Trump’s tax plan emphasizes cutting the corporate tax rate and simplifying the individual income tax system. However, the plan would cut not only the corporate tax rate, but the rate for all types of businesses regardless of income level or business type. Whether a business is a hugely profitable multinational corporation or a tiny sole proprietorship, its income would be taxed at 15%.

One concern that's been raised is that this new system would create a tax loophole that would encourage individuals to try to make their income sources qualify to register as pass-through entities such as limited liability companies (LLCs) and S corporations. Here's what that type of strategy would entail. 

What Is a Pass-Through Entity?

A pass-through entity or pass-through business, also called a flow-through entity, is one that pays taxes through the individual income tax code rather than through the corporate tax code, explains the Tax Foundation on its website. Sole proprietorships, S corporations, partnerships and LLCs are all pass-through businesses, in contrast to C corporations, which are not.

C corporations tax owners’ profits twice, once at the corporate level and again at the personal level. Not surprisingly, smaller companies that don’t need the unique ownership structure of a C corp – or the ability to sell shares to the public – will organize as LLCs or S corporations. (See Understanding S Corporations and S Corp vs. LLC: Which Should I Choose?)

Why Become an LLC?

Small operations that don’t plan to raise money from public shareholders but that want a higher level of legal and financial protection for their personal assets often form LLCs. All 50 states allow LLCs that consist of just one person. Almost any line of business may be incorporated as an LLC, but banking, trust and insurance businesses may not, and some states impose additional restrictions, such as California’s prohibition against architects, licensed healthcare workers and accountants registering as LLCs. (See LLC vs. Incorporation: Which Should I Choose? and Why should I register as a Limited Liability Company (LLC) if I am self-employed and have no employees?)

The process to form an LLC is simple. While it varies by state, it typically entails filing articles of organization with the state, completing a fill-in-the blank form and paying a filing fee. For better financial and legal protection, owners should create an LLC operating agreement even in states that don’t require one. (See The Basics of Forming a Limited Liability Company and How Do I Set Up a Limited Liability Company?)

Who Can Become an LLC?

Anyone can form an LLC, but that doesn’t mean anyone can generate income as an LLC.

“A regular salaried employee could theoretically quit their job, create an LLC and sell their freelance services back to their company to avoid paying a higher income tax rate,” says CPA Aaron Lesher of Hurdlr, a small business finance app for independent workers, freelancers and solo entrepreneurs. However, Lesher notes, “The employee-as-an-LLC idea is a massive audit red flag.”

It isn’t simply up to employers or employees to decide how workers are classified. Their classification depends on how they measure up to various guidelines in the tax code.

“The IRS is very clear on the difference between a contractor and an employee,” says Josh Zimmelman, president of Westwood Tax & Consulting LLC, a New York-City-based accounting firm. “There are three main factors they look at: financial control, behavioral control and relationship type.”

  • Financial control: The IRS looks at whether the worker is paid a regular wage, an hourly rate or a flat fee per project. “An employee is generally guaranteed a regular wage amount for an hourly, weekly or other period of time,” the IRS states on its website. “This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.”
  • Behavioral control: The IRS looks at whether a worker has control over when, where and how he or she performs the work. “For example, an employee has regular hours and is told where to work; a contractor is offered more freedom as long as the work gets done,” Zimmelman says.
  • Relationship type: The IRS reviews any written agreements between worker and employer, including the permanency of the relationship. “For example, if a worker receives benefits like health insurance, sick pay, vacation pay, etc., then they are likely an employee,” Zimmelman says. “Misclassifying an employee as a contractor may result in penalties, especially if that worker is paid in the same manner as regular employees are paid.”

The first step in any plan to turn salaried personal income into LLC income is that the employer would have to agree to pay the employee as an independent contractor. Certain employers might be game because they would no longer be obligated to give that worker health benefits, Zimmelman says.

Few employers would likely participate in such a plan, however.

“Most employers know that hiring a self-employed person who is considered a disregarded entity – in this case, the LLC…will cause huge problems with the State Department of Labor and no one wants that,” says enrolled agent, accredited tax advisor and accredited tax preparer 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 company tries to represent that a person whose work hours they are controlling – and whose desk space and equipment they are providing – is a contractor, they are inviting the IRS, the state and the Department of Labor to audit them, and they won’t win, she says.

Assuming the worker and employer could work out a true independent contractor relationship that would survive an audit, the worker would need to weigh whether their new pay rate as a contractor combined with the loss of benefits – which might run the gamut from health and dental insurance to life and disability insurance to 401(k) contributions and paid time off – would be worth the tax savings.

Could Individuals Who Became LLCs Save on Taxes Under Trump’s Tax Plan?

Now we get to an even trickier part: the current taxation of LLC income versus the proposed taxation of LLC and other business income.

Unlike C corporations, LLCs are not considered a separate entity and do not pay taxes themselves. As we explained earlier, LLCs are pass-through entities. By default, single-owner LLCs are taxed as sole proprietorships, but LLCs can choose to be taxed as S corps or C corps, which can benefit some businesses by reducing their employment taxes (Medicare and Social Security taxes). (See How Will Forming an LLC Impact My Personal Tax Situation? and How Is a Limited Liability Company Taxed?)

Let’s assume that an LLC wants to be taxed as an S corp to save money on payroll taxes while avoiding the double taxation of a C corp.

Under Trump’s plan, the change in business tax rates and the large discrepancy between the proposed business tax rate of 15% and the two higher personal income tax rates of 25% and 35% might appear to create the potential for abuse by savvy individuals who can convert personal income to business income in a legitimate, audit-proof way. Tax experts, however, say it’s not that simple.

Independent contractors who run small corporations will not easily be able to abuse the system because these people will have to be employees of their own corporations and pay taxes via payroll, Eisenkraft explains. “In this case, the sole officer will receive a W-2 and be paying taxes at his or her ordinary tax rate based on wages and other income items on the tax return,” she says.

Those wages, in other words, would be taxed at the personal rate under the Trump proposal of 10%, 25% or 35% and subject to Social Security and Medicare taxes (FICA).

“The flow-through portion may be taxed at a reduced rate depending on new legislation, but the IRS will not allow that employee to take less than a reasonable salary,” Eisenkraft says. “There are many court cases out there where an officer making hundreds of thousands of dollars tries to take a $25,000 salary, and they lose in tax court and the IRS wins.”

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

The tax rate an independent contractor pays on income is the same under current law and under the proposed Trump tax plan, says financial advisor Bradford Daniel Creger, president & CEO of Total Financial Resource Group in Glendale, Calif.

“An individual must pay income taxes on income received from their own efforts – i.e., their own earnings – as ordinary income. Merely forming an entity doesn’t change this,” he says. “It only complicates the returns, but the income tax outcome is the same.”

There is one sense in which the Trump tax plan is exploitable, Creger says: the S corporation.

The simplest and most prevalent example of a pass-through business, the S corporation, currently allows owners to take both salary ncome and additional income that represents the business’s profits as an S-corp distribution.

The difference between these two types of income is that the salary is subject to payroll taxes and the S corp distribution is not, Creger explains. By separating salary from business profits, the owner saves a slight amount in taxes by avoiding payroll taxes on the amount received as an S corp distribution.

But the S corp distribution that business owners receive is taxed at normal, ordinary income tax rates according to their individual income tax bracket. The only savings from this tax strategy under the current system is the payroll tax savings, Creger says.

Under Trump’s proposed tax plan, however, the S corp distribution would be taxed at 15% instead of at the individual’s ordinary rate. The more owners can receive as a distribution of profits from their businesses, the more they are likely to save.

Ordinary income tax rates could be higher or lower than they are now, depending on how tax brackets crystalize and where an individual business owner fits. According to the current plan, after the lowest bracket (10%), the next highest personal income tax bracket would be 25%, so anything from then on would be a savings.

If the tax plan is approved, the IRS will likely battle taxpayers over the matter of “reasonable compensation,” and argue that owners’ salaries are too low and their S corp distributions are too high as it seeks to collect more taxes.

The Bottom Line

What will happen with the whole issue of how business owners might best exploit a revised tax code remains to be seen. It does shine a new light on a way of reducing taxes that more individuals will surely explore and it would heavily favor entrepreneurs over salaried workers who earn the same level of income. Stay tuned to see what Trump’s tax reform looks like, if it or a revised version passes, and how it will affect taxes on business owners.

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