While there was a lot of hype and media coverage of the anxieties of individual taxpayers this year, the small business owner need not feel overlooked. That is because the 30 million or so small businesses across America were all asking the same question: Am I operating in the correct entity to maximize tax savings?
This question has been ongoing ever since the Tax Cuts and Jobs Act of 2017 was enacted. Interpretation of this portion of the tax code has undergone numerous IRS clarifications over the past year. While this meant for a very challenging few months during tax season, it also meant tax preparers acquired a significant amount of knowledge and understanding that provided them with the ability to help business owner clients navigate these treacherous waters moving forward.
Large companies operating as C corporations saw the greatest benefit as their tax rates dropped significantly from 35 percent to 21 percent. Even though small businesses did not receive the same double-digit tax windfall, they were certainly not left out.
Sean Lydon, CPA, ABV, provides private wealth management and accounting services to his firm’s clients in the Washington, D.C., metropolitan area. As a CPA wealth manager, Lydon and his firm work with over 70 small businesses, ranging from startups to businesses with annual revenue of $180 million. He recently provided some insight into common concerns he is hearing from his business owner clients and how he’s advising them.
It’s All About the Choice of Business Entity
With so many small businesses conducting business in various ways — from independent freelancers to doctors and lawyers to manufacturers to retail operations — tax advisors must look at each individual business operation and business segment individually.
While the Tax Cuts and Jobs Act gave significant tax breaks to S corporations and LLCs, operating as a C corp could still have its benefits. If a company is accumulating profits to repay debt or to fund capital expenditures, a C corporation could allow it to retain more profits on an after-tax basis than if it was organized as an S corporation or LLC. On top of this, for small business owners considering a sale of their business, a C corporation has the potential benefit for its shareholders to take advantage of the qualified small business stock provision that allows them to exclude 100 percent of the gain from the sale of their stock from income taxes.
However, despite the potential benefits of a C corporation, perhaps one of the greatest opportunities created by the Tax Cuts and Jobs Act of 2017 is related to electing S corporation status. Businesses that have avoided this in the past should re-evaluate this decision, as there may be substantial tax savings for companies with low debt, and low cap-ex requirements.
Section 199A Created a New, but Opaque Opportunity
Lydon advises small business to do a deep analysis of the application of Section 199A and the deduction for qualified business income (QBI). While there is potential for substantial tax savings for business owners, companies looking to benefit from this new pass-through entity deduction do not have a clear or uniform means for capturing this opportunity. The tax preparer must assess every entity, and each business segment within each entity, on a case-by-case basis to develop individualized guidance.
Maximizing Tax Minimization Strategies
The 2017 tax law also provides opportunities for tax-smart income planning. For example, in the case of service businesses, such as doctors and lawyers, it’s important to try to keep the owner’s taxable income below $415,000, and as close to $315,000 as possible. The use of a cash balance defined benefit plan can be very useful in creating tax deductions by putting additional funds in an account that grows tax free. As a hypothetical illustration, consider the following: A “service” business owner with $415,000 of taxable income makes an additional $100,000 of contributions to a cash balance plan; if they had $415,000 of taxable income before this contribution, this $100,000 contribution would lower taxable income to $315,000 and could create a tax savings of $50,000 to $60,000, depending on the state.
Small business clients with sales up to $25 million can also benefit from electing an accounting method that changes them from an accrual basis to cash basis, which provides a one-time tax windfall and other planning opportunities for future years.
Plan for Today…and Tomorrow
While the official “tax season” may be over, the “tax planning” season never ends. Performing a four-to-five-year tax projection is critical to effective tax planning. This forward-thinking process is critical for analysis and tax bracket management strategies, such as grouping charitable contributions, harvesting capital gains in a lower-income tax year, opening a donor-advised fund and using a charitable trust.
As a small business grows in size and owners move into a high-net-worth category, exploring estate planning opportunities becomes increasingly important. The transfer of wealth, sale of a business or passing it on to loved ones and family members all carry potential tax consequences, and clients can benefit from early consultation with a trusted advisor.
For high-net-worth clients that already have or are looking to possibly establish LLCs or trusts for their family, the window on the higher estate tax exemption is an opportunity to save substantial estate tax by gifting appreciating assets to family members at a discounted value into a family LLC or trust.
Whether a client owns a small business or a high-growth enterprise, it’s always important they understand there are a number of tax-minimizing strategies that can be deployed. Working with a trusted advisor, especially one with knowledge of both the tax and financial planning sides of the equation, is critical as we continue to adjust to the “new normal” created by the Tax Cuts and Jobs Act of 2017.
