Confusion is the name of the game after lawmakers attempted to level the playing field between the new 21-percent tax rate for incorporated security businesses and the tax bill for income passed through to the owners of entities such as S corporations, Limited Liability Company (LLCs) and partnerships.
Despite creating a unique 20-percent deduction for pass-through income, last December’s Tax Cuts and Jobs Act (TCJA) has many security dealer and integrator business owners facing personal tax rates as high as 29.6 percent – far above the new 21-percent rate for regular corporations.
Pass-Through Business Benefits
The income from a security business that has elected or chosen to be treated as a pass-through entity is taxed only once, on the owner’s personal tax return – as opposed to a regular “C corporation,” which has its profits taxed at the corporate level and again at the tax rates of dividend recipients.
Security dealer and integrator owners operating as pass-through entity benefit from the legal advantages of regular corporations along with the tax advantages of a sole proprietorship. Of course, the most attractive feature of pass-through businesses in the past was the tax savings. While “members” of an LLC are subject to employment tax on the entire net income of the business, only the wages of S corporation shareholders who are employees are subject to employment tax. The remaining income is paid to the owner as a "distribution" – which was taxed at a lower personal tax rate, if at all.
An S corporation designation allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the business, or sells his or her shares, the S corporation can continue doing business relatively undisturbed. Similar rules now also apply to partnerships. Maintaining the business as a distinct, separate entity defines clear lines between the shareholders and the business that significantly improve shareholders protection from liability.
A LLC, on the other hand, is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with security dealer or integrator owners in partnerships or sole proprietorships, LLC “members” report business profits or losses on their personal income tax returns – the LLC itself is not a separate taxable entity.
TCJA Changes the Landscape
As mentioned, the tax rate for regular, incorporated businesses has been lowered from 35 percent to 21 percent; and there is no more special tax rate for so-called “Personal Service Corporations (PSC)” – those unique entities dependent on the personal services of their owner.
An unintended consequence of the lowered tax rate for regular corporations is that a majority of businesses currently operating as pass-through business entities end up paying more in taxes by remaining a pass-through than they would by revoking the pass-through election or switching from pass-through to a C corporation.
Another important factor in the pass-through entity/regular corporate form debate involves fringe benefits. Currently, the vast majority of pass-through business owners can no longer deduct state and local income taxes and are permitted to write off only $10,000 of their property taxes. C corporations face no similar deduction restrictions.
A more than two-percent shareholder in an S corporation cannot participate in the operation’s fringe benefits. Health insurance, for example, is not deductible to an S corporation, but it is to C corporations.
Of course, a security business owner is not forced to spend a lot of money on health insurance. There are always Health Reimbursement Accounts (HRAs), allowing unlimited contributions that, if unused, can be rolled over to the next year. It is a similar story with other fringe benefits with work-arounds available.
The TCJA created a 20-percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by businesses operating as S corporations, partnerships, LLCs and sole proprietorships; however, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income. All businesses below the income thresholds – regardless of whether they are “service professionals” or not – can take advantage of the 20-percent deduction. For income above the threshold, the new law also provides a deduction -- although the 20-percent deduction from pass-through income applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner.
Personal Service Corporations may be gone, however, the 20-percent deduction will not help everyone because of restrictions placed on “specified service trades and businesses.” So-called “service businesses” are not eligible for the deduction, and include businesses defined as those in the fields of consulting, as well as “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.”
Changing Your Business Designation
Changing circumstances, revised tax laws and even the success of a security business may prompt a reassessment of the type of entity used. Although many of the tax law’s provisions apply to all business entities, confusion need not be the name of the game when choosing among the various entities – or choosing to be treated as a C corporation.
Not only will the decision to change the business’ entity by a security dealer or integrator owner have an impact on how much is paid in taxes, it will also affect the amount of paperwork required for the business, the personal liability faced by the principals and, especially important in today’s economy, the operation’s ability to raise money.
Since some areas of the law specifically target each entity, choosing among the various entities can result in significant differences in federal income tax treatment. Of course, there is more to choosing the right structure for a security business than taxes. Guidance is also needed when making many of the accounting method changes necessary in order to comply with the new law.
Naturally, the question of whether to switch entities for can be especially difficult for closely-held and family businesses that are often structured as pass-throughs. In the eyes of many experts, there is no longer a reason to operate a business as an S corporation or other pass-through entity.
Other experts advise the owners of S corporations and other pass-through businesses to remain patient – after all, converting from a pass-through entity to a C corporation can be a complicated process requiring quite a few adjustments.
How to Make the Switch
With so much potential profit at stake for pass-through businesses and their owners, the best approach might be for every security dealer/integrator owner to choose their business entity based on the new “reformed” tax law. To help in this decision-making process, professional advice is strongly recommended.
A security business can revoke its so-called “subchapter S” election by March 15 to have it apply for the whole calendar year. If the decision that it is no longer advantageous to be an S corporation comes later, the election can be made at that point and become effective from that point on. A security business choosing to terminate their operation’s S corporation status cannot reapply for five years.
The annual tax return provides an opportunity to re-consider the options available. Entities with more than one shareholder or member can elect corporate status on its annual tax returns; thus, an entity that is a partnership under state laws may elect to be taxed as a C corporation, or S corporation, for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under so-called “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified corporations and may not elect to be treated as any other type of entity.
Pass-through owners considering moving to a corporate entity should be aware of the dreaded “accumulated earnings tax” – a 20-percent tax on businesses holding too much cash. The personal holding company tax, another 20-percent penalty on undistributed passive income earned by a closely-held, regular incorporated business is also a factor.
There is also the matter of how much of the security dealer or integrator’s earnings will be distributed to shareholders. While corporations will pay a 21-percent income tax rate, pass-through business owners could, as mentioned, pay as much as 29.6 percent, depending on their tax bracket and income type.
Corporate distributions will also be taxed; thus, if a C corporation’s profits are going to be distributed as dividends, the tax rate will likely be higher as a pass-through. Naturally, the distribution policies can vary widely, especially among family businesses, requiring consideration of whether there are family members who are accustomed to getting distributions every year, or if there are trusts that have distribution requirements.
Mark E. Battersby is a freelance writer who specializes in tax-related issues. Email him at [email protected].
