Biden’s election campaign hinted at his ambitious initiatives that include increased corporate taxation, leading to economic growth and improved infrastructure. Since the elections, the debate has moved to the senate, and business leaders are watching with bated breath because of his proposed corporate tax increase to 28%.
Business formation statistics for 2021 may show a decrease of 4.5% in startups in the last four quarters compared to the same previous period. However, new business formations are still above the levels of 2013. These statistics are an encouraging sign of confidence in the country’s economy, but small businesses are waiting to hear how the corporate tax reform will affect them.
There is no official plan yet, but the proposals recently became public. So far, it appears the tax proposals are aimed at taxing the county’s biggest companies and not small businesses. Here is what we know so far:
Taxation Impact on Startups
Depending on the entity structure, there are two main proposed changes likely to affect small business taxation.
Corporate Income Taxes
Looking back at the history of corporate taxation, there was a time during the 1950s when it was leveled at 52%. Since the Trump era, it was reduced from 35% to 21%. The suggested corporate tax rate of 28% might not seem so huge compared to past rates, but it is big enough to affect C-Corps. Up until now, they have used them to their advantage since it offers a low tax rate and insignificant double taxation.
Corporate tax does not apply to small businesses but only to those that are incorporated. So, it doesn’t affect LLC owners, partnerships, or sole proprietorships who report their business profits on their personal income.
End of Pass-Through Tax Deductions
It appears that the proposed tax plan is going to eliminate the pass-through deductions enjoyed by S-corps, partnerships, or sole proprietorships. This deduction is a significant, but rather complex deduction which is often so restricted that many businesses feel they get no benefits from it.
The value of the pass-through deduction will be set according to the personal income, business activity, and year of the tax payment. Even though many business owners have few benefits from these deductions, for some this loss may impact their taxes, increasing the amount due.
Differences Between LLC and S-Corp Taxation
LLCs and corporations are both business entities that can elect to have a tax status known as an S-Corp. Most small business owners prefer to form an LLC with its default pass-through taxation, while others want the benefits of an S-Corp. Watch this video from The Really Useful Information Company to learn more.
LLC Taxation
By default, LLC owners are members of the LLC and cannot be employees. Therefore, they pay self-employment taxes and pass their business net profit onto their individual tax returns. The income tax payable is based on their tax bracket and self-employment taxes.
S-Corp Taxation
LLC owners can elect that their business is taxed as an S-Corp, allowing them to be treated as its employees for tax purposes. The S-Corp continues to maintain the pass-through status of an LLC, avoiding the double taxation of other corporations.
Opting for the S-Corp status may help reduce the amount of self-employment taxes paid, and business owners can contribute to retirement or health insurance premiums before taxation. There is one requirement, the owner-employee must earn a salary that matches the employment.
Some businesses can benefit from the S-Corp status, and according to TRUiC, their savings must be at least $2,000 a year to offset the extra bookkeeping and payroll service costs.
Electing Between an LLC and S-Corp
S-Corp vs LLC depends on the type of business and how the business owner wants to be taxed. In businesses where the owner wants to be taxed as an employee, then an S-Corp status is ideal. However, there is no reason why a business should elect an S-Corp if its profits are not enough to pay the owner a reasonable salary and a minimum of $10,000 in annual distributions.
Finally, a business must meet the requirements for an S Corporation. The S-Corp cannot have more than 100 shareholders, it must issue only one class of stock, all owners must be private individuals, and they must either be US citizens or have permanent resident status.
Operating as a default LLC is the best choice for LLCs who are growing and reinvesting in their business. This means they have low net income and from the profits, they can deduct expenses before declaring them on their individual tax return.
Final Word
Every small business needs an income tax strategy, especially future startups, as the government starts rolling out its proposals. The most likely of these proposals to affect small businesses are those that suggest tax credits will be offered to small businesses if these adopt employee retirement plans.
You may be interested in: S-Corporation vs. LLC Which one is Better for Your Startup?
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