qualified dividends are subject to tax at long-term capital gains rates (0% / 15% / 20%). Other dividends are subject to tax at ordinary income rates.
Corporate taxes are calculated and reported on Form 1120; dividends paid to shareholders are reported on Form 1099-DIV. Ordinary and qualified dividends are usually reported directly on Form 1040; taxpayers who receive ordinary dividends of more than $1,500 per year report them on Schedule B.
Corporations that receive dividends from a related corporation may be able to claim a dividends received deduction (DRD). The DRD essentially prevents corporate income from being taxed three times. Under prior law, a corporation might be allowed to deduct as much as 70%, 80%, or 100% of the dividends it received, based on its ownership interest in the distributing corporation. Under the TCJA, the partial dividends received deduction is reduced. Corporations that in previous years might have been allowed to deduct as much as 70% or 80% are now limited to a deduction of 50% or 65% of the dividends they receive.
The TCJA also provides for a 100% DRD for certain dividends received by domestic corporations from foreign corporations.
The corporate rate change is a permanent change, it does not sunset at a future date.
2 – Personal Services Corporations Are No Longer Taxed At A Special Rate
The TCJA eliminates the special tax rate applied to personal services corporations (PSCs). Under prior law, PSCs paid tax at a 35% rate compared to 21% under the TCJA.
3 – The Corporate AMT is Eliminated
The TCJA eliminated the corporate alternative minimum tax (AMT). The change is effective for tax years starting after 2017. Before the TCJA, the AMT rate was 20% on income above $40,000.
The corporate AMT repeal is also a permanent change, it does not return at a future date.
4 – New Tax Benefit for Pass Through Business Entities
Many Sole Proprietors, Partners, and S Corporation Shareholders will benefit from a new tax benefit for pass-through businesses. While net income from these types of businesses is taxed at individual rates, which can be as high as 37% in 2018, the TCJA provides a deduction of up to 20% of a business owner’s net business income reported on a Schedule C, E or F. The deduction may be limited depending on the individual’s taxable income or type of business activity.
For example, a freelancer with net business income of $72,000 can deduct the lesser of 20% of net business income or 20% of taxable income. If the freelancer uses the Single filing status and claims the $12,000 standard deduction, the freelancer can deduct $12,000 from taxable income [i.e. 20% of ($72,000 – standard deduction)]. As a result, the freelancer will only pay tax on $48,000 of income.
Confused as to how tax reform will impact you? Bring in your 2017 tax return to one of our Block Advisors locations, and at no cost you will receive an analysis of how tax reform will impact you, a Second Look® Review, and suggestions on how to make appropriate W-4 adjustments to maximize your tax outcome.