During the October 2013 special legislative session, Governor Kitzhaber signed House Bill 3601, which, among other things, reduced tax rates for qualifying business income. House Bill 3601, codified in Oregon Revised Statutes § 316.043, only benefits business owners with certain types of entities and the right type of income. Under current law, all income over $5,000 is taxed at 9 percent and above. The new rates, which will go into effect for tax years beginning January 1, 2015, are as follows:
|Amount of Taxable Income||Applicable Rate|
|Up to $250,000||7%|
|$250,001 - $500,000||7.2%|
|$500,001 - $1,000,000||7.6%|
|$1,000,001 - $2,500,000||8%|
|$2,500,001 - $5,000,000||9%|
The new rates are only available to entities with pass-through tax structures such as S corporations and other entities taxed as partnerships. This includes limited liability companies with more than one member that have not elected to be taxed as a corporation. Business owners that will not get to enjoy the new rates are (1) C corporations, which are subject to two levels of tax–one at the corporate level and one at the shareholder level; (2) sole proprietors, who have no separate entity for legal or tax purposes; and (3) single member limited liability companies. Unless the member of a single member limited liability company elects to be taxed as a corporation, the entity is treated as a disregarded entity and it is taxed like a sole proprietorship.
As stated above, the income must be the right kind – it must be nonpassive income, which does not include interest, dividends, capital gains, or wages. The Internal Revenue Code § 469 defines “passive” activity as activity in which the taxpayer does not materially participate. Most rental activity is passive, except in the case of real estate professionals.
In addition to having the right type of entity and the right type of income, the business and taxpayer must meet the following requirements to take advantage of the reduced rates:
(1) The taxpayer must materially participate in the day-to-day activities of the business;
(2) The entity must employ at least one non-owner employee; and
(3) A minimum of 1,200 aggregate hours of work in Oregon must be performed by non-owner employees.
Income tax rates are just one of many reasons why it may be time to evaluate if your choice of entity is the best for your business. Forming an entity limits the personal liability of the business owners. Whether a business has employees, and if so, how many, may also have an impact on choice of entity from a tax perspective. Limited liability companies offer pass-through taxation, flexible management, and limitation of liability for its members. S corporations offer pass-through taxation and limitation of liability for its shareholders, but eligibility is limited. For example, an S corporation can only have a limited number of shareholders, while a limited liability company is not subject to any limitation on the number of members it can have. S corporations can only issue a single class of stock. Limited liability companies offer full flexibility in capitalization structure. Additionally, S corporations must comply with the formalities of the Oregon Business Corporation Act, which is less flexible than the Act governing limited liability companies. Now is a good time to speak to your legal and tax professionals to determine if a change should be made to your business before the new tax rates go into effect.
As published in The Northwest Apartment Investor Newsletter