When is the last time you talked to your accountant about your business’s entity type? If you’re like most business owners, it’s probably not something you regularly think about. Whether you are taxed at the corporate level as a C-corporation, or have a pass-through entity such as an S-corporation or a limited liability company (LLC), there have been plenty of changes in the tax laws recently to warrant at least considering your entity type.
If you have a pass-through entity, you must consider the individual tax rates. The most notable change is the return of the 39.6 percent tax bracket starting in 2013. This tax rate kicks in when federal taxable income exceeds $450,000 for married couples and $400,000 for single individuals. The highest federal rate was previously 35 percent.
Tax rate increases
Effective Jan. 1, 2013, was an increase in the capital gains tax rate from 15 to 20 percent for taxpayers in the new 39.6 percent tax bracket. A related change was the qualified dividend rate that was permanently tied to the capital gains rate. Therefore, the qualified dividends rate increases from 15 to 20 percent, along with the capital gains rate for taxpayers in the 39.6 percent tax bracket.
The Affordable Care Act has also resulted in some additional taxes starting in 2013 for high earners. The most notable provision is the 3.8 percent Medicare surtax on net investment income, which kicks in when modified adjusted gross income (MAGI) exceeds $200,000 for individuals, $250,000 for couples filing jointly, or $125,000 for couples filing separately. Net investment income includes interest, dividends, rents, royalties, capital gains and other passive activities.
Entity type matters
Entity type can be an important factor in whether you are subject to the 3.8 percent surtax. You may have a pass-through entity with enough income to push you over these limits, in which case you will pay an additional 3.8 percent tax on your investment income. This tax is assessed on the lesser of investment income or the excess MAGI over the above mentioned limits.
Another new tax resulting from the Affordable Care Act is the 0.9 percent additional Medicare tax on “earned” income. When earned income exceeds $200,000 for individuals or $250,000 for married couples, they must pay an additional 0.9 percent tax on earned income over these amounts. Earned income includes wages or self-employment income.
As you can see, there are several tax increases or additional taxes once certain income limits are exceeded. The profit from a pass-through entity such as an S-corporation or an LLC gets included on your personal income tax return, making it easier to reach these higher income levels. Since a C-corporation pays its own income tax and its profits are not added to the shareholders’ personal tax returns, the business income does not increase the shareholders’ individual income, triggering the various new or increased tax rates.
Another distinct advantage for C-corporations in Ohio is that they are no longer subject to Ohio income tax on their profits. Pass-through entities in Ohio, on the other hand, are subject to Ohio income tax because the business profit is included in the shareholders’ adjusted gross income, which gets included in their state taxable income.
Other entity type considerations
There are many other considerations when evaluating the choice of entity, such as future plans to sell your business, annual profits to be retained in the business, other sources of family income, and so on.
Your entity type does give you some control over what income is taxed on your individual return versus being taxed at the corporate rates. With the new 39.6 percent tax bracket, increased capital gains rate, 3.8 percent Medicare surtax on investment income and 0.9 percent additional Medicare tax on earned income, it may be a good time to review your tax situation in order your optimize your after-tax dollars, both in the short- and long-term.
Business Entity Help
Tax rate changes may or may not warrant a change in entity type, but it may be a good time to evaluate your options. If you’re looking to reevaluate your business’s entity type, contact Rea & Associates. Our team of Ohio tax professionals can work with you to assess the status of your business and help you determine how certain tax changes may impact your business.