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Editorial 9 MIN READ

LLC vs S-corp: the 2018 recalibration

Twenty-nine months after we last ran the numbers, §199A has rewritten the decision tree and the low-wage trick now has two price tags

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What changed in the statute, in operational terms
  2. Below the threshold: the S-corp election still helps, with a smaller window
  3. At and above the threshold: the low-wage strategy reverses
  4. Watson is still the governing case on reasonable compensation
  5. Where the decision actually lives now
  6. Sources

he LLC vs S-corp question has a different answer in November 2018 than it had in June 2016. The mechanics of the payroll-tax crossover are intact; §199A, the new 20% deduction for qualified business income, has bolted a second variable onto the dashboard and it points the opposite direction from the first one.

Twenty-nine months ago, we ran the payroll-tax crossover and concluded that the S-corp election started paying for itself somewhere north of $60,000 of net self-employment income, with the real lever being the ratio of reasonable compensation to distributions. The ratio still matters. The band in which you can freely move the wage dial is now narrower, and above the §199A threshold it can invert.

What changed in the statute, in operational terms

Section 199A, enacted as part of Pub. L. 115-97 on December 22, 2017, gives owners of pass-through trades or businesses a deduction of up to 20% of qualified business income. The deduction sits on the 1040 below AGI and above taxable income. It does not reduce self-employment tax. It reduces income tax only, and only on the QBI slice.

The two provisions that matter for the LLC-vs-S-corp call are §199A(c)(4) and §199A(b)(2). Section 199A(c)(4) excludes from QBI any reasonable compensation paid to an S-corp shareholder and any §707(c) guaranteed payment to a partner. The wage line is out; the distribution line is in. Section 199A(b)(2) kicks in above the statutory threshold and caps the deduction at the greater of 50% of W-2 wages paid by the qualified trade or business, or 25% of W-2 wages plus 2.5% of the unadjusted basis in qualified property. Below the threshold, the wage cap does not apply. Above it, wages paid become the ceiling on the deduction.

The thresholds for 2018, per §199A(e)(2), are $157,500 of taxable income for single filers and $315,000 for married-filing-jointly, with a full phase-in of the wage cap and SSTB exclusions over the next $50,000 for singles and $100,000 for joint filers. These numbers determine which of the two regimes the taxpayer is in, and they are the fulcrum of every planning memo written this year.

The proposed regulations Treasury published on August 8, 2018, at 83 Fed. Reg. 40884, locked down most of the first-order operational questions. We walked through REG-107892-18 in full in August. The piece you are reading assumes those definitions stand.

Below the threshold: the S-corp election still helps, with a smaller window

If the owner's total taxable income on the 1040 is under $157,500 for a single filer or $315,000 for a joint filer, the analysis is close to the 2016 one, with a wrinkle. The §199A wage cap does not apply. Neither does the specified-service-trade exclusion. The owner gets the full 20% deduction on QBI, whether the business is a consulting practice, a plumbing company, a law firm, or an e-commerce LLC.

Run the numbers on a consulting LLC netting $140,000 to a single owner in 2018. As a default-taxed LLC, the $140,000 is Schedule C, subject to 15.3% self-employment tax on the first $128,400 (the 2018 Social Security wage base, set by the Social Security Administration's November 27, 2017 announcement) plus 2.9% Medicare on the remaining $11,600. After the SE deduction, the owner takes a 20% §199A deduction on roughly $130,000 of QBI (QBI is reduced by the deductible portion of SE tax per Prop. Reg. § 1.199A-3(b)(1)(vi)), so the deduction is about $26,000.

Run the same business as an S-corp with $60,000 of reasonable compensation and $80,000 of distribution. The $60,000 salary carries $9,180 of combined FICA (15.3%). The $80,000 distribution carries nothing. QBI is $80,000 (the distribution slice; the wage is outside QBI per §199A(c)(4)) minus a small portion of the S-corp's share of employer payroll tax, call it $76,000. The 20% deduction is about $15,200.

Comparing totals: the default LLC owed $21,416 in SE tax and took a $26,000 income-tax deduction. The S-corp owed $9,180 in payroll tax and took a $15,200 income-tax deduction. The S-corp payroll-tax saving is about $12,200. The §199A deduction is about $10,800 smaller. Net, the S-corp still wins by roughly $1,400, assuming a 22% marginal rate on the §199A-deductible slice and ignoring payroll-processing fees.

The margin is real but it is slim, and it inverts fast if the reasonable compensation figure has to come up. At $80,000 of wage against $60,000 of distribution, the §199A deduction shrinks further, the FICA bill grows, and the S-corp's edge over the default LLC disappears. In the $100,000 to $160,000 single-owner zone, the post-TCJA S-corp election still usually pays, but the band is narrower than it was in 2016 and the wage figure has less room to wander.

At and above the threshold: the low-wage strategy reverses

Above the §199A threshold, the decision tree bends. Section 199A(b)(2) limits the deduction to the greater of 50% of W-2 wages the qualified trade or business paid or 25% of wages plus 2.5% of unadjusted basis. For a service business with no meaningful depreciable property, the effective cap is 50% of wages.

Here is the inversion. In the 2016 playbook, every dollar an S-corp owner moved from wage to distribution saved 15.3% FICA up to the wage base and 2.9% Medicare above. In the 2018 above-threshold playbook, moving a dollar from wage to distribution still saves FICA, but it also shrinks the W-2 wage figure that caps the §199A deduction. Below a certain wage-to-QBI ratio the cap starts binding, and the owner loses some or all of the 20% deduction on the distribution they worked so hard to create.

The pivot sits around the point where 50% of wages equals 20% of QBI, or equivalently, where wages equal 40% of QBI. Below that ratio the cap binds. Above it, the cap does not bite and the deduction is fully the 20% of QBI figure.

Take a married-joint return with $500,000 of combined taxable income, all of it from a non-SSTB operating business run through an S-corp with $400,000 of net. If the owner takes $80,000 in reasonable compensation and $320,000 as distribution, wages are 20% of QBI, the 50%-of-wages cap is $40,000, and the §199A deduction is $40,000, not the $64,000 that 20% of $320,000 QBI would suggest. Raising the wage to $160,000 lifts the cap to $80,000, and because QBI shrinks to roughly $240,000, the 20%-of-QBI figure is $48,000 and now binds. The deduction is $48,000. The higher wage produced a bigger deduction, which is the opposite of the pre-TCJA intuition.

The math is not that the higher wage is "free." It is that the marginal cost of wage (15.3% FICA on the slice up to the base, then 2.9% above, plus the 0.9% additional Medicare on the top end) has to be weighed against the marginal benefit of a larger §199A cap. The tradeoff is genuinely two-sided, and at certain income levels the optimal wage is higher than the wage the taxpayer would have set on payroll-tax logic alone.

For specified service trades above the threshold, the analysis stops mattering at a different point entirely: the §199A deduction phases out to zero by $207,500 (single) or $415,000 (joint). An SSTB owner fully above the phase-in range gets no §199A deduction regardless of wage structure, which returns the decision to the pre-TCJA payroll-tax question. We covered the SSTB definitions in the proposed regs piece; Prop. Reg. § 1.199A-5(b) is the controlling cite.

Watson is still the governing case on reasonable compensation

None of the §199A arithmetic gives the taxpayer permission to set a higher wage than the reasonable-compensation doctrine allows, nor a lower one. The Eighth Circuit's decision in David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), is the controlling modern authority. The Supreme Court denied cert, and the IRS reasonable-compensation fact sheet still reads like the Watson record.

Watson was a CPA with 25% of an accounting firm. His wholly owned S-corp billed the firm for his services and paid him $24,000 a year while distributing roughly $200,000. The IRS recharacterized most of the distribution as wages, and the courts agreed. The Eighth Circuit affirmed the district court's finding that a reasonable wage for Watson's work was about $91,044 per year, adopting the government's expert analysis over Watson's intent-based argument. The holding is narrow, but the reasoning is broad: reasonable compensation is whether the payments received were truly remuneration for services performed, tested against market data for comparable work, not against the taxpayer's preferred tax outcome.

The Watson floor has always set a ceiling on the aggressiveness of a payroll-tax strategy. It now also sets a floor on the §199A aggressiveness in the other direction, because if the owner pushes the wage up to chase the wage cap above threshold, the IRS has no incentive to challenge the figure as unreasonably high, but the taxpayer still needs the number to be defensible if a future examiner looks at related-party services or at the payroll deduction from the other side. The safe zone is the same market-comp band it always was, roughly the cost to hire a non-owner to do the owner's job.

Where the decision actually lives now

For 2018 returns being filed next spring, the decision tree looks like this. If taxable income is comfortably below $157,500 or $315,000, the S-corp election still usually beats the default LLC, the margin is just smaller than it was pre-TCJA, and the wage figure should sit in the Watson-defensible band. The move away from ultra-low wage figures that CPAs were pricing in 2016 is mostly about preserving the §199A deduction on the distribution slice, not about new IRS enforcement.

If taxable income is above the threshold and the business is an SSTB, §199A does not apply once you clear the phase-in. The decision reverts to 2016 payroll-tax arithmetic, and the S-corp election is still worth running for the FICA savings, subject to Watson.

If taxable income is above the threshold and the business is non-SSTB, the optimal S-corp wage is higher than payroll-tax logic alone would suggest, because the 50%-of-wages cap under §199A(b)(2) is usually the binding constraint. The S-corp post-TCJA piece walked through this inversion in February when it was first visible; the August regs did not meaningfully move it.

If the business is a single-member LLC with modest income, no election at all is often the right answer. Self-employment tax at 15.3% on a $50,000 net, against the full 20% §199A deduction with no wage-cap concern, produces a cleaner return than an S-corp election that costs payroll-processing fees and professional time to maintain.

Rule of thumb: below the threshold and netting more than $80,000 as a single-member operating business, elect S-corp with a Watson-defensible wage around 35 to 45 percent of net, and do not let a CPA talk you into a wage so low it eats your §199A deduction.

Sources

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