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Trump's Business Tax Cuts May Be the Demise of S-Corporations in Favor of Limited Liability Companies

by
Lee Reams, BSME, EA
on
9/12/2017
Trump's Business Tax Cuts May Be the Demise of S-Corporations in Favor of Limited Liability Companies

As part of his tax plan, Trump would cut the top rate on corporate taxable income from 35% to 15%, and so as not to discriminate against small businesses, he is also proposing to cut the top tax rate on pass-through businesses from 39.6% (the current top marginal rate for individuals) to 15%. Please note that some administration sources also refer to 20% as the proposed top rate for businesses.

The term “pass-through business” refers to business entities whose income or losses are reported directly on the business owners’ individual 1040 returns, as opposed to the business itself being taxed, as is the case with C-corporations. Pass-through entities include partnerships that issue K-1s, which report each owner’s share of the business’s income or losses; these figures are transferred to each owner’s 1040. Self-employed taxpayers who report their business income on a Schedule C are also considered pass-through entities, as business profit or loss is included on these individuals’1040s.

This means that partners and self-employed individuals would enjoy a much lower maximum income tax rate of 15% or 20% on their earnings than would wage-earning employees, who would still be subject to rates as high as 39.6% (or 35%, using Trump’s proposed top marginal tax rate). Although the IRS uses stringent definitions of “self-employed” and “employee,” if this provision passes, it could lead to some creative tax planning in which people who are currently treated as employees would be treated as self-employed so that they could take advantage of the lower tax rates; this would be especially true for those in higher marginal brackets.

Although S-corporations are also pass-through entities, it appears they would not benefit from the lower tax rates since income passed through on a K-1 from an S-corporation is investment income and the required “reasonable compensation” paid to owners of the S-corporation constitutes employee wages, neither of which is subject to the reduced tax rates. So, absent any special accommodation for S-corporation distributions, it appears S-corporation owners will not benefit from the proposed reduced tax rates.

If that is true, we will surely see a shakeup in business entities, with the limited liability company (LLC) becoming the favorite structure of eligible small businesses needing liability protection and wanting the benefits of lower business tax rates. At the same time, existing S-corporations will look to abandon their existing entity structure in favor of one that benefits from the lower tax.  

Lee Reams Sr., EA writes for TaxBuzz, a tax news and advice website. Reach him at [email protected] or on LinkedIn.

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Lee Reams, BSME, EA

Lee Reams, BSME, EA

Editor-in-Chief

Besides his role at CountingWorks as an educator and speaker to thousands of accountants nationwide, Lee manages a technical research service for a large group of tax accountants which sharpens his technical skills. Lee served on the Board of Blackline Systems, is a former Board of Director for the California Tax Education Council, is a Past President of the San Fernando Valley Chapter of Enrolled Agents, Member and Past Director for the California Society of Enrolled Agents.

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