Grant Thornton LLP’s Year-End Tax Guide for Privately Held Businesses is designed to give comprehensive information about the complex tax issues you worry about. We include a portion of the guide here. The full guide, available by downloading the PDF, additionally includes segments on incentives/credits, buying and selling a business, and compensation and benefit plans. It also contains many practice tips, tables highlighting tax rules, explanations of tax law changes and more.
This year we’ve put together three guides for your ease of use. In addition to the guide for privately held businesses, take a look at our Year-End Tax Guide for Private Wealth Planning and our Year-End Tax Guide for Compensation and Benefits. Each guide is focused on its topic while being expansive in its coverage.
Tax law changes: What’s new this year?
Individual taxes on business income
Business taxes: The entity view
Incentives: Getting the credit you deserve
Buying and selling your business
Compensation and benefit plans
The tax code is a double-edged sword for privately held businesses. On one hand, the code offers significant benefits to privately held businesses that public companies cannot enjoy. On the other, most privately held businesses have two levels of tax rules to worry about: their entity-level requirements and the tax burden on their individual owners. Fortunately, it’s the ideal time for tax planning for privately held businesses. Congress finally made permanent some of the most beneficial temporary business provisions and extended many others for five years. You can now look well into the future and use long-term tax planning strategies without worrying if some of the most important business provisions will be re-enacted.
It’s time to start thinking further ahead. If you wait until your filing deadline to think about taxes, it’s too late. Our Year-End Tax Guide for Privately Held Businesses
is your reference tool for understanding some of the most important tax issues facing privately held businesses. We’ve organized your planning considerations into easy-to-understand sections covering individual taxes applying to business owners, choosing an entity, credits and incentives, buying and selling your business, and benefit plans. To make tax planning easy, we’ve also included:
- Comprehensive tables that lay out important tax rules, limits and rates
- Explanations of many important new tax law changes
- Planning tips you can use right now
Remember, this guide can't cover all possible strategies, and tax law changes are always possible. Check with a tax professional for the most up-to-date tax rules and regulations before making any tax decisions.
Tax law changes: What’s new this year?
Lawmakers gave businesses a tremendous gift at the end of last year by making many of the tax code’s most popular business provisions permanent. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) made 22 temporary tax incentives permanent, including the following popular business provisions:
Research credit (with improvements!)
Increased Section 179 expensing limits
Reduced five-year holding period for S corporation built-in gains
15-year life for qualified leasehold, retail and restaurant improvements
100% exclusion from gain for qualified small business stock
In addition, the PATH Act extended the new markets tax credit and bonus depreciation for five years, though the bonus depreciation percentage is scheduled to decline. But it wasn’t all good news. Congress also enacted strict new partnership audit rules and adjusted several filing deadlines.
R&D credit boost
The PATH Act not only made the R&D credit permanent for the first time in its 30-year history, but it enhanced it in ways that make it even more valuable for entrepreneurial privately held businesses.
The R&D credit has historically provided little incentive for startup businesses because it provides no value until the company is turning a profit. Beginning this year, the credit is now partially refundable against payroll taxes. Businesses with less than $5 million in annual gross receipts, and no gross receipts outside of the last five years, can claim up to $250,000 in R&D credit against payroll taxes. Larger companies that are starting to become profitable may also be able to take advantage of the credit for the first time under a separate change. Many companies starting to generate income often have net operating losses from past years that push them into the alternative minimum tax (AMT), which limits their ability to benefit from the R&D credit. Privately held businesses with no more than $50 million in annual gross receipts can now claim the R&D credit against the AMT.
Bonus depreciation has become a business staple during the economic recovery, allowing businesses to deduct half the cost of eligible equipment the year it is placed in service, with the rest depreciated using normal rules. The PATH Act extended this popular temporary provision, but with a big caveat. Property placed in service in 2016 and 2017 is still eligible for the full 50% bonus depreciation amount, but the depreciation rate is scheduled to decline to 40% in 2018 and 30% in 2019, before disappearing in 2020.
Congress has extended this popular provision many times in the past and will likely face intense pressure to increase the percentages in 2018 and 2019, and extend it to cover 2020 and beyond. In the meantime, Congress made a new kind of building improvement eligible for bonus depreciation in 2016: qualified improvement property. Previously, only qualified improvements made to leased property were eligible, and the improvements had to have been made more than three years after the building was placed in service. Congress dropped these requirements beginning this year, so you can deduct half the cost of qualified building improvements in 2016 even if you’re not leasing the space and the building is less than three years old.
Section 179 expensing
Section 179 provides an even more valuable depreciation incentive for privately held businesses that place less than $2,010,000 of new business equipment into service this year. Under Section 179, businesses can now expense up to $500,000 in new equipment. This limit has been made permanent and indexed to inflation. The $2 million phase-out limit was also made permanent and has already been adjusted to $2,010,000 for inflation. The $500,000 expensing limit is reduced on a dollar-for-dollar basis by the total amount by which eligible equipment placed in service exceeds $2,010,000. So if you’ve placed $2,510,000 in eligible property in service in 2016, you won’t benefit from Section 179.
New filing deadlines
C corporations and partnerships have had their filing deadlines essentially swapped beginning with 2016 returns (due in 2017). Partnership returns will be due three-and-a-half months after the close of the year, or March 15, instead of April 15, for calendar-year partnerships. C corporation deadlines are moving in the opposite direction and won’t be due until four-and-a-half months after the year close, or April 15, instead of March 15, for calendar-year C corporations.
Congress enacted the deadline changes in an attempt to stagger the filing deadlines so that flow-through entities such as trusts, S corporations and partnerships are all due on March 15 while taxpaying entities like individuals and C corporations are due a month later, on April 15 (April 17 in 2017 because April 15 falls on a Saturday). The deadlines are a little more complicated for extended returns. Generally, all returns except for those for trusts and some C corporations are now eligible for six-month extensions, meaning the extended deadline for partnership returns remains Sept. 15. Calendar year C corporations will receive only five-month extensions until 2026; so for now, their extended deadline also remains Sept. 15. There are special rules for C corporations with a fiscal year ending June 30. In addition, trusts are still permitted only a five-month extension.
New partnership audit rules
Lawmakers enacted legislation late last year that replaces the current partnership audit procedures with a new process that dramatically increases partnerships’ payment and reporting responsibilities. Many privately held businesses are organized as partnerships, and the new audit rules are designed to shift the burden for actually assessing tax after a partnership-level adjustment from the IRS to the taxpayer. Only partnerships with 100 or fewer partners can opt out of the new rules, and this can be done only if their partners are individuals, C corporations, estates of deceased partners or S corporations (with each shareholder counting toward the 100-partner limit).
Partnerships that cannot elect out face new responsibilities after an adjustment made after an IRS exam. The partnership will generally be required to pay any tax resulting from the adjustment at the partnership level or issue statements to all partners, passing the adjustment on to them. The new rules also come with many other new restrictions on administrative proceedings and partner participation. The legislation is generally not effective until partnership tax years beginning in 2018 or later, but all affected partnerships should evaluate their partnership and operating agreements now. The partnership’s designated representative has sweeping authority to make decisions on behalf of the partnership, and many of the elections can shift the economic burden of adjustments to different partners in different ways. It’s particularly important to understand how adjustments can affect partners that have previously exited or been newly admitted to the partnership depending on the election.
Individual taxes on business income
Individual taxes have everything to do with privately held business planning. Privately held businesses are typically more sensitive than public companies to their owners’ tax burdens. In fact, privately held businesses such as S corporations and partnerships generally aren’t taxed at the entity level. Instead, the income, credits and deductions of these businesses are passed through the entity and taken only on the individual returns of their owners. Even private C corporation income, which is first taxed at the entity level, is eventually taxed a second time at the individual level when distributed to owners.
The unique nature of privately held businesses means tax planning should start with understanding how the business income will be taxed at the individual-owner level. Most income is taxed as ordinary income. Ordinary income includes your salary and bonuses for working in your business, any self-employment income and almost all business income that flows through to you, including rent, royalties, interest and general business income on Line 1 of your business’s tax return. In general, only qualified dividends and capital gains from assets held more than one year are subject to special lower rates.
The top rate on ordinary income is 39.6%, while the top rate on long-term capital gains and qualifying dividends is 20%. These figures don’t include employment tax and net investment income (NII) tax. As the tables in the complete PDF of this guide demonstrate, your income is subject to different rates as you climb the tax brackets. The top tax rate that applies to you is often called your marginal tax rate, or the rate you would pay on an additional dollar of income. We've included tables with the full tax brackets for investment and ordinary income.
Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may differ significantly from the nominal rate in your top tax bracket. Many high-income taxpayers who own their own businesses can be stuck paying the alternative minimum tax (AMT) if they have common triggers like high state and local taxes, investment advisory fees, accelerated depreciation adjustments and related gain or loss differences on disposition. High-income individuals can also end up paying more tax for every additional dollar of additional income because of the personal exemption phaseout (PEP) and “Pease” phaseout of itemized deductions. Both of these phaseouts begin at an adjusted gross income level of $259,400 (single) or $311,300 (joint) in 2016. See our Year-end Tax Guide for Private Wealth Planning for planning strategies related to the AMT and other individual income tax issues.
Business owners should give special consideration to employment and NII taxes. Understanding which tax, if either, applies to your business income can significantly affect your tax bill.
First look at employment taxes. The taxes on earned income that are used to fund Social Security and Medicare are called employment taxes because they apply to salaries, wages and bonuses. The Social Security tax on earned income is capped ($118,500 in income in 2016), but the Medicare tax has no limit. Both employees and employers pay Medicare tax at a 1.45% rate until earned income reaches $200,000 (single) or $250,000 (joint), and then the employee rate share increases to 2.35%.
The business income from sole proprietors and partners is generally self-employment income (there are exceptions), meaning they pay both the employee and employer share of Medicare tax. You take an above-the-line deduction for the employer portion of self-employment tax. Owners of C corporations and S corporations don’t pay employment or self-employment taxes on any business income unless it is salary (whether or not distributed), but the salary taken must be reasonable.
Perform a reasonable compensation study
If you own a corporation and work in the business, consider your salary carefully. S corporation owners typically benefit from a low salary because income that isn’t salary isn’t generally subject to employment tax. This income typically won’t be subject to NII tax either unless you are a passive owner. On the other hand, owners of a C corporation usually benefit from a higher salary and lower distributions. You will pay employment tax on the salary, but the salary is deductible at the corporate level so earnings paid out as salary are taxed only once. Earnings that are instead distributed as dividends are taxed twice, once at the corporate level and again at the individual level.
The IRS understands the benefits taxpayers can receive by adjusting their salaries and will challenge the salary amount if the IRS deems it unreasonable. You may want to consider using a reasonable compensation analysis to ensure your salary meets IRS standards. The factors courts use to determine reasonable compensation depends on the court jurisdiction, but the IRS will typically look to training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, employee payments and bonuses, the amount comparable businesses pay for similar services, compensation agreements, and the use of a bonus formula to determine compensation.
Net investment income tax
The tax on NII was added in 2010 to expand the reach of the Medicare tax beyond earned income and create an equivalent tax of 3.8% on investment income. It applies to NII to the extent adjusted gross income (AGI) exceeds $200,000 (single) or $250,000 (joint). NII includes rent, royalties, interest, dividends and annuities. There is an exception if the income is derived in the ordinary course of a trade or business in which you are not passive. On the other hand, all income from businesses in which you are passive is NII regardless of the type of income. In addition, income from trading in financial instruments is always NII.
It can be tricky to figure out how employment and NII taxes fit. If you have to pay employment or self-employment tax on a stream of income, it is not included in NII. You never have to pay both taxes on the same income. The rules do not allow you to choose one or another, but in general, self-employment taxes are preferable because of the deduction on the employer share of tax.
Most income that isn’t subject to employment taxes is included in NII, but not all. There may be income that isn’t subject to employment or NII tax. An S corporation owner who is not passive in the business will typically pay employment taxes on salary only and will not owe self-employment tax or NII tax on the rest of the S corporation’s operating income. In some cases, a limited partner who participates in the partnership’s business may also escape both NII and employment tax on the partnership’s operating income. One key is to avoid passive characterization.
Business taxes: The entity view
Entrepreneurship comes with its own burden, especially on the tax side. But for privately held businesses, there are many benefits. You have opportunities for structuring and ownership that are unavailable to public companies. So the key to planning for and managing your business’s tax burden starts with understanding business tax structures.
Choosing an entity: Understanding business tax rates
Business structures generally fall into two categories: C corporations and pass-through entities. C corporations are taxed as separate entities from their shareholders and offer shareholders limited liability protection. Pass-through entities effectively “pass through” taxation to owners, so the business income is generally taxed only at the owner level. Some pass-through entities don’t provide limited liability protection, while S corporations, limited partnerships, limited liability partnerships and limited liability companies generally do.
There are many considerations in choosing a structure, but one of the biggest differences is that C corporations endure two levels of taxation. A C corporation’s income is taxed first at the corporate level and again at the shareholder level when it is distributed to shareholders as dividends. Generally, the income from pass-through entities is not taxed at the entity level and is taxed only at the owner level.
So how do the tax rates on pass-through entities and C corporations compare? Individual owners of pass-through businesses pay tax on all income, regardless of whether it is distributed, so the top rate on pass-through entities is 39.6% if you are not passive (excluding any self-employment taxes) and 43.4% if you are. That’s higher than the 35% corporate rate, but only if no corporate earnings are distributed. If all C corporation earnings are distributed, the combined rate of corporate and dividend tax is actually 50.5%. See our table for a comparison of the top rates of pass-through entities and C corporations, depending on how much of the earnings are distributed.
If you plan on reinvesting your earnings in the business without distributing it, the top C corporation rate of 35% can be very appealing. But remember, unless you plan to die without receiving a dividend or selling the stock, the earnings will eventually need to be distributed by the business. So the single level of tax enjoyed by pass-through entities still provides a distinct advantage, especially when you exit the business.
Download the PDF to read more of Grant Thornton's Year-End Tax Guide for Privately Held Businesses, which additionally covers:
Incentives: Getting the credit you deserve
Buying and selling your business
Compensation and benefit plans
A host of planning tips and tax law change alerts
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