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Editorial 10 MIN READ

The S-corp election in May 2021: the PTET changes the math

A second independent reason to elect has appeared this year, and it is the biggest re-weighting of the S-corp memo since §199A

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 7 sections
  1. What Notice 2020-75 actually did
  2. The mechanics, run through one return
  3. The 2021 numbers the wage calculation runs on
  4. The reasonable-compensation record, 2021 version
  5. Who should still elect, reweighted for PTET
  6. One loose thread, carried forward
  7. Sources

he S-corp election in 2021 earns its keep for a reason that did not exist when we last revised this memo in October 2019. A dozen states have enacted elective pass-through entity taxes that pay state income tax at the entity level, generate a federal deduction for the entity, and pass a credit through to the shareholders. For owners of a closely held S-corp in a high-tax state, that workaround is worth more than the payroll-tax savings the election was originally sold on.

The numbers inside the election have moved too. The 2021 Social Security wage base is $142,800 and the §199A thresholds have stepped up to $164,900 single and $329,800 joint under Rev. Proc. 2020-45. The reasonable-compensation doctrine is where we left it. The new file to pull is not Watson or McAlary; it is the PTET statute for whichever state the shareholder pays tax to.

What Notice 2020-75 actually did

On November 9, 2020, Treasury and the IRS issued Notice 2020-75, announcing that forthcoming proposed regulations would confirm a position states had been probing since the TCJA's $10,000 state and local tax cap took effect. The notice: a partnership or S corporation that pays a state or local income tax imposed on the entity itself may deduct that tax as a business expense in computing non-separately stated income, without regard to §164(b)(6)'s cap on individual SALT deductions. The notice is effective for specified income tax payments made on or after November 9, 2020, and taxpayers could rely on it for open tax years ending after December 22, 2017.

Three words in the notice carry most of the weight: "imposed on the partnership or S corporation." The deduction only works where the state statute makes the entity, not the owner, the primary taxpayer. A voluntary election that collects what would have been the shareholder's tax at the entity level qualifies as long as the election converts the legal incidence. A composite or withholding regime that remits the owner's tax on the owner's behalf does not.

The notice did not invent the PTET. Connecticut had already enacted a mandatory entity tax in 2018; New Jersey followed with the Business Alternative Income Tax at the end of 2019. What Notice 2020-75 did was bless the elective version, which is the version every other high-tax state is now racing to enact. By the spring 2021 legislative sessions, Alabama, Arkansas, Georgia, Idaho, Louisiana, Maryland, New York, Oklahoma, Rhode Island, and South Carolina had PTET statutes on the books or in conference. The statutory details vary; the federal plumbing is the same.

The mechanics, run through one return

Picture an S-corp with $400,000 of net income after a reasonable wage, held 100% by a single shareholder who lives in a state with a 6.85% top rate and an elective PTET. Without the election, the $400,000 flows through to the shareholder, who pays roughly $27,400 of state tax and can deduct $10,000 of it on Schedule A under §164(b)(6). The other $17,400 is paid with after-tax federal dollars.

With the PTET election, the S-corp writes the $27,400 state check itself. Under Notice 2020-75, that check is a §162 business expense of the S-corp; non-separately stated income on the K-1 drops to roughly $372,600. At a 24% federal marginal rate, the $27,400 deduction is worth roughly $6,576. The state gives the shareholder a credit, usually dollar-for-dollar, for the $27,400 the entity paid, so the shareholder's state tax liability is satisfied and the cap on personal SALT deduction no longer matters for this income. The net federal benefit of the election, in this case, is the $6,576 the SALT cap would otherwise have eaten.

Scale changes the picture. A California or New York City shareholder at or near the top marginal brackets, running several hundred thousand dollars through an operating S-corp, can capture PTET savings in the five figures annually. For an owner in a no-income-tax state (Wyoming, Texas, Nevada, South Dakota, Washington), the PTET is simply not a variable. For everyone in between, the memo now has two columns where for thirty years it had one.

The election is not free. It has to be made within a state-prescribed window (often by the 15th day of the third month of the tax year, though statutes differ). It is generally irrevocable for the year. Nonresident shareholders complicate the credit mechanics, because the shareholder's home state may or may not give a credit for tax paid by an out-of-state entity. Trust and estate shareholders raise a separate set of pass-through issues. The back-office burden is real. For a single-shareholder S-corp in a state with a clean elective statute, the arithmetic tends to outrun the burden by a wide margin.

The 2021 numbers the wage calculation runs on

Rev. Proc. 2020-45, published November 9, 2020 as the 2021 inflation adjustments, set the §199A threshold at $164,900 for single filers, $164,925 for married filing separately, and $329,800 for a joint return. The §199A phase-in ranges of $50,000 single and $100,000 joint are unchanged from the statute. The 2021 Social Security wage base is $142,800, up from $137,700 in 2020 and from $132,900 in 2019. The 12.4% OASDI piece runs on wages up to that $142,800; the 2.9% Medicare piece (plus 0.9% Additional Medicare above the §1401(b)(2) thresholds) runs uncapped.

Re-running the illustration we used in the 2019 field report with the 2021 numbers: same service S-corp, $160,000 of net income before wages, single shareholder, taxable income kept just under the 2021 threshold by a deductible retirement contribution. At a $50,000 wage and $110,000 distribution, combined employee-and-employer FICA on the wage runs $7,650. The §199A deduction on the $110,000 of QBI is $22,000, worth roughly $5,280 at a 24% marginal rate. Move the wage to $90,000, FICA climbs to $13,770 (still below the $142,800 OASDI cap and inside the 15.3% combined rate on the full wage), 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 of FICA and gives up roughly $1,920 of §199A benefit. Net cost of moving the wage up: roughly $8,040. That is the same shape we saw in 2019; the cap has moved but the planning is unchanged.

The §199A(c)(4) exclusion still bites the same way. Reasonable compensation paid to an S-corp shareholder is not qualified business income. A recharacterization on exam that moves a dollar from distribution to wage hits the taxpayer for FICA on the moved dollar and for the lost 20% deduction on the moved dollar. At a 24% marginal rate, that still stacks to roughly $153 per $1,000 moved, before interest and penalties. The doctrine we walked through in the 2016 piece and again in the February 2018 post-TCJA memo is unchanged; what §199A(c)(4) did was make the cost of losing on it larger.

The reasonable-compensation record, 2021 version

The cases are the same: Watson, McAlary, Glass Blocks Unlimited. The Tax Court has not issued a reasonable-comp opinion since 2019 that reshapes the doctrine. What has moved is the examination posture. TIGTA has continued to flag S-corp officer compensation as a priority area in its FY 2021 work plan, and the IRS Small Business/Self-Employed Division has kept S-corp reasonable compensation on its compliance campaign list since 2018. The returns the agency pulls still skew hard toward single-shareholder S-corps reporting zero or nominal officer wages on a 1120-S that reports meaningful net income; the selection inside the sub-1% examination rate is not random.

The file we described in 2019 is the file that still defends the return in 2021: a written compensation rationale dated before the last payroll of the year, citing a BLS OES comparable for the role the shareholder actually performs; an hours log contemporaneous enough to survive cross-examination; and a §199A aggregation memo under 26 CFR § 1.199A-4 if the owner runs more than one trade or business and the factor test might plausibly be met. What 2021 adds to the folder is a PTET election memo for every state where the entity pays tax: which statute, which election form, which credit mechanic, which effective date. The PTET is the newest document in the folder, and for many owners it is now the most valuable one.

Who should still elect, reweighted for PTET

The 2016 rule of thumb has not moved: 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. Neither does the PTET. What the PTET changes is the answer for owners who previously sat on the edge. A California operating business at $250,000 of net income, where the payroll-tax arithmetic alone was a close call, now has a separate federal deduction worth a couple of thousand dollars a year that only an S-corp or partnership can deliver. For a New York or New Jersey shareholder at higher income, the PTET can be the largest single line item on the entity's federal return that the sole proprietor or single-member LLC cannot replicate.

Above the §199A threshold, the election still earns its keep as the cleanest way to generate W-2 wages for the §199A(b)(2) limitation, the argument we laid out in 2019 and the final regs did not disturb. For a non-SSTB clearing meaningful income above $329,800 joint, the S-corp election plus a PTET election in a state that offers one is the combination that captures both federal mechanics at once.

For an SSTB above the phase-in ceiling, the §199A deduction is still gone and the election is still about payroll tax. PTET adds a layer of savings that does not care whether the business is an SSTB; the SALT workaround runs on legal incidence, not on §199A classification. For SSTB owners in high-tax states, the PTET is the part of this memo they have been waiting thirty years for.

For founders planning priced equity, a foreign co-founder, or a stock sale to an entity buyer, the election is still the wrong call. The S-corp eligibility restrictions in IRC § 1361(b) have not moved, and neither has the QSBS exclusion under IRC § 1202, which remains C-corp-only. A 2021 founder who will raise institutional capital in the next three years should resist the election for the same reasons we gave five years ago.

One loose thread, carried forward

The self-rental aggregation question we flagged as unfinished in 2019 is still unfinished in 2021. The Rev. Proc. 2019-38 rental real estate safe harbor is now three filing seasons old and is still awkward for single-property structures. The new overlay is that a PTET election by the operating S-corp does not automatically flow to the sibling rental LLC, which files its own returns in its own state. For any client with a building in a sibling entity leased to an operating S-corp, the 2021 memo is a three-way reconciliation: the §199A aggregation under § 1.199A-4, the self-rental trade-or-business characterization, and the PTET election windows in each state where the two entities pay. The answers are knowable and the memo is worth writing before the next filing season opens in January.

Sources

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