The newly proposed tax bills are making their way through the House and Senate. Let’s look under the hood and find out how they may affect your startup. I’ll be breaking down the main changes by whether you own a “C-corporation” versus a “pass-through entity” (LLC, sub-chapter S-corporation, or sole proprietorship).
Pass-Through Entity Changes (LLCs, Sub-Chapter S-Corps, or Partnerships)
Most startups are pass-through entities, meaning they may be treated as corporations, but their profits are “passed through” as income to the owner(s). The new tax bills appear to favor these entities, but when you look more closely, the provisions are complicated as hell.
The “advertised” rate on income is 25 percent, but this plan isn’t quite so simple. Only “passive” owners qualify outright for the 25 percent rate, so if you work at your startup, you won’t automatically qualify. Instead, you’ll pay 25 percent on the first 30 percent of profit, and then the old individual rate applies for the rest. (Actually, the 25 percent rate can be more than 30 percent if you create a complicated formula to show that the profit went into capital investment.) So realistically, this deal is good for investors (i.e., angel investors) but not so great for the founders who work there. There is much more to it—I have only begun to scratch the surface.
I’m unsure why these bills favor passive investors above those who actually work at their businesses as founders. Maybe it’s to prevent founders from paying themselves low salaries so they can qualify for the 25 percent rate instead? I’d think we’d reward those who start their own business and work more than the investors. Please submit a comment below if you know.
Calculating all this is going to be chaos, and hiring IRS tax staff to analyze it will be expensive for our government. CPAs and angel investors are the biggest winners. Oh, and don’t forget the unintended consequences with this plan. Hmmmm. Here’s a though: Maybe I’ll quit working at Vertical IQ so I can reduce my tax rate? That way I could keep more of my earnings and not necessarily have to work for it!
Startups backed by professional investors such as venture capitalists are usually C-corps – meaning the corporation and profits are treated as separate entities from its owners. The House and Senate bills cut the C-corp tax rate down to 20 percent from its current top rate of 35 percent. But keep in mind, in order to withdraw money from a C-corp, you need to pay dividends. The dividend tax rate should mostly remain unchanged at 23.6 percent. Therefore, if you pay a dividend, your total rate is 43.6 percent. This is just the federal rate; it doesn’t include the state tax rates.
This tax reduction is a good thing if your startup earns a profit. However, most C-corp startups don’t earn profits because they invest revenue back into their businesses to grow faster. The main way owners of C-corp startups earn money is by selling their businesses/shares, which will continue to be taxed through the capital gains rate, which is 23.6 percent–mainly unchanged.
Our government pretty much has to reduce the C-corp tax rate. Currently, with the C-corp tax rate at 35 percent and the dividend rate at 23.6 percent, the total federal rate was 58.6 percent, plus a state tax, which means C-Corps often are paying more than 65 percent. No wonder big businesses were moving overseas.
Hope this helps!
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