Denice R. Preston
The Tax Cuts and Jobs Act, also known as former President Trump’s Tax Plan, was signed into law by the president on December 22, 2017. The plan focused on simplifying individual income taxes and reducing the corporate tax rate. The tax rate for C corporations is 21%. This is a reduction from 35%.
A common concern was that the new system would create a tax loophole, encouraging individuals to form pass-through entities such as Limited Liability Companies (LLCs) and S Corporations. This allows them to tax their business income based on the individual tax rate. The LLC tax rate will vary.
What is a pass-through entity?
An LLC is a “pass-through” entity, also known as a flow-through entity. This means it pays its taxes using an individual income tax code, not a corporate code. Pass-through businesses include LLCs as well as sole proprietorships and S Corporations. C Corporations do not.
Calculating the LLC tax rate
C-Corps are taxed twice, once on the corporate level and then again on the individual level. Unsurprisingly, smaller companies that do not require the unique ownership structure or the ability to sell stock to the public often choose to organize as S corporations.
Filing an LLC, based on the individual’s tax rate, can be beneficial because LLC owners can deduct up to 20 percent of their business income. Depending on the individual’s filing status and income, this could ultimately range between 10% and 37%.
Often, small businesses do not plan to raise money from public investors and want more protection of their assets from LLCs. In all 50 states, LLCs can consist of only one person. Almost any business can be formed as an LLC except for banking, trust, and insurance companies. California prohibits architects, licensed healthcare professionals, and accountants from registering as LLCs.
How to file as an LLC
The process of forming an LLC can be done relatively quickly. The process varies from state to state but typically involves filing articles of incorporation with the state. This is followed by completing an online form and paying the filing fee. Even in states without an operating agreement, owners can benefit from better legal and financial protection by creating one.
It is possible to form an LLC, but it does not mean you can earn income from it. CPA Aaron Lesher of Hurdlr, a small-business finance app, says that “a salaried employee can theoretically quit his or her job, form an LLC, and sell freelance services to the company to avoid paying higher income taxes.” Lesher warns that “the employee-as -LLC concept is a massive Audit red flag.”
The classification of workers is not solely up to the employer or employee. The tax code has guidelines that determine how workers are classified.
The IRS is clear about the differences between a contractor and an employee, says Josh Zimmelman of Westwood Tax & Consulting LLC in New York City. They consider three factors: financial control, behavioral control, and the type of relationship.
Financial Control: IRS examines whether the worker receives a regular salary, hourly rate, or flat fee for a project. On its website, the IRS explains that an employee is guaranteed a wage amount, hourly, weekly, or any other period. This usually indicates an employee, even if the wage or salary has a commission added to it. An independent contractor will usually be paid a fixed fee. It is not uncommon for independent contractors to be paid hourly in certain professions, such as the law.
Behavioral Control: When determining whether an employee controls when, where, and how to perform their work, the IRS will examine the worker’s control.
Relationship Type: IRS examines any written agreements between the worker and employer, including whether the relationship is permanent. 5 For example, if that workers who receive benefits such as health care, sick pay, or vacation pay are most likely employees, Zimmelman states. Misclassifying an employee to be a contractor can result in penalties. This is especially true if the worker similarly receives compensation to regular employees.
The LLC Tax Reform Plan: How LLCs Can Save Money
By default, single-owner LLCs are taxed as sole proprietorships. However, they can choose to be taxed as S-Corps or C Corporations. This may benefit some businesses by reducing their employment taxes. Single-owner LLCs will be taxed by default as sole proprietorships. However, LLCs may choose to tax as S-Corps and C-Corps. This can benefit some businesses, as it reduces their employment taxes, Medicare and Social Security taxes.
Assume that an LLC would like to be taxed in the same way as an S-Corp. This will save them money on payroll tax and avoid double taxation. Trump’s tax plan may provide tax relief due to the changes in the business tax rates and the vast discrepancy between the 21% flat rate for business taxes and income tax rates ranging from 10-37%. Tax experts say that it is more complex than you might think.
The 2017 tax law requires that independent contractors who run small corporations be treated as employees and pay payroll taxes. Eisenkraft explains that “in this case, the sole employee will receive a W-2 and pay taxes at the ordinary tax rate, based on their wages and other income items in the tax return.”
These wages are subject to Social Security and Medicare tax ( FICA) and the 10%, 25%, or 35% personal rate of the Tax Cuts and Jobs Act.
Eisenkraft says that while the IRS may allow employees to receive a lower salary, it will not permit them to do so. In court cases, officers earning hundreds of thousands of dollars try to take a salary of $25,000 and lose in tax court.
What are Tax Loopholes?
Tax loopholes allow businesses and individuals to lower their tax obligations. Some view tax loopholes as unethical. However, corporations constantly look for ways to improve their competitiveness and provide returns to shareholders. Some companies filter money through different entities to find loopholes. An additional two percent is a significant amount. Tax loopholes can be legal, but not tax avoidance which is illegal.
