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Editorial 10 MIN READ

The S-corp election in late 2019: a field report

Twenty months after the first §199A memo, the final regs are out, the wage base has moved, and the examination letter reads differently

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 7 sections
  1. What T.D. 9847 actually nailed down
  2. The 2019 numbers the wage calculation runs on
  3. What the reasonable-compensation cases look like in 2019
  4. The operational file we now tell clients to keep
  5. Who should still elect, now that the numbers are firmer
  6. One loose thread
  7. Sources

wenty months after TCJA rewrote the S-corp planning memo, the regulations have landed, the Social Security wage base has stepped up to $132,900, and the reasonable-compensation examination letter is arriving at addresses that had not seen one in years. The 2019 S-corp election is a different animal than the 2018 version, not because the statute moved, but because the Treasury guidance, the inflation adjustments, and the enforcement posture all moved at once.

The short version: T.D. 9847 is controlling, aggregation is now a real planning lever, and the wage you would have set in early 2018 on a guess is the wage you should set today on a record.

What T.D. 9847 actually nailed down

On February 8, 2019, Treasury published the final §199A regulations as T.D. 9847, adopting the August 2018 proposed regulations with modifications. The final package runs through §§ 1.199A-1 to 1.199A-6 and settled a handful of questions that were open in the planning memos we wrote in early 2018.

Three settlements matter for S-corp owners. First, the definition of a qualified trade or business. The final regs confirmed that a §162 trade or business is the operative test, not a lower activity threshold, and that self-rental and common-control rental arrangements can rise to a trade or business when the facts support it. Second, the SSTB "reputation or skill" catchall in §199A(d)(2)(A). The final regs narrowed it sharply; it now reaches endorsement income, appearance fees, and licensing of the person's identity, not every closely held service business whose value travels with the owner. Most small S-corp service businesses that worried about the catchall in 2018 no longer need to. Third, and most operationally consequential, the aggregation rules under 26 CFR § 1.199A-4.

Aggregation is elective, and it is the planning lever that most S-corp-heavy clients did not know they had eighteen months ago. If the same person (or group, measured through the §267(b) and §707(b) attribution rules) owns 50% or more of two or more trades or businesses, and they meet two of three factual factors (same or customary products and services, shared centralized elements such as personnel or accounting or IT, or operational interdependence), the owner can treat them as one for the W-2-wages and UBIA limitations that apply above the §199A threshold. None of the aggregated businesses may be an SSTB. The ownership test has to be met for a majority of the taxable year and on the last day of the year. Once aggregated, the group has to stay aggregated in subsequent years.

What this means concretely: an owner who runs an operating S-corp that pays W-2 wages and a separate entity that holds the real estate and leases it back to the operating company can, on the right facts, aggregate the two for §199A purposes. The wages paid by the operating company then support the §199A deduction on the rental income as well. A contractor with three jobsite LLCs aggregated into one payroll S-corp will often get a materially larger deduction than the same facts run without the election. This is the kind of structural savings that was speculative in the 2018 memo and is now on the return form.

The 2019 numbers the wage calculation runs on

Two Rev. Proc. 2018-57 adjustments and the SSA wage-base move changed the arithmetic in ways that do not show up in the statute. The 2019 §199A threshold is $160,700 for single filers, $160,725 for married filing separately, and $321,400 for a joint return. The phase-in ranges above are the same $50,000 and $100,000 the statute sets in §199A(e)(2) and (d)(3). The 2019 Social Security wage base is $132,900, up from $128,400 in 2018. An S-corp that sets an owner wage anywhere in the five-to-six-figure range common for closely held service businesses is moving the 12.4% OASDI piece across that $132,900 ceiling; the 2.9% Medicare piece (plus 0.9% Additional Medicare above the §1401(b)(2) thresholds) runs uncapped above it.

Here is the revised version of the math we walked through in the February 2018 piece on the post-TCJA election. Same service S-corp, $160,000 of net income before wages, single shareholder, taxable income kept just under the 2019 threshold by a deductible retirement contribution. At a $50,000 wage and $110,000 distribution, FICA runs 15.3% on $50,000 (call it $7,650 combined employee and employer). The §199A deduction on the $110,000 of QBI is $22,000, worth roughly $5,280 at a 24% marginal rate. Bump the wage to $90,000 and the FICA climbs to $13,770 (still under the OASDI cap), the distribution drops to $70,000, and the §199A deduction drops to $14,000 (worth roughly $3,360). The $40,000 wage shift costs roughly $6,120 in FICA and gives up roughly $1,920 of tax benefit. Net cost of moving the wage up: roughly $8,040. The floor for the wage is whatever the reasonable-comp doctrine would impute; the ceiling is whatever the owner is willing to pay to avoid argument. The arithmetic hasn't reversed, but the penalty for moving the wage too high is now measurable on a single return.

The calculus above the threshold still runs the other way. A non-SSTB above the §321,400 joint threshold that pays no meaningful W-2 wages hits the §199A(b)(2) limitation and loses the deduction that lower wages would not have blocked. The §199A-4 aggregation election is, for a taxpayer in that band, often the difference between losing the deduction and keeping it.

What the reasonable-compensation cases look like in 2019

The doctrine has not moved since Watson. What has moved is how often the IRS is opening the file. Treasury Inspector General for Tax Administration reviews and published enforcement discussion through 2019 make the pattern visible: of the roughly 14.8 million Form 1120-S returns filed across FY 2017 through FY 2019, the IRS field-examined 31,691, about 0.2%. The examined population skews hard toward single-shareholder S-corps reporting zero officer compensation on a 1120-S that also reports meaningful net income. TIGTA's published analysis flagged 4.4 million returns across three tax years that fit that profile. The examination rate is still small in absolute terms. The selection, inside that small rate, is not random.

The live cases still worth reading are the same ones that bounded the doctrine before §199A was enacted. Watson v. United States, 668 F.3d 1008 (8th Cir. 2012) is still the Eighth Circuit's cost-of-replacement analysis: David Watson's $24,000 wage on $200,000-plus of distributions moved up to roughly $93,000 on expert testimony about what an experienced CPA would have commanded in that market. The opinion does not stand for a ratio. It stands for the proposition that the wage is what a third party would pay to hire the shareholder to do the shareholder's job.

Sean McAlary Ltd. v. Commissioner, T.C. Summary Opinion 2013-62 is the quieter cousin and, for single-shareholder S-corps, the more instructive fact pattern. McAlary was a solo real-estate broker who ran $518,189 of gross receipts through his S-corp, drew $240,000 to himself, and reported zero wages. The IRS expert used BLS median wages for real estate brokers in Southern California ($48.44 per hour) to arrive at $100,755 of reasonable compensation. The Tax Court cut it to $40 per hour, or $83,200, but the shape of the analysis is what matters: a BLS lookup, an hours estimate, and a court willing to do arithmetic. An S-corp owner who can produce a BLS citation for the comparable job, and an hours log, has most of an audit defense already written. Glass Blocks Unlimited v. Commissioner, T.C. Memo. 2013-180 rounds out the trio. The court recharacterized roughly $31,000 a year of distributions as wages on facts where the S-corp reported almost no net income but the shareholder was working full time. Low profitability is not a defense to a wage requirement; the services performed, not the cash available, drive the floor.

What §199A added, which we flagged in the 2018 memo and is now confirmed in the cases our members are fighting, is the second-order cost of a recharacterization. When the IRS moves a dollar from distribution to wage on exam, the taxpayer pays FICA on the moved dollar and loses the 20% §199A deduction on the moved dollar, because §199A(c)(4) excludes reasonable compensation from QBI even when the "reasonable" number is the one the agency imposed. On a $70,000 recharacterization for a taxpayer at a 24% bracket, that stacks to roughly $10,700 in combined FICA and lost-deduction cost before penalties. The pre-TCJA version of the same recharacterization cost roughly the FICA alone.

The operational file we now tell clients to keep

The doctrine has not become more precise. The record that defends it has. Three things belong in every S-corp shareholder's year-end folder for the 2019 return.

A written compensation rationale, dated before the last payroll of the year, that cites a specific labor-market comparable for the role the shareholder actually performs. BLS OES data (bls.gov/oes) is the source the courts accept; local recruiter data and professional association salary surveys support it. If the owner does more than one role, each role gets its own comparable and its own hours estimate. The 40/60 ratio heuristic is not a substitute; the courts in Watson and McAlary did not accept ratios, they accepted numbers.

An hours log, or something close enough to survive cross-examination. This is the part shareholder-employees resist most, and the part the McAlary record turned on. Weekly calendar entries, saved emails, and time-tracking data from whatever operational tool the business already uses are sufficient. The bar is not a punch clock; it is a contemporaneous record the owner can stand behind.

A §199A aggregation memo, if the owner runs more than one trade or business and the factor test under § 1.199A-4 might plausibly be met. The memo documents which businesses are aggregated, which factors support aggregation, and the ownership structure as of the last day of the taxable year. The Form 8995 and 8995-A attachments do most of the reporting work, but the supporting record has to be created once and kept consistent, because the regulation bars de-aggregating in a later year absent a material change.

Who should still elect, now that the numbers are firmer

The 2016 rule of thumb we wrote in the original S-corp piece still holds on the payroll-tax side: at roughly $50,000 of net income above what the owner would draw as a reasonable wage, the administrative cost of running payroll, filing 1120-S, and paying for the professional service to avoid the traps becomes worth the FICA savings. §199A did not move that floor materially. What it added was a second, independent reason to elect: above the §199A threshold, the election is the cleanest way to generate the W-2 wages that the §199A(b)(2) limitation requires. A partnership or a sole proprietorship can pay wages too, but the partner's or proprietor's own services are paid out as guaranteed payments or self-employment draw, both of which fall outside the W-2 calculation. For a non-SSTB clearing meaningful net income above the threshold, the S-corp election is sometimes the only clean way to rescue the deduction.

For an SSTB above the phase-in ceiling, the §199A deduction is gone either way and the election reverts to its pre-TCJA logic. Pay a reasonable wage, take the rest as distribution, and save the payroll-tax difference on income above the $132,900 wage base.

For anything ambitious about raising priced equity, taking on a foreign co-founder, or selling to an entity buyer in a stock deal, the election remains the wrong call. We said this in 2016 and we said it again in February 2018; the final regs did not change it. If the five-year plan includes any of those moves, the 2553 is a structural liability and not a tax win.

One loose thread

The final regs settled most of the 2018 open questions. They did not settle rental real estate held in a separate entity that leases to an operating S-corp under common control. The preamble to T.D. 9847 and Notice 2019-07 created a safe harbor for qualifying rental enterprises (250 hours of rental services per year, separate books, contemporaneous records), but the safe harbor is awkward for single-property structures and the self-rental rule's "trade or business" characterization still runs on facts and circumstances. For any client with a building held in a sibling LLC, the aggregation question and the self-rental question are the 2019 work that the 2018 memo flagged and did not finish. We will come back to it when the first examination letter on a self-rental aggregation lands at our desk.

Sources

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