
A legal loophole is an ambiguity or shortcoming in a law that can be exploited to circumvent or avoid the intended purpose of the system.
Contrary to popular belief, legal loopholes are not illegal. They are law provisions that allow small business owners to minimize their taxes by using legal means. Those interested should consult a legal expert, with one such being Jeremy Eveland provides guidance to companies on legal obstacles.
1. Subchapter S Election
A “Subchapter S” election allows shareholders to avoid some of the double taxation that C corporations must endure. Normally, profits that a corporation earns are taxed at the corporate level, and then again when they’re distributed to shareholders as dividends. With an S election, however, profits pass through the corporation and are declared on shareholders’ personal tax returns, eliminating the second taxation step.
An S election must be made no later than the first day of the corporation’s third month of business. A newly formed corporation may make an S election by filing IRS Form 8869, or equivalent state forms.
If an S election is filed before the beginning of a corporation’s first tax year, it will not be valid (Frentz, T.C. Memo. 1980-12). This rule also applies to the election of a qualified Subchapter S subsidiary (QSub), which is a subsidiary of a parent S corporation. In order to qualify for QSub treatment, the parent S corporation must meet the same ownership and control requirements as a regular S corporation.
A QSub can be created by filing IRS Form 8869 or its equivalent state form. A QSub can maintain voting and nonvoting stock. Additionally, the parent can transfer ownership of its shares through a sale.
As an added benefit, S corp status provides personal liability protection for shareholders. This means creditors cannot pursue the personal assets of a shareholder to pay for the company’s business debts. However, the decision to elect S corporation tax status should not be taken lightly. Several disadvantages exist, and an operating agreement should be reviewed for provisions that could potentially violate the tax laws. As a result, there are times when an LLC should not make a Subchapter S election.
2. Qualified Business Income (QBI) Deduction
The QBI deduction—which was created by the Tax Cuts and Jobs Act (TCJA)—is a new, tax-deferral-type deduction that allows taxpayers to write off up to 20% of their qualified business income. It’s only available to people who own or participate in a pass-through business entity, which includes sole proprietorships, partnerships, LLCs treated as S corporations, and some trusts and estates.
Amounts considered qualified business income include income from any trade or business conducted in the United States, but there are some exceptions. For example, capital gains and losses are excluded from QBI, as are interest income and salary. Also, certain types of rental income are not eligible for the deduction. However, there is a safe harbor rule that can be used to treat this type of income as qualifying QBI if certain requirements are met.
It’s important to note that the deduction is only available if your total taxable income doesn’t exceed a threshold set by the IRS. This limit is based on factors including the type of business, W-2 wages paid by employees, unadjusted basis investment in qualified property (UBIA), qualified real estate investment trust dividends, and qualified publicly traded partnership (PTP) income.
In addition, there are additional limitations based on whether or not you’re involved in a specified service trade or business (SSTB) and how much you have in SSTB-related assets. For this reason, it’s important to check out the IRS regulations and consult a Tax Pro in your area if you’re interested in taking advantage of this deduction.
3. Qualified Business Expenses (QBE) Deduction
Whether you run a business in a traditional sense or as part of the fast-growing gig economy, it’s important to be aware of the tax deductions that are available. One of those is the Qualified Business Income (QBI) Deduction, which is designed to cut taxes for pass-through businesses that are owned by individuals or trusts. This is a new deduction that’s tied to the Tax Cuts and Jobs Act passed in 2018.
QBI is defined as net profit from any qualified trade or business that is operated by you, your spouse or an unmarried domestic partner who owns at least 20% of the business. However, rental income is not eligible for this deduction unless you meet the safe harbor rules set forth by the IRS. The QBI deduction is only available through 2025, so it’s a “use-it-or-lose-it” proposition. A tax professional can help you determine if this deduction applies to your situation.
4. Subchapter C Deduction
When a new business is formed, choosing the right legal structure is an essential step. This choice will determine how taxes are paid on profits as well as which tax forms shareholders or managers use to file tax returns. One popular business structure is the C corporation. This type of corporate structure is a separate legal entity from its owners. It is taxed at the entity level and at the shareholder level when dividends are distributed. This double taxation can significantly reduce a company’s net operating income.
If a C corporation wants to pass its federal income tax losses through to its shareholders for individual income tax purposes, it must make a Subchapter C “deduction election” for the current year. This election must be made before the corporation’s first tax return for the year that begins after December 31 of the preceding calendar year. The corporation must also meet the other requirements for a subchapter C election, including having no more than 100 shareholders, not having any non-U.S. citizens or foreign residents as shareholders, and not issuing preferred stock.
Another option for C corporations is to make a qualified subchapter S subsidiary (QSub) election. This election will allow the corporation to treat its 100% owned QSub as a disregarded entity for federal income tax purposes. This will cause the subsidiary’s items of income, deduction, credit, and assets to be passed through to its shareholders.
Although this deduction is only available to corporations that pay out dividends, it could have a major impact on many small businesses’ bottom line. However, this “loophole” is not guaranteed to remain open forever. Congress may decide to shut down this benefit, especially if it can identify other ways to generate revenue from small-business owners.
5. Subchapter D Deduction
S corporations can avoid self-employment taxes on dividend payments made to shareholders, partners, or members if they allocate that income between those individuals at each tier based on profit/loss percentages. The only problem is that Congress has threatened to shut down this perceived “loophole.” But if it does, you’ll need to make a quick move. The window is closing fast. You’ll only have a few months left to take advantage of it. Then it’s too late.