Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 10 MIN READ

LLC vs S-corp: the 2021 payroll-tax crossover, recalibrated again

A $142,800 wage base, $164,900 and $329,800 thresholds, and a §199A regulatory regime that stopped moving

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. The 2021 numbers, anchored
  2. Below the threshold: the slim-margin case
  3. Above the threshold: the wage cap still inverts the intuition
  4. Watson, still the case that bounds the wage
  5. Where the decision actually lives in 2021
  6. Sources

he LLC-vs-S-corp crossover has three moving numbers in 2021: the Social Security wage base at $142,800, the §199A taxable-income threshold at $164,900 for single filers and $329,800 for joint filers, and a set of final regulations that stopped wobbling in February 2019. Two and a half years after the last recalibration, the decision tree looks the same in shape and slightly tighter in the numbers.

If you read the 2016 original and the 2018 recalibration, the update here is incremental. The statute has not moved. The regs have settled. The thresholds have crept up with inflation, and the CPA playbook that emerged in 2019 has had a full filing season to prove itself.

The 2021 numbers, anchored

Start with the figures, because the math is the article.

The 2021 Social Security wage base is $142,800, announced by the Social Security Administration on October 13, 2020, up from $137,700 in 2020. FICA on wages is 6.2% Social Security from the employee plus 6.2% from the employer, for 12.4% up to the wage base, plus 1.45% Medicare on each side for another 2.9%, then a 0.9% additional Medicare tax on earned income above $200,000 single or $250,000 joint under IRC § 3101(b)(2). Self-employment tax under IRC § 1401 is the same 15.3% combined rate up to the wage base and 2.9% above, applied to 92.35% of net earnings from self-employment.

The §199A thresholds for 2021, set by Rev. Proc. 2020-45, § 3.27, are $164,900 of taxable income for single filers and $329,800 for joint filers, with the full phase-in of the wage-and-property limitation and the SSTB exclusion running over the next $50,000 single or $100,000 joint. That puts the top of the phase-in range at $214,900 and $429,800 respectively. These are taxable-income figures on the 1040, not gross revenue, and they sit below the §199A deduction on the return by design.

The final §199A regulations, T.D. 9847, were published in the Federal Register at 84 Fed. Reg. 2952 on February 8, 2019, with a correcting amendment at 84 Fed. Reg. 15954 on April 17, 2019. Those regs replaced the August 2018 proposed package on which the 2018 recalibration was written. For most pass-through operating businesses the final text tracked the proposal, with the largest changes in the SSTB definitions (a tightened "principal asset is the reputation or skill" carve-out in Treas. Reg. § 1.199A-5(b)(2)(xiv)) and in the aggregation election mechanics in § 1.199A-4. The baseline arithmetic did not move.

Below the threshold: the slim-margin case

For a single-owner operating LLC netting under the §199A threshold, the 2021 analysis is a close cousin of the 2018 one.

Take a $140,000 net from a solo consultant, filing single, no other wages. Taxable income after the standard deduction ($12,550 for single filers in 2021 under Rev. Proc. 2020-45, § 3.17) lands comfortably below $164,900, so the §199A wage-and-property cap under IRC § 199A(b)(2) does not apply. Neither does the SSTB exclusion under § 199A(d). The full 20% of QBI deduction is on the table in either entity form.

Run it as a disregarded LLC. SE tax applies to 92.35% of $140,000, or $129,290. All of that sits under the $142,800 wage base, so SE tax is 15.3% of $129,290, or roughly $19,781. Half of SE tax is deductible above the line at roughly $9,890. QBI is net earnings from SE reduced by the deductible SE tax per Treas. Reg. § 1.199A-3(b)(1)(vi), producing a QBI of about $130,110 and a 20% deduction of about $26,020.

Run it as an S-corp with $60,000 of reasonable compensation and $80,000 of distribution. FICA on the $60,000 wage is 15.3%, or $9,180. The distribution carries no payroll tax. QBI is the $80,000 of pass-through profit reduced by the S-corp's share of employer FICA (roughly $4,590), so call it $75,410, and the 20% deduction is about $15,082. The wage figure is excluded from QBI under IRC § 199A(c)(4).

Compare. The disregarded LLC owed $19,781 in SE tax and produced $26,020 of §199A deduction. The S-corp owed $9,180 in FICA and produced $15,082 of §199A deduction. Payroll-tax savings of $10,601, minus a §199A-deduction shrinkage of about $10,938, valued at a 22% marginal rate, gives back $2,406 of income-tax value. Net, the S-corp wins by roughly $8,195 before administrative costs.

Knock off $1,500 for a 1120-S at a competent small-firm CPA and another $600 a year for payroll processing through Gusto or a similar service, and the margin is around $6,000. That is real money for a solo, but it is not the double-digit thousand-dollar margins the 2014-era S-corp boosters quoted, and it disappears fast if the reasonable-compensation figure has to move up. At $90,000 wage against $50,000 distribution, the S-corp margin collapses to roughly $2,000, and at $100,000 wage it goes negative once administrative overhead is counted.

The band in which the S-corp pays is narrower than it was in 2016 and about the same as it was in 2018. The §199A deduction is the reason: the wage dollars the owner moves out of QBI to save payroll tax are the same dollars that would otherwise be deductible at 20%, and the two effects partially offset. Below roughly $80,000 of net, the margin is too thin to be worth the administrative drag. Above roughly $250,000, the owner clears the threshold and the analysis changes shape.

Above the threshold: the wage cap still inverts the intuition

Clear $164,900 single or $329,800 joint and the §199A(b)(2) limitation starts to bite. The deduction is capped 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. For a professional-services S-corp with no meaningful depreciable property, the cap is 50% of wages and nothing else.

Treas. Reg. § 1.199A-2(b), finalized under T.D. 9847, clarified that the W-2 wages are the wages reported by the qualified trade or business, not the wages the taxpayer personally earned in another capacity. For an owner-only S-corp, the W-2 wages are the owner's own salary. The inversion the 2018 piece flagged is now operational doctrine: above the threshold, moving a dollar from wage to distribution saves FICA but shrinks the W-2 figure that caps the deduction, and below a certain wage-to-QBI ratio the cap binds.

The pivot is the same arithmetic as 2018. The cap of 50% of wages equals the 20% of QBI figure when wages equal 40% of QBI. Below that ratio the cap binds and the deduction shrinks. Above it the cap is slack and the deduction is a full 20% of QBI.

Take a joint return with $500,000 of combined taxable income, all from a non-SSTB S-corp netting $400,000 with no W-2 employees other than the owner. At $80,000 wage and $320,000 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 a pure 20%-of-QBI calculation would yield. Raise the wage to $160,000, and the cap becomes $80,000 while QBI drops to roughly $232,000 (net of employer FICA), so 20% of QBI is $46,400, which now binds and sets the deduction at $46,400. The higher wage produced the larger deduction.

The marginal arithmetic is not "wage is free above the threshold." FICA still costs 2.9% Medicare on every marginal wage dollar above the $142,800 base, plus 0.9% additional Medicare on the slice above $250,000 joint under IRC § 3101(b)(2). Those costs have to be weighed against the marginal §199A benefit, which at a 24% or 32% bracket on the QBI slice is 4.8 to 6.4 cents on the dollar. In the bands where the cap is binding, the benefit exceeds the cost and the optimal wage moves up. In the bands where the cap is slack, the benefit is zero and the optimal wage moves back down.

For SSTBs above the threshold, IRC § 199A(d)(3) phases the deduction out to zero by the top of the range, $214,900 single and $429,800 joint. An SSTB owner fully above the phase-in gets no §199A deduction at all, and the decision reverts to the 2016 arithmetic: pure payroll-tax savings on the distribution slice, subject to reasonable compensation. Treas. Reg. § 1.199A-5(b) continues to define the specified service trades, with law, health, accounting, consulting, financial services, and "any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners" as the tightened formulation.

Watson, still the case that bounds the wage

David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), remains the controlling modern authority on reasonable compensation in an S-corp. Watson, a 25% partner in an accounting firm through a wholly owned S-corp, paid himself $24,000 in salary while distributing approximately $200,000. The IRS recharacterized most of the distribution as wages, and the Eighth Circuit affirmed the district court's finding that a reasonable wage for Watson's work was $91,044, adopting the government's expert's comparables analysis. Cert denied later that year.

What Watson supplies is a record. The court relied on compensation surveys, comparable-position data, and the testimony of a valuation expert to set the number. That is the kind of evidence an IRS examiner wants to see in the file. Payroll surveys from professional associations, postings for the same role in the local market, and a brief contemporaneous memo in the owner's file are the minimum. Founders who cannot articulate why their wage is the wage lose on audit.

The §199A regime does not change Watson's logic. What it changes is the direction of the taxpayer's incentive above the threshold. Pre-TCJA, every wage dollar was a tax cost to the owner, and the Watson floor held the wage from falling below defensible. Post-TCJA above threshold, the wage dollar can produce a §199A benefit larger than its FICA cost, which means a rational taxpayer may push the wage up, and the IRS has no reason to challenge a high wage as unreasonable. The floor is the same; the taxpayer is pressing upward against it instead of downward.

Where the decision actually lives in 2021

For a 2021 return, the decision tree comes out like this.

Below the §199A threshold, a solo operating business netting more than roughly $80,000 still benefits from the S-corp election, with a Watson-defensible wage sitting in the 35 to 45 percent of net range. The margin is in the low single-digit thousands after administrative costs. Below $80,000 of net, the disregarded LLC with the full 20% §199A deduction usually wins once payroll and return-prep costs are priced in.

Above the threshold in a non-SSTB, the optimal wage is usually higher than the 2016 payroll-tax logic suggested, because the 50%-of-wages cap is binding more often than not. The right move is to run the cap math first and the FICA math second, then settle on a wage that maximizes §199A without exceeding what Watson would defend.

Above the threshold in an SSTB, the §199A deduction phases out entirely and the analysis reverts to 2016 payroll-tax arithmetic, full stop. The S-corp election still pays on the FICA spread, subject to reasonable compensation.

Two 2021-specific wrinkles are worth naming. The first is the continuing state patchwork. California's 1.5% S-corp franchise tax with an $800 minimum still closes most of the federal gap for California residents and occasionally erases it. New York City's General Corporation Tax continues to hit S-corps as if they were C-corps. Seventeen states now have pass-through entity taxes on the books as a workaround to the $10,000 SALT cap under TCJA, and several of those, Connecticut's conspicuously, require careful election analysis for S-corps in particular. Price the election in the owner's actual state.

The second is the health-insurance and retirement-contribution side, which the 2018 piece undersold. For a 2%-or-more S-corp shareholder, self-employed health-insurance premiums must be added to W-2 wages under IRC § 1372 and then deducted above the line. A SEP or solo 401(k) contribution can be calculated off the W-2 wage only, which means an ultra-low salary caps retirement contributions as surely as it caps the §199A deduction. For owners trying to fund a solo 401(k) at anything near the IRC § 415(c) limit of $58,000 for 2021, the wage has to be high enough to support the contribution, and that calculation often sets the wage before any of the tax arithmetic above it does.

Rule of thumb for 2021: below the §199A threshold, elect S-corp if your net is comfortably above $80,000 and your defensible wage sits below 70% of net; above the threshold in a non-SSTB, elect S-corp and set the wage at the level that maximizes the §199A(b)(2) cap rather than the level that minimizes FICA.

Sources

Keep reading

More from the journal.