What potential business owners should know about entity structure considerations and tax reform

by | Aug 10, 2018 | Articles

What will your business look like in one year, five or 10 years? In this two-part series, we’ll explore what you must consider during the planning stages of any business enterprise.

Who will fund the business?

Capitalization is an important consideration when starting any business enterprise. Any entity can take on debt; however, the entity structure matters when taking on equity. A sole proprietorship, which is only funded by its owner, is the simplest capital structure. Conversely, a C corporation can receive capital from any type of investor, whether it’s an individual, flow-through entity or another corporation. The corporation can sell plain vanilla common shares: where, each investor receives a proportionate share of the voting power and value of the company, preferred shares where certain investors are provided a preferred return and liquidation preference, or non-voting shares where the investors have ownership in the company but cannot participate in board or governance matters.

Partnerships, like corporations, can receive capital from any type of investor, however, partnerships have more considerations than corporations. For example, partnerships can award profits interests to management and other individuals for performance. Profits interests allow the company to incentivize management and key employees by awarding them a share of the company’s future income growth without diluting the company’s ownership.

How do income taxes affect my cash flow?

A business owner must know how taxes will affect future cash flow. The Tax Cuts and Jobs Act (TCJA) lowered the highest stated corporate tax rate from 34% to 21%. Among other provisions, the new corporate rate is much lower than the highest stated individual tax rate, and in lowering the corporate tax rate, the corporate alternative minimum tax was eliminated and net operating losses – produced after tax year 2017 – no longer expire.

The TCJA also created IRC Section 199A, which allows entities other than C corporations a deduction equal to 20% of combined qualified business income (QBI), the net amount of income, gain, loss and deductions from any trade or business other than a specified service trade or business.

However, the performing of services as an employee is not considered a qualified business. Furthermore, the QBI deduction cannot exceed more than 20% of the taxpayer’s taxable income, reduced by net capital gain. This new deduction allows flow-through entities to maintain a competitive, effective tax rate with C corporations.

Although the QBI deduction is limited to 20% of qualified trade or business income, it is further limited for taxpayers who are married filing jointly (MFJ) with taxable income greater than $315,000 – to the extent of 50% of a business’s W-2 wages paid to employees or 25% of a business’s W-2 wages plus 2.5% of the original cost of depreciable property.

This limitation, commonly referred to as the W-2 limitation, is gradually phased in for MFJ taxpayers with taxable income of $315,000, and completely phased-in when taxable income reaches $415,000.

To be eligible for the QBI deduction, the business income must be effectively connected with a trade or business within the United States. Unfortunately, the QBI deduction does not look kindly upon service trades or businesses. Specified service trades are not included as a qualified trade or business under the new Section 199A rules; therefore, the QBI deduction is completely eliminated when taxable income for MFJ taxpayers is more than $415,000.

Taking federal and state tax laws into consideration is a must when planning for any business venture. In part two, I’ll address other areas you need to know about.

This article originally published in the Houston Business Journal.

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