If you operate a business in South Carolina, the income you derive from that business may be taxed advantageously at the state level. I previously touched on the 3% South Carolina Active Trade or Business tax rate, but in this article we are going to fully explore the ins and outs of how it works.
What qualifies as Active Trade or Business Income in South Carolina?
SC Code Section 12-6-545 (1) defines Active Trade or Business Income or loss as follows:
(1) “Active trade or business income or loss” means income or loss of an individual, estate, trust, or any other entity except those taxed or exempted from tax pursuant to Sections 12-6-530 through 12-6-550 resulting from the ownership of an interest in a pass-through business. Active trade or business income or loss does not include:
(a)(i) passive investment income as defined in Internal Revenue Code Section 1362(d) generated by a pass-through business and income of the same type regardless of the type of pass-through business generating it; and
(ii) expenses related to passive investment;
(b) capital gains and losses;
(c) payments for services referred to in Internal Revenue Code Section 707(c);
(d) amounts reasonably related to personal services. All amounts paid as compensation and all guaranteed payments for services, but not for the use of capital, as defined in Internal Revenue Code Section 707(c) are deemed to be reasonably related to personal services. In addition, if an owner of a pass-through entity who performs personal services for the entity is not paid a reasonable amount for those personal services as compensation or payments referred to in Internal Revenue Code Section 707(c), all of the owner’s income from the entity is presumed to be amounts reasonably related to personal services. For purposes of this section, amounts reasonably related to personal services include amounts reasonably related to the personal services of the owner, the owner’s spouse, and any person claimed as a dependent on the owner’s income tax return.
In other words, if you’re actively operating a business, you have Active Trade or Business Income. “Actively operating” means you have active involvement, spend a significant amount of time on the the business, the activity is consistent and you’re engaged in the activity to generate a profit.
How does the reduced tax rate for Active Trade or Business Income work?
The income you earn from an Active Trade or Business is taxed at a flat rate of 3%. For instance, if you earn $100,000 from such a business, you will owe $3,000 in tax. If you earned $101,000, the tax would be $3,030 and so on.
Contrast this with income earned from a W-2. Using the same amount as above, you’d owe $5,730 based on the South Carolina tax tables (2023). Based on these amounts, the marginal tax rate is 6.4% and the effective tax rate is 5.73%. The marginal tax rate is the tax on the next dollar of income that you’d earn and the effective tax rate is your weighted-average tax rate.
Based on the above, and as outlined in the South Carolina Department of Revenue’s own instructions, the election should not be made for taxpayers with income less than or equal to $16,680 based on 2023 tax rates.
Who is eligible to elect the reduced tax rate on Active Trade or Business Income, and how do I qualify?
There are three criteria that must be met to be eligible to make the election:
- The income must be from an active trade or business, which is defined above.
- The income must be from a pass-through entity. Pass-through entities are sole proprietorships, partnerships, S-Corporations and limited liability companies (LLCs) taxed as one of the above.
- The pass-through entity must be owned by a “qualified owner or owners.” A qualified owner is an individual, trust, estate or “an entity type not included in SC Code Sections 12-6-530 through 12-6-540 and 12-6-550 and not exempt from South Carolina Income Tax.”
What adjustments or deductions can be applied to SC Active Trade or Business income?
There are several adjustments that may need to be made to arrive at the active trade or business income amount.
Positive adjustments include:
- The taxpayer has insufficient basis
- The taxpayer does not have sufficient at-risk amounts, or
- The loss is a passive activity loss under Internal Revenue Code Section 469
Negative adjustments include:
- Suspended losses from a pass-through business
- Net operating loss carryforward from a Sole Proprietorship
In addition to the above, there is also an adjustment for the deductible portion of self-employment tax, as it’s a business expense.
The adjustments are fairly complex and the above is only a high-level listing. Make sure you consult a tax professional for help in this area.
How do partnerships and S-Corps report SC Active Trade or Business Income to individual owners?
Partnerships and S-Corporations report an owner’s share of income and expenses on a Form K-1. You’ll likely receive both a federal and a South Carolina K-1 after the business tax return is filed. On the South Carolina K-1 there should be an amount reported for Active Trade or Business income.
How do I make the election?
There are two ways to make the election:
- At the entity level using South Carolina Form I-435 which is filed with the business income tax return
- At the owner level by filing South Carolina Form I-335 with your individual tax return
To take advantage of the 3% flat tax rate you will use one of the above methods, but not both.
Making the election, and paying the subsequent tax, at the entity level may have increased tax benefits at the federal level. This is known as the pass-through entity tax (PTET) and is a result of states’ reactions to the Tax Cuts and Jobs Act of 2017 which took effect in 2018. This topic can be an entire article unto itself, however, we do have a handy step-by-step guide on how to make these payments in South Carolina.
Conclusion
Owning and operating an active business in South Carolina can be a tax advantageous endeavor. While making the Active Trade or Business election and having your business income taxed at a flat 3% is a relatively straightforward exercise, there are some nuances you should be aware of in making the election. The assistance of a tax advisor, especially one that’s familiar with South Carolina tax laws, can be an invaluable resource for pass-through entity owners in this regard.
