Section 199A S Corp Benefits
Posted January 20, 2019
Section 199A provides a huge tax deduction for small business owners. S Corps provide a huge tax reduction in the name of self-employment taxes. What about combing both of these wonderful tax vehicles and obtaining Section 199A S Corp benefits? The answer is Yes. There are many situations where you must leverage an S Corp to maximize your Section 199A qualified business income deduction. But we’ll walk you thru the basics first.
Section 199A Calculation Recap
The basic Section 199A pass-through deduction is 20% of net qualified business income, which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. This is direct cash in your pocket. Who says Obamacare isn’t affordable now?
Here is the exact code-
(2) DETERMINATION OF DEDUCTIBLE AMOUNT FOR EACH TRADE OR BUSINESS. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-
(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or
(B) the greater of-
(i) 50 percent of the W-2 wages with respect to the qualified trade or business, or
(ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.
Recall that the W-2 and / or depreciable assets limitation does not start until household income exceeds the upper limit of the 24% marginal tax bracket ($160,725 for singles and $321,450 for married filing jointly, using 2019 numbers).
To prime the pump here; if you earn $450,000 as a household and you have a single member LLC not being taxed as an S corporation, your Section 199A deduction will be limited based on W-2 wages (or lack thereof). We’ll show some examples with Mr. Slate, Fred and Wilma.
S Corp Benefits Recap
The basics of the S corporation benefit is the reduction of self-employment taxes (Social Security and Medicare taxes). This is done by taking the economic benefit of the business and chopping it up between distributions and reasonable shareholder salary. Let’s say the net income after expenses (economic benefit) is $100,000. If you paid yourself $40,000 in shareholder wages the remainder of $60,000 is distributed to the owner(s).
What’s the big deal? The economic benefit ($100,000) is taxed at the income tax level. That is a no-brainer and unavoidable. But you only pay Social Security and Medicare taxes on the $40,000… in other words, the $60,000 is only subjected to income tax, whereas the $40,000 is subject to Social Security, Medicare and income taxes.
This S corporation benefit existed before the Section 199A deduction tax law; and the benefit does not change with the Section 199A deduction. We’ll talk about combining these recaps into a Section 199A S Corp combined benefit.
Section 199A Wage Limit I
As mentioned earlier, if your household taxable income exceeds the 24% marginal tax bracket, your Section 199A deduction will have a secondary test of W-2 wages paid (let’s forget about the depreciable assets test for now). Let’s highlight this with an example-
Mr. Slate operates as a sole proprietor and earns $500,000 but does not pay any W-2 wages since he does not have any employees. His deduction is the lessor of 50% of the W-2 wages (or $0 in this example) or 20% of the $500,000 (or $100,000). $0 is less than $100,000 even in Canada. As such the Section 199A deduction would be $0 although Mr. Slate earned $500,000 in qualified business income. Yuck.
What if Mr. Slate paid himself wages as a sole proprietor? Well, the IRS says No. The IRS says that owners operating as sole proprietors, and entities taxed as sole proprietors such as single-member LLCs, are not employees and therefore cannot be paid W-2 wages. This also includes partners in partnerships and members in multi-member LLCs.
Instead, let’s say Mr. Slate had employees but still operated as a sole proprietor. If he paid out $200,000 in W-2 wages to his employees and had $300,000 in net business income, his Section 199A deduction would be the lessor of 50% of $200,000 ($100,000) or 20% of $300,000 ($60,000). In other words, he would deduct $60,000.
Let’s back up to the example where Mr. Slate did not have any employees. What could he do? Sure, he could hire Fred to run the crane, but employees are expensive. Mr. Slate could create an LLC and tax it as an S Corp. He would take his $500,000 economic benefit and chop it up between reasonable shareholder salary and distributions.
Let’s say he paid himself $175,000 in W-2 wages. His Section 199A deduction would be the lessor of
- 20% of $325,000 ($500,000 less $175,000 in W-2 wages), or $65,000, or
- 50% of W-2 wages of $175,000, or $87,500.
In this example, he would want to reduce his salary to increase his Section 199A deduction, but you have to pay a reasonable salary according to the IRS. We’ll talk later about the maximizing the Section 199A deduction using a 28% W-2 wages component.
Section 199A Wage Limit II
You could still be burned with this Section 199A W-2 wage limit in another way. Let’s say Fred operated a single-member LLC and earned $100,000 after expenses. Fred chose well and married Wilma who is a big shot surgeon making $500,000. Therefore, their household income is $600,000 and now this adds the secondary test for the Section 199A deduction.
Fred would need to pay W-2 wages otherwise his Section 199A deduction would be $0. Therefore, we would recommend Fred elect to be taxed as an S corporation, pay himself $40,000 in W-2 wages, and deduct $12,000 as a Section 199A deduction (20% of $100,000 less $40,000).
In August 2018, the IRS released Proposed Regulations 1.199A to offer some additional insight to Section 199A. The Treasury Department and the IRS held a public hearing on the proposed regulations on October 16, 2018 and they received 335 comments which can be reviewed in Treasury Decision 107892-18. Fun.
All kidding aside, there are some wonderful suggestions. One in particular was about how the new Section 199A deduction is making S Corps attractive all over again as this blog post illustrates, not just from a savings of self-employment taxes, but from a Section 199A savings. As such, a comment requested that guaranteed payments and similar “wage-looking income” be counted as W-2 wages without a W-2. We’ll have to wait and see on that. Until then, the S Corp election appears to be quickest and easiest way ensure you get the most from the Section 199A deduction.
Section 199A Wage Optimization
Given all that you’ve learned about Section 199A deduction limitations and phaseouts, such as W-2 and net business income, there is a magical percentage where your W-2 and net business income limits are the same. Huh? On one hand we don’t want salary too high because we pay too much in Social Security and Medicare taxes. On the other hand we don’t want salary too low because we are limiting the Section 199A deduction.
So we attempt to set these two limits equal to each other… just like the old fashioned solver plugin for MS Excel. “Hey Excel! What up?! Can you change a few variables for me until these two numbers are equal? By the way, it might be circular too. Good luck.”
You might have seen a number of 28.57%. This is practically correct, but technically incorrect since it does not factor in employer payroll taxes. We say practically correct since the difference is immaterial. Here is an analysis-
|Payroll Tax (Employer) @8%||2,000||3,200||2,235|
|Net Biz Income (NBI)||73,000||56,800||69,830|
|Section 199A W-2 Limit||12,500||20,000||13,968|
|Section 199A NBI Limit||14,600||11,360||13,966|
We assumed that employer payroll tax portion is 8% of the salary. This includes Social Security, Medicare and unemployment taxes. This might be higher in some states, but let’s play along with 8%. We also assumed the example above with Fred’s lovely wife Wilma making $500,000 as a surgeon, and therefore the household income is $600,000.
As you can see, the $25,000 salary (or 25%) results in Section 199A deduction being limited by W-2 amount. Next, the $40,000 salary results in Section 199A deduction being limited by net business income (NBI).
Using Excel’s solver plug-in, or manually changing the salary to bracket the two limits, results in a salary of $27,935 or 27.9%. This magical W-2 optimization for maximizing Section 199A deduction means that both W-2 and net business income limits are the same, and neither is specifically controlling.
New York City
New York City, New Hampshire and Tennessee have an S Corp tax which essentially eliminates all the self-employment tax savings that S corporations are famous for. How does this play into Section 199A?
Using the same examples above, let’s say Fred and Wilma lived in New York City (or New Hampshire or Tennessee, take your pick). Fred would lose most of his S Corp benefits because of the New York City S Corp tax rate of 8%ish. In other words, let’s say he would save $6,000 in Social Security and Medicare taxes, he would pay all that to New York City for corporate taxes. Up until Section 199A, Fred would remain a single-member LLC and report his business activities on Schedule C taking his self-employment tax lumps. Gulp.
With Section 199A and it’s W-2 wage limit calculation, Fred might want to elect S corporation status to grab his Section 199A deduction; while his savings in self-employment taxes would be gobbled up by his corporate taxes, he would now enjoy a Section 199A deduction. The Section 199A deduction and subsequent tax benefit might exceed the NYC tax on his S corporation.
Let’s play with some math. Fred is banking $500,000 net income as a NON-specified service trade or business reported on his Schedule C and on Form 1040. He’s getting killed on self-employment taxes… sure… but he is also losing out on the Section 199A deduction because of his income (recall that once you exceed the 24% marginal tax rate, there is a secondary Section 199A deduction test based on wages and / or depreciable assets).
He S elects his business so he can pay wages… this reduces his self-employment taxes and increases his Section 199A deduction. The win. But he now has to pay NYC an S Corp tax. The loss. But his wins might exceed his losses allowing him to punch a ticket to the tax savings playoffs. Ok, a bit dramatic, but you get it.
We can review your particular situation to see if an S Corp election to create Section 199A S Corp benefits makes sense. Here is our summary of the major issues recently updated by the final regulations, rental property safe harbor (Notice 2019-7) and how all this crud affects S corporations-
Jason Watson, CPA is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.