Former President Trump’s tax plan—otherwise known as the Tax Cuts and Jobs Act—was signed into law on Dec. 22, 2017. The plan emphasized cutting the corporate tax rate and simplifying the individual income tax system. Whether a hugely profitable multinational corporation or a sole proprietorship, every business that counts as a C corporation (or C-Corp) is now taxed at a flat rate of 21%, down from the original 35%.
One commonly-voiced concern was that this new system created a tax loophole that encourages individuals to register as pass-through entities, such as limited liability companies (LLCs) and S Corporations (or S-Corps). Doing so allows their business income to be taxed based on their individual tax rate. This means that the LLC tax rate varies.
- Certain business types saw massive tax savings from the Tax Cuts and Jobs Act.
- Independent contractors may not find the system as beneficial as others.
- An LLC can determine if it will be a C-Corp or an S-Corp. This can result in lowering an individual's social security and Medicare taxes.
- Due to the tax cuts, the IRS is paying closer attention to affected businesses.
- The law doubled an individual's standard deduction.
What Is a Pass-Through Entity?
An LLC is considered a pass-through entity—also called a flow-through entity—which means it pays taxes through an individual income tax code rather than through a corporate tax code. In addition to LLCs, sole proprietorships, S Corporations, and partnerships are all pass-through businesses. C Corporations are not.
How the LLC Tax Rate Is Calculated
C-Corps tax the profits of owners twice: once at the corporate level and again at the personal level. Not surprisingly, smaller companies not requiring the unique ownership structure of a C-Corp—or the ability to sell shares to the public—most often organize as LLCs or S Corporations.
Meanwhile, because LLC owners can deduct up to 20% of their business income before their tax is calculated, it can be highly beneficial to file as an LLC based on an individual's own personal income tax rate. Ultimately, this could range from 10% to 37% based on each individual's unique filing status and income level.
Small operations that have no plan of raising money from public shareholders but want a higher level of legal and financial protection for their personal assets often form LLCs. All 50 states allow LLCs to consist of just one person. Almost any line of business may be incorporated as an LLC except banking, trust, and insurance businesses. Some states impose additional restrictions, such as California’s prohibition against architects, licensed healthcare workers, and accountants registering as LLCs.
How to File as an LLC
Forming an LLC is relatively simple. While it varies by state, the process 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.
Anyone can form an LLC, but that doesn’t mean anyone can generate income as an LLC. According to CPA Aaron Lesher of Hurdlr, a small business finance app, “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." 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 another period,” 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 generally paid 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 they perform 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 [such as] 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.”
The first step in any plan to turn salaried personal income into LLC income is that the employer must agree to pay the employee as an independent contractor. Certain employers may be game as such an agreement would no longer obligate them to provide health benefits to that worker. However, it's unlikely that most employers would participate in such a plan.
“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 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 concludes.
Assuming the worker and employer could work out a true independent contractor relationship that would survive an audit, the worker must weigh whether their new pay rate as a contractor combined with the loss of benefits—which might include health, dental, life, and disability insurance, 401(k) contributions, and paid time off—would be worth the tax savings.
How LLCs Save Under the LLC Tax Reform Plan
Unlike C corporations, LLCs are not considered separate entities so they do not pay taxes themselves. By default, single-owner LLCs are taxed as sole proprietorships, but LLCs can choose to be taxed as S-Corps or C-Corps, which may benefit some businesses by reducing their employment taxes, namely Medicare and Social Security taxes.
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 flat business tax rate of 21% and the income tax rates between 10-37% might appear to offer tax relief. Tax experts, however, say it’s not that simple.
Independent contractors running small corporations cannot easily abuse the system because the terms of the 2017 tax law require that they 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 their ordinary tax rate based on wages and other income items on the tax return."
Those wages, in other words, are taxed at the personal rate under the Tax Cuts and Jobs Act 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, 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.”
Taxation of Owner’s Salary vs. Pass-Through Profits
The tax rate an independent contractor pays on their income is the same under the Trump tax plan as it was under previous tax law, says financial advisor Bradford Daniel Creger, president & CEO of Total Financial Resource Group in Glendale, CA.
“An individual must pay income taxes on income received from their own efforts—that is, their own earnings—as ordinary income," he says, "Merely forming an entity doesn’t change this. 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 income and additional income representing 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 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 tax plan, however, the S-Corp distribution is taxed at 15% instead of at the individual’s ordinary rate. Thus, the more owners are able to receive as a distribution of profits from their businesses, the more they are likely to save.
What Was the Goal of the Tax Cuts and Jobs Act?
The Tax Cuts and Jobs Act was enacted in order to lower taxes on corporations and increase an individual's deductible income amounts. The Act was developed and implemented in order to increase worker productivity and corporate profit in order to further stimulate the economy.
What Does a Tax Cut Do?
A tax cut helps individuals by lowering the amount that is either taken out of their paychecks or is written to revenue services come tax season. For corporations, there could be a broad tax cut, such as "corporate tax has been lowered from 15% to 13%," or it can be more opaque, such as a changing of the law when it comes to permitted depreciation or other accounting practices.
What Are Tax Loopholes?
Tax loopholes are ways in which either businesses or individuals can lower their tax liabilities. While some consider tax loopholes unethical, most corporations are constantly looking for ways to gain an edge n their competitors and deliver returns to their shareholders. An extra two percent can be a substantial amount, which is why some companies will filter money through other entities and pursue other loopholes. Tax loopholes are legal and not to be confused with tax evasion, which is illegal.
The Bottom Line
The extent to which business owners have exploited the revised tax code remains to be seen. The Tax Cuts and Jobs Act heavily favors entrepreneurs over salaried workers who earn the same level of income. LLCs owners may be able to take advantage of the rate changes, but they will probably need to work with an accountant and possibly a lawyer to ensure they are not only doing it legally, but profitably as well.