Starting a business? Among the many factors you should be considering is the type of business you’re going to launch – what business entity will you choose?
When making your decision, there’s one rule to remember surrounding entity selection: Choose the type of entity that works for your business and leave tax manipulations to accountants.
So how do you weigh up the options? Entity selection and its impact upon cash flow, leadership, management, exit opportunities, asset protection, and tax rates is more complex then simply deciding if you want to be a pass-through entity (e.g. a partnership, traditional LLC, S-Corporation, sole proprietorship) or a separate taxable entity (e.g. a regular C-Corporation). Here’s what you should be thinking about and how the Tax Cuts and Jobs Act of December 2017 has changed the tax landscape for today’s entrepreneurs.
What to consider when choosing a business entity
There are some historical and general considerations for entity types that remain unchanged. For our firm’s practice, we traditionally consider these elements when working with clients to select the best business entity for them:
- What’s the core business (e.g. services, professional, manufacturing, etc.)?
- Is outside investor capital desired or necessary?
- Is control a factor?
- Is liability protection important?
- Where will the business operate?
- How important are fringe benefits for the working owners?
- Will there be passive shareholders?
- How capital intensive is the business?
- Is inventory an important component?
- Is incentive ownership (e.g. stock) options for employees important?
- Are retirement options important?
These basic questions remain important to determine optimal entity selection. However, since December 2017, when the Tax Cuts and Jobs Act was signed into law, budding entrepreneurs should consider some additional questions, including:
- What’s the spread between corporate and individual tax rates?
- Will there be foreign qualifying sales?
- What are the impacts of state and local taxation?
- What about the changes to alternative minimum taxes?
- What’s the role of intangibles for the enterprise?
- How will the current level of estate and gift tax exemptions impact the business?
The changing nature of tax policy
Generally, tax law changes are incremental. In every generation there’s an upheaval and significant shift in tax policies. In December 2017 the US upended its tax policies. How long these changes remain is unknown. All tax policies are temporary depending upon the mood of Congress and the Administration. Tax policies will always be newsworthy as governments attempt to balance their revenue wants while avoiding destroying businesses’ appetite for growth and profitability.
So, advisors and entrepreneurs alike must reflect upon the complex business environment at hand along with keeping an open mind about future changes. As the concept of entropy reminds us, all matters move from order to chaos. The speed of change is merely a function of facts and circumstances.
The impact of lower corporate tax rates
So, what’s an entrepreneur to do now? First, with corporate tax rates at 21% (with a lower rate for qualified foreign profits of 13%) a taxable C-Corporation must be (re)considered. Under prior law, corporate rates topped at 35% and excess profits were subject to dividend taxes (the double tax conundrum) of another 20%. Once you add state taxes (California can add another 10% on both type of taxes), the government retains more profits then owners. This was a bad result.
Today, the federal tax rate of 21% instead of 35% drives a more balanced equation. With individual tax rates at 37% (as low as 29.6% under qualified business income rules) the effective costs of double taxation are reduced compared to prior laws. One important change stemming from the recent tax overhaul is the limitation of the deductibility of state taxes on individual tax returns. For highly profitable businesses that require reinvestment of earnings, the ability to fully deduct state taxes is a prime benefit reserved for corporations and lost to individuals.
Additional considerations include financing the capital growth for the business. With reduced tax rates, it’s economically efficient to use corporate profits to internally fund expansion. For wealthy owners, shared ownership, minority discounts, and employee stock ownership programs provide methodologies for reducing future estate and exit taxes.
Single or multiple entity business?
After thinking through the above questions, founders and entrepreneurs should also consider if they want to operate under a single or multiple entity enterprise. A one-size fits all is an outdated business model.
As revenues and profits become more and more generated from intellectual properties, entrepreneurs should consider splitting their businesses into options that align their economics with the business enterprise.
Adapting your business to change
Taxation is only one aspect in deciding what type or types of entities you choose. Businesses have a purpose. That purpose is to deliver a service so valuable that its customers are willing to pay it a profit to provide it. Remember that customers don’t care about a business’s tax status. Owners should also consider the complexities of their business during formation and in subsequent review.
However, don’t overthink it. The worst thing that can happen is that your business is tax inefficient. While inefficient structures can cost you money, it isn’t life or death. Smart business owners seek to balance tax with operating efficiencies. There’s no single solution. Each business is different, and each founder must adapt to changing realities.
Ever-changing tax rules and regulations create opportunities and hassles. The common entrepreneur stays the course without questioning alternatives. The smart entrepreneur adapts to these changes and harvests a better bounty of profits and cash flow. Change is inevitable; reacting to it is a choice. Ultimately, that choice is yours. Now, make a smart one.