One of the most important changes that were introduced in the U.S. legislation was the reduction of the corporate tax from 35% to 21% in 2018. Another tax bill was passed that was especially beneficial to small-time business owners.

About 95% of the business owners operate on a small scale. Although big corporate businesses pay tax through a flat rate, the small businesses are more like a “Pass-through entity.” It means that the profit that the business makes goes through the owner’s personal tax return after which it is taxed according to the ordinary or normal tax rates.

While the Pass-Through income will be taxed at the ordinary income tax rates, a significant number of small business owners will be able to deduct or reduce up to 20% of their qualified business income from the beginning of 2018.

Pass-through taxations’ effect on tech companies

The reduction of the tax rate has come as a big relief to technological companies. Most of the big tech companies come under C-Corporations while others like S-Corporations and Partnerships come under Pass-Through. A number of private companies that have equity-backed-portfolio are heading towards becoming an S-Corp or a partnership. The main reason for wanting to make the switch is because of the exemption of 20% for business or trade income.

Investors of profitable technology companies are counting on the Pass-Through income deduction as being beneficial for the company but, whether or not it proves to be beneficial depends a lot on the W-2 workforce wages. On the other hand, companies that are struggling to make a profit will likely suffer as they are hardly generating any profit. The limitations of losses being deductible under the ‘business loss limitations” affect them negatively.

The rules that are to be applied to tech companies with different streams of revenue and a consulting or service component have not been specified yet. However, the general rule is that incomes that come from “specified service trade or businesses” are not eligible to have deductions from the Pass-Through income. Some examples are companies that specialize in the field of law, financial services, accounting, health, and consulting.

There is an exception for individual taxpayers. If their taxable income does not cross $315,000 for married couples or joint filers and $157,000 in taxable income for single candidates, then they would get additional exemption apart from the benefits of W-2 limitation.

Business loss limitation

The new tax disallows excess of business losses in the span of a taxable year. But, this isn’t a cause for alarm as the excess of business losses could be carried under the net operating loss provisions’ division.

In order to calculate the “excess business loss” as per the new law, the taxpayer would have to calculate the excess of their aggregate business/trade deductions over their aggregate gross income/profit and the threshold amount of the taxpayer. In this case, the “threshold amount” of the taxpayer will be $500,000 for married, jointly filers and $250,000 for single filers (considering inflation).

Restrictions on the Pass-Through deduction

The dream of getting 20% reduction did not become a reality for everyone as there were terms and conditions applied to the Pass-Through law. The restrictions were put in situations like the one where the people aren’t able to rectify their W-2 pages. Had they been allowed to rectify the pages, people would start taking advantages of the opportunity to have 100% of their Pass-Through income.

Moreover, the overall structure of Pass-Through deduction is a bit complex since its generosity relies on several factors, including the type of business activity, the total taxable income of the business owner, the business wages paid to the employees, and the business property value.

Thus, the deduction value depends on the total taxable income of the taxpayers, among other things. The pass-through deduction diminishes the taxable income, albeit it does not affect the adjusted gross earnings.

Pass-Through vs. C-Corp

The new tax bill caused a lot of confusions and raised many questions. The most common question that business owners are asking is whether they should switch over from C-Corp to Pass-Through. It is much lower at 21% than what is the Pass-Through for businesses at 25%.

LLC’s and S-corporations come under the Pass-Through entities, which mean that they are treated at the expense and the income of their owners. C-Corporations are the most basic form of corporation in every sense. They are taxed with corporate income tax at the end of a fiscal year. It is in addition to the dividend tax and their personal income taxes.

However, the 2016 House Republican Tax reform plan suggested that after the C-Corp has paid the amount it had to, it is taxed at about 15%-35% more of the amount that is left. But, for an LLC or even S-corporation, there is no such corporate tax that they have to pay. On top of that, they can apply the company’s loss against their own income. This is making people question whether it would be a good idea for profiting business to make the switch and whether or not they can do it.

C-Corporations have a limited liability for officers, directors, shareholders, and employees. The company will continue to function regardless of whether someone leaves or not. There is no such limit on the number of shareholders or the sale of stocks.

Although S-Corporations also enjoy a lot of the same benefits, there is a limitation of 100 shareholders at the most and the owner cannot be from another C-Corp, LLC, partnership, or any sort of trust.

One of the biggest drawbacks of being a C-Corp is probably the double taxation. This means that apart from having to pay taxes on the income, they are also taxed on any amount of money that is distributed to the shareholders. Overall, they are more regulated than S-Corps are.

Having some knowledge about the C-Corp and S-Corp, along with what business you have and what are your expectations from it, will help you in making an informed decision that will be best for you.

How does the Pass-Through law affect the masses?

When you look at the pass-through law objectively, it is ideal only for businesses that do not involve plenty of workforces such as commercial property companies. The eligibility for the pass-through law beyond certain threshold indicates lucrative tax benefits only for those who already have a high income. And the deduction of 17.4 percent added is too low and temporary. Further, the efforts taken to limit the deduction’s cost are not feasible.

In the past thirty years, there has been a shift towards pass-through businesses from C corporations resulting in pass-through businesses accounting for nearly 94 percent with earnings of over 64 percent. They also employ over half of the workforce in the private sector. The wages paid account for over $1.6 trillion.

With such a stronghold, the House bill and Senate bill aimed at lowering the rate of pass-through income below the ordinary income of the businesses. It is in this context, the real issue originates. If the rate is lower than the high individual rates, it will serve as a strong incentive for people to turn into consultants, instead of employees. The average income earner will try to organize their work in such a manner that they get the benefits that come with the pass-through reform. And entities changing their business structure, to an S Corp, for instance, need to consider the cost implications. And there are other considerations to mull over like the loss limitation, ability to offset on wages, income from investment and how you want to carry the losses (forward or backward). Thus a deeper understanding of the rule is necessary for people to really enjoy the benefits.