Pass-through business entities, car washes and other businesses operating as partnerships, limited liability companies (LLCs), S corporations, and sole proprietorships, have long been extremely popular. In fact, one form of a pass-through business entity, the S corporation, is currently the most-used business entity. LLCs are the pass-through entities most frequently chosen today.
Unfortunately, thanks to the recently enacted “reforms” under December’s Tax Cuts and Jobs Act (TCJA), the owners of many small businesses operating as pass-through entities will face personal tax rates as high as 29.6 percent — far above the new 21-percent corporate tax rate. Little wonder that many have begun considering switching to the basic C corporation for their car wash operations.
PASSING THROUGH BUSINESSES
In addition to benefitting from profits being taxed only once — not at the business level but rather only when passed onto the owner’s tax returns — many car wash owners choose to operate as so-called “pass-through” business entities because of the protection from personal liability it affords.
As mentioned, under the just passed TCJA, the tax rate for incorporated car wash businesses will be reduced from the former 35-percent rate to 21 percent for the 2018 tax year and thereafter. Unlike the TCJA’s temporary provisions for individuals that largely expire in 2026, the business tax cuts are, for the most part, permanent.
An incorporated business electing to operate as an S corporation or a car wash operator choosing another form of pass-through entity, has its pass-through income taxed only once, similar to the manner in which a sole proprietor is taxed. By electing to operate as a pass-through entity, an operator can benefit from the legal advantages available to businesses with a corporate structure as well as the tax advantages available to a sole proprietorship.
One of the best features of a pass-through entity such as an S corporation was the tax savings for both the car wash business and its shareholders. While “members” of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S corporation shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
An S corporation designation allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the car wash business, or sells his or her shares, the S corporation can continue doing business relatively undisturbed. Similar rules now also apply to partnerships. Maintaining the business as a distinct, separate entity defines clear lines between the shareholders and the business that improve liability protection for the shareholders.
An LLC is, on the other hand, a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with car care services business owners in partnerships or sole proprietorships, LLC “members” report business profits or losses on their personal income tax returns; the LLC itself is not a separate taxable entity.
OTHER PARTNERSHIP TAXES
As a general rule, the losses from a pass-through entity cannot be claimed by the shareholder or partner in excess of the amount they have invested — their “basis.” And, not too surprisingly, there are several tax issues pass-through businesses must consider.
Partners, for example, are considered to be self-employed, not employees, and required to file a Schedule SE with their Form 1040 and pay self-employment taxes. Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare.
Partners are responsible for paying double what a normal employee would pay (because employers normally match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for one-half of the self-employment tax that can be deducted from taxable income.
While pass-through entities are generally not subject to federal income tax, they may be liable for and required to make estimated tax payments based on entity-level taxes such as gain built-in from an earlier entity change, so-called “BIG” taxes, a tax on passive income, voluntary and involuntary terminations, as well as a tax on the operation’s earnings accumulated rather than paid out.
TCJA AND PASS-THROUGH BUSINESSES
The TCJA created a 20-percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by car washes and other businesses operating as S corporations, partnerships, LLCs, and sole proprietorships. All businesses under the pass-through income thresholds, regardless of whether they’re “service” professionals or not, can take advantage of the 20-percent deduction.
However, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income. For pass-through income above the threshold, the new law also provides a deduction for up to 20 percent — but only for “business profits.”
In other words, that 20-percent deduction from pass-through income applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner. That so-called “reasonable” compensation has not been defined by our lawmakers as yet.
On the downside, those operating as a pass-through business lose things like fringe benefits, are required to pay themselves “reasonable” compensation, and or obliged to deal with the other restrictions. And, then, there is the elimination of a number of itemized, personal deductions.
Currently, the vast majority of pass-through business owners can no longer deduct state and local income taxes and are permitted to write off only $10,000 of their property taxes. A regular ‘C’ corporation faces no similar deduction restrictions.
SWITCHING TO CORPORATE FORM
In the eyes of many experts, there is no longer a reason to operate a car wash or other car care business as an S corporation or other pass-through entity. However, converting from a pass-through entity to a regular C corporation can be a complicated process requiring quite a few adjustments.
Going the other way, a sale of assets by an S corporation that was formerly a C corporation during the “recognition period” is subject to the already mentioned BIG or built-in-gains tax. The BIG tax is imposed on the incorporated car wash business at the highest corporate tax rate, based on the appreciation in asset value that existed on the date the corporation became an S corporation. The shareholders may then be subject to a second tax on distribution of the sale proceeds.
This “double tax” created by imposition of the built-in gain rules can be eliminated if the corporation holds and sells assets only after the 10-year recognition period has expired. Naturally, the longer the recognition period is, the tougher that is to do.
Under the former rules, distributions made by an S corporation converting to a regular C corporation during the post-termination transition period (PTTP), can be tax-free to the shareholders. Distributed funds from those accumulated adjustment accounts can also reduce the adjusted basis of the stock.
Under the new TCJA rules, adjustment of a terminated S corporation (even if only changing accounting methods) is taken into account ratably during a six-year period beginning with the year of change.
The annual tax return provides an opportunity to re-consider the options available to some car care businesses. Entities with more than one shareholder or member can elect corporate status on their annual tax returns. Thus, an entity that is a partnership under state laws may elect to be taxed as a C corporation or S corporation for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified corporations and may not elect to be treated as any other type of entity.
CHANGING BUSINESS ENTITIES
Changing circumstances, revisions of the tax laws, and even the success of the business might prompt a reassessment of the entity used for a car wash business. And, best of all, the annual tax return is not the only option when selecting the entity that makes the most economic sense.
Although many of the tax law’s provisions apply to all business entities, some areas of the law specifically target each entity. Choosing among the various entities can result in significant differences in federal income tax treatment, but there is also more to choosing the right structure for a business than just taxes.
Not only will the decision to change the car wash business’ entity have an impact on how much is paid in taxes, it will also affect the amount of paperwork required for the business, the personal liability faced by the principals, and, especially important in today’s economy, the operation’s ability to raise money.
To switch or not to switch? If earlier tax law changes are any indication, the IRS should issue guidelines to help switch entities without a penalty. Since every situation is different, the best approach might be to choose the entity for your car care operation based on the current tax law. To help in this decision-making process, professional advice is strongly recommended.
Mark E. Battersby is an Ardmore, PA-based freelance writer, specializing in finance and tax issues.