How Becoming an LLC Could Save Taxes Under the Tax Cuts and Jobs Act of 2017

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How Becoming an LLC Could Save Taxes Under the Tax Cuts and Jobs Act of 2017

Former President Trump’s tax package, dubbed the Tax Cuts and Jobs Act, was signed into law on December 22, 2017. The strategy focused lowering the corporate tax rate and streamlining the income tax system for individuals. Every firm that qualifies as a C corporation (or C-Corp) is now taxed at a flat rate of 21%, down from 35% before.

One often expressed fear was that the new system would create a tax loophole that would encourage people to register as pass-through businesses such as limited liability corporations (LLCs) and S Corporations (or S-Corps).This permits their company revenue to be taxed at their personal tax rate. As a result, the LLC tax rate varies.

Key Takeaways

  • The Tax Cuts and Jobs Act resulted in huge tax reductions for some company types.
  • The arrangement may not be as useful to independent contractors as it is to others.
  • An LLC may choose whether to be a C-Corp or an S-Corp. As a consequence, an individual’s social security and Medicare taxes may be reduced.
  • The IRS is paying extra attention to impacted firms as a result of the tax reduction.
  • The bill increased an individual’s standard deduction by doubling it.

What Is a Pass-Through Entity?

An LLC is a pass-through entity, sometimes known as a flow-through entity, which implies it pays taxes under an individual income tax law rather than a corporation tax system. Pass-through enterprises include sole proprietorships, S Corporations, and partnerships, in addition to LLCs. C Corporations, however, are not.

How the LLC Tax Rate Is Calculated

C-Corp profits are taxed twice: once at the company level and once at the personal level. Not surprisingly, smaller businesses that do not need the distinctive ownership structure of a C-Corp or the capacity to offer shares to the public often form as LLCs or S Corporations.

Meanwhile, since LLC owners may deduct up to 20% of their company revenue before taxes are computed, filing as an LLC depending on an individual’s personal income tax rate can be very advantageous. Finally, depending on each individual’s filing status and income level, this might vary from 10% to 37%.

Small businesses that do not intend to raise funds from public shareholders but want more legal and financial protection for their personal assets often create LLCs. LLCs may be formed by only one person in all 50 states. Except for banking, trust, and insurance companies, almost every kind of company may be formed as an LLC. Some jurisdictions have further limits on the formation of LLCs, such as California’s ban on architects, professional healthcare workers, and accountants.

How to File as an LLC

Creating an LLC is a straightforward process. While the procedure varies by state, it usually requires submitting articles of organization with the state, filling out a form, and paying a filing fee. Even in places where one is not required, owners should form an LLC operating agreement for greater financial and legal protection.

  Tax Loss Carryforward

Anyone may create an LLC, but not everyone can produce revenue from it. “A typical paid person might hypothetically leave their job, form an LLC, and sell their freelancing services back to their firm to avoid paying a higher income tax rate,” says CPA Aaron Lesher of Hurdlr, a small business financial software. According to Lesher, “the employee-as-an-LLC notion is a major audit red flag.”

It is not only the responsibility of companies or employees to determine how workers are categorised. Their categorization is determined by how they compare to several standards in the tax law.

“The IRS is pretty clear on the distinction between a contractor and an employee,” says Josh Zimmelman, head of New York City-based accounting company Westwood Tax & Consulting LLC. “They look at three major factors: financial control, behavioral control, and relationship type.”

  • The IRS examines whether the worker is paid a regular pay, an hourly rate, or a flat charge per job. The IRS website claims that “an employee is often promised a regular compensation amount for an hourly, weekly, or other term.” “Even if the income or salary is augmented by a commission, this typically shows that the person is an employee.” In most cases, an independent contractor gets paid a set price for the task. However, in other professions, such as law, independent contractors are often paid on an hourly basis.”
  • Behavioral control: The IRS considers whether a worker has control over when, where, and how the job is performed. “An employee, for example, has set hours and is instructed where to work; a contractor is given greater latitude as long as the task is completed,” Zimmelman explains.
  • Relationship type: The IRS examines any written agreements between a worker and an employer, including the relationship’s permanence. “For example, if a worker gets benefits such as health insurance, sick pay, vacation pay, and so on,” Zimmelman explains. “Misclassifying an employee as a contractor may result in fines, particularly if the person is paid in the same way as regular workers.”

The employer must agree to pay the employee as an independent contractor as the first stage in any strategy to convert salaried personal income into LLC revenue. Certain businesses may be willing to play since such an arrangement would relieve them of the need to offer health coverage to that employee. However, most firms are unlikely to engage in such a scheme.

“Most employers are aware that hiring a self-employed person who is considered a disregarded entity—in this case, the LLC—will result in significant problems with the State Department of Labor, which no one wants,” says Abby Eisenkraft, author of 101 Ways to Stay Off the IRS Radar and CEO of Choice Tax Solutions Inc. in New York City.

“If a firm claims that a worker whose work hours they control—and for whom they provide desk space and equipment—is a contractor, they are inviting the IRS, the state, and the Department of Labor to audit them. And they will not prevail “She draws a close.

  Determining Adjustments to Income on Your Tax Return

Assuming the worker and employer can establish a true independent contractor relationship that will withstand an audit, the worker must decide whether the tax savings outweigh the loss of benefits, which could include health, dental, life, and disability insurance, 401(k) contributions, and paid time off.

How LLCs Save Under the LLC Tax Reform Plan

LLCs, unlike C companies, are not considered independent businesses and hence do not pay taxes on their own. Single-owner LLCs are treated as sole proprietorships by default, but LLCs may elect to be taxed as S-Corps or C-Corps, which may benefit certain firms by lowering employment taxes, such as Medicare and Social Security.

Assume an LLC wishes to be treated as an S-Corp in order to save money on payroll taxes while avoiding double taxation as a C-Corp. The shift in corporate tax rates and the wide disparity between the flat company tax rate of 21% and the income tax rates ranging from 10% to 37% under Trump’s proposal may seem to bring tax relief. Tax experts, on the other hand, say it’s not that straightforward.

Independent contractors who manage small businesses cannot simply game the system since the wording of the 2017 tax reform compel them to be workers of their own businesses and pay taxes via payroll. “In this instance, the lone officer will get a W-2 and pay taxes at their standard tax rate based on earnings and other income items on the tax return,” Eisenkraft adds.

Those earnings, in other words, are taxed at the personal rate of 10%, 25%, or 35% under the Tax Cuts and Jobs Act, as well as subject to Social Security and Medicare taxes (FICA).

“While the flow-through part may be taxed at a lower rate, the IRS will not permit that person to be paid less than a fair compensation,” Eisenkraft adds. “There are several court examples when an officer earning hundreds of thousands of dollars attempts to claim a $25,000 wage and loses in tax court.”

Taxation of Owner’s Salary vs. Pass-Through Profits

According to financial expert Bradford Daniel Creger, president and CEO of Total Financial Resource Group in Glendale, CA, the tax rate an independent contractor pays on their income is the same under the Trump tax plan as it was under prior tax law.

“An person must pay income taxes on revenue earned through their own efforts—that is, their own earnings—as ordinary income,” he explains. “Creating an organization does not alter this.” It just adds to the complexity of the forms, but the income tax result remains the same.”

There is one way to take advantage of Trump’s tax proposal. “The S company,” Creger explains.

The S-Corporation, the simplest and most common kind of a pass-through firm, now permits owners to collect both compensation income and extra revenue reflecting the organization’s profits as an S-Corp dividend.

  Schedule K-1: Beneficiary's Income, Deductions, Credits

The distinction between these two sorts of income is that salaries are subject to payroll taxes whereas S-Corp distributions are not, according to Creger. By keeping salaries separate from company earnings, the owner saves a little amount of money in taxes by avoiding payroll taxes on the amount received as an S-Corp dividend.

However, the S-Corp dividend received by company owners is taxed at regular income tax rates based on their individual income tax bracket. According to Creger, the only savings from this tax method under the existing system are payroll tax reductions.

However, under Trump’s tax proposal, the S-Corp payout is taxed at 15% rather than at the individual’s usual rate. As a result, the more owners may get as a distribution of earnings from their firms, the more likely they are to save.

What Was the Goal of the Tax Cuts and Jobs Act?

The Tax Cuts and Jobs Act was passed in order to reduce corporate taxes while increasing individuals’ deductible income levels. The Act was created and implemented to boost worker productivity and business profit in order to stimulate the economy further.

What Does a Tax Cut Do?

A tax decrease benefits people by decreasing the amount deducted from their paychecks or written to revenue services during tax season. For firms, the tax drop might be broad, such as “corporate tax has been reduced from 15% to 13%,” or it could be more subtle, such as a change in the legislation regarding authorized depreciation or other accounting procedures.

What Are Tax Loopholes?

Tax loopholes are strategies for corporations or individuals to reduce their tax bills. While some people believe that tax loopholes are immoral, most firms are continuously seeking for methods to acquire a competitive advantage and generate returns to their shareholders. A two percent increase may be significant, which is why some businesses will route money via other firms and seek other loopholes. Tax loopholes are permissible, as opposed to tax avoidance, which is criminal.

The Bottom Line

The degree to which company owners have taken advantage of the new tax legislation remains to be revealed. The Tax Cuts and Jobs Act promotes entrepreneurs over salaried employees earning the same amount of money. Owners of LLCs may be able to benefit from the rate adjustments, but they will almost certainly need to consult with an accountant and maybe a lawyer to verify they are not only doing so lawfully, but also financially.

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