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If you’re a small-business owner, you’ve probably heard of the 2018 tax bill—also known as "Tax Cuts and Jobs Act." This bill has not only changed individual taxes, but it’s also reformed corporate taxes in the U.S.—especially for small businesses—making this one of the best times to start that side hustle you’ve been dreaming of.
Whether you’re already running your own business or just thinking about starting one, this is good news for you! How do these tax changes help you? Read on!
The new bill is doing away with the marginal tax rate system for corporations. Before this bill, you paid taxes depending on the tax bracket you fell into. So, if you made more money, you paid more taxes—and vice versa. Now, corporate taxes will include a flat 21% tax on all profits. So, it’s good-bye tax brackets and hello flat rates! The bill is also taking the U.S. corporate tax system from worldwide to territorial. That just means corporations will no longer pay U.S. taxes on profits earned outside the country.
You may be working a side gig and wondering when you should make your business official. Or, you might have an LLC but question if you could save money by switching to another business structure. You have plenty of options for how to structure your business, but there’s a lot of tax information to take into consideration. Since the new tax bill changed up the tax laws for small businesses, you should talk to a tax pro. An expert can you give you advice about which small-business structure is best for you, so you can keep more of your hard-earned money.
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The most common structures for small businesses are:
- Sole Proprietorship
- Partnership (Limited and Limited Liability)
- Limited Liability Company (LLC)
- C Corporation
- S Corporation
- Nonprofit Corporation
A sole proprietorship is the easiest business type to form, and it puts you in total control. But it’s not all daisies and butterflies. Sole proprietorship also makes you personally responsible for any company debt. If you don’t file paperwork with the government to claim a particular business structure, the IRS automatically assumes your business is a sole proprietorship. That means your individual assets, business assets, and debts are lumped together.
So what does this look like exactly? Well, let’s use Jane as an example. In early 2018, she started a photography business—something she’s dreamed of doing for years. Way to go, Jane! But Jane didn’t file any paperwork to state what type of business she’s running, so the government assumed it’s a sole proprietorship. Now, all of her business debt, assets, loans, and equipment are considered personal debts and assets. If Jane decides to close her business, she’ll be responsible for repaying any business loans.
If you decide to take the plunge with a sole proprietorship, be sure to open a separate checking account and set it up to house your business income and to pay expenses. Don’t let anything else go into or come out of that account; it should be for business expenses only. Then, what you have left is profit. Talk about a good system!
You’ll need to set aside 25% of your profits for your federal quarterly estimates. In most cases, that will put you pretty close to what you’ll need to pay, unless you make more than $60,000 to $70,000 in profits. At that point, you may want to kick your percentage up a little bit. Talk to a tax expert to get advice about the right amount to set aside for taxes.
It’s also important to contact your tax professional about all state and local compliance issues, like state franchise and excise taxes, Department of State annual reports, local personal property taxes, local business licenses, state and local contractor requirements, and/or other professional licenses. Following state and local filings’ rules can be just as important to the well-being of your business as obeying federal tax rules.
The two most common kinds of partnerships, limited partnerships (LP) and limited liability partnerships (LLP), are the simplest business structures if two or more people are running a business together. Unfortunately, they also have the greatest potential for personal conflict in the day-to-day running of the company—as compared to other business types. Check out Dave’s opinion on partnership businesses: Reward Without Partnership.
In a limited partnership, only one partner has unlimited liability; all other partners have limited liability. The partners with limited liability also tend to have limited control over the company. Profits are passed through to the unlimited liability partner’s personal tax returns, while the unlimited partners pay self-employment taxes.
Let’s say Jane enters into an LP as an unlimited partner with her friend Tina. Tina won’t have as much control over the company, but there’s an upside to this: She could avoid being forced to pay off business debts with personal assets should the business take a turn for the worse. Jane, however, would be totally responsible if something goes wrong. So if their company gets slapped with a lawsuit, it’s Jane’s feet that will be held to the fire—not Tina’s.
Limited liability partnerships, on the other hand, protect each person from debts and obligations against the partnership, and neither partner is held responsible for the actions of the other. If Jane decides that her partnership with Tina should be an LLP, both she and Tina will be personally protected from business debts or legal claims.
Limited Liability Company (LLC)
LLCs help separate personal assets and liabilities from business ones, reducing your personal risk if something bad happens to your business. In an LLC, your profits and losses can pass through to your personal income without facing corporate taxes, but members of an LLC are considered self-employed and must pay self-employment taxes.
If Jane decides to make her photography gig an LLC, she would have an extra layer of protection if something went wrong with the business—like a lawsuit. And instead of paying corporate taxes, she would pay self-employment taxes.
Unlike an LP and LLP, C corporations completely separate personal and business assets and liabilities. They offer the most protection for their owners, but they also require more reporting, paperwork and record keeping.
C corporations’ profits are taxed twice—first when the company makes a profit and again on the shareholders’ personal tax returns. C corporations are completely independent from their shareholders.
So, say Jane creates a C corporation with Tina, and they’re both shareholders. If Tina decides to sell her ownership to another person, the company will continue operating without a hitch. Since this is a C corporation, Jane will have to pay corporate taxes and Jane (plus any other shareholders) will have to pay income taxes on her personal tax returns—not pass-through taxes like in other business structures.
An S corporation is structured to avoid double taxation, like what happens in a C corporation. S corporations allow profits, and some losses, to pass directly through the owners’ personal income without being subject to corporate tax rates. (More on why you might file individual—rather than corporate—taxes later.) But there are some limits on S corporations: You can’t have more than 100 shareholders, and all shareholders must be U.S. citizens. Plus, S corporations still have to follow strict filing and operational processes.
Do you know who wants to start an S corporation? Yes, Jane! If Tina is a co-owner but she sells her ownership, the company would continue right along. Jane would also only pay pass-through taxes—income taxes through her individual tax return—without the additional corporate tax.
Nonprofit Corporation – 501(c)(3)
Nonprofit corporations are for charity, education, religious, literary or scientific work. Because their work benefits the public, nonprofits can receive tax-exempt status, meaning they wouldn’t pay state or federal income taxes on any profits they make.
If Jane were to file with the IRS as a nonprofit, she would have to follow special rules about money the company earns. For example, she wouldn’t be able to donate to any political campaigns through the business. But, Jane would be protected from any company debts.
Changes to Tax Law
All that said—whew!—sole proprietorships, limited liability companies, partnerships and S corporations don’t have to pay taxes at the company level—unlike C corporations and nonprofits. Instead, all business income passes through to their owners’ individual tax returns. There, the business income is taxed at the owners’ individual income tax rate.
Under the new law, taxpayers with pass-through businesses like these will also be able to deduct 20% of their income on their taxes. In other words, if you own a small business and it generates $100,000 in profit in 2018, you’ll be able to deduct $20,000 before the ordinary income tax rates are applied.
Let’s go back to Jane and her photography business. By the end of the year, her business made $40,000 gross income. After the 20% deduction, her taxable income was $32,000. She worked with a tax pro she trusted and found out she owed $3,840 before her personal deductions and exemptions (putting her in the 12% tax bracket since she’s single). Before the tax bill, she would have fallen in the 25% tax bracket (because she made $40,000), so Jane would have paid $10,000 before deductions and exemptions. See why it’s a good time to consider opening that small business? Way to go, Jane!
There are phase-out income limits that apply to some business owners such as lawyers, doctors and consultants. They’re set at $157,500 for single filers and $315,000 for pass-through business owners who file a joint return.
Related: Running your own business? Save time on tax prep with our free checklist to help you gather the right documents the first time around. Download your free tax preparation checklist.
Other Benefits to Starting a Small Business Now
The pass-through income deduction isn’t the only benefit making this a great time to start your small business. Before the new tax plan, when a business owner claimed new equipment as a loss to get a tax break, this tax benefit was spread out over several years. So, small-business owners didn’t receive the full benefit for multiple years. Under the new tax law, small-business owners get the deduction right away. This makes pouring some cash into your small business much more appealing. And the more you can invest in your business, the more efficient you can become and the more profits you can make!
If you’re thinking about starting your own small business, you should have a healthy emergency fund. (You want to be able to stay operational for around six months if push comes to shove.) And make sure the new tax law isn’t your only motivation to start your business. Laws can always change. If you already have your own small business and aren’t sure whether it’s set up properly and to your benefit, make sure you get help from a professional tax advisor. They can guide you through the process of switching business types to reduce your tax burden and make the most of your business!
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