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Editorial 9 MIN READ

The sole proprietorship, 20 months later: what §199A did to the math

A 20 percent deduction on Schedule C income, two income thresholds, and a specified-service list that knocks out exactly the consultants who do best as sole props

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What §199A actually does for a Schedule C filer
  2. The two thresholds and the phase-in windows
  3. The SSTB problem, which is larger than the name suggests
  4. The revised when-to-switch calculation
  5. What did not change, and what to watch
  6. Sources

sole proprietor netting $100,000 in 2018 will owe self-employment tax on roughly $92,350 of that, and will also, for the first time, get to deduct 20 percent of her qualifying business income off the top of her federal taxable income. The second number is why the 2017 version of this article no longer describes the decision correctly.

This is the post-TCJA read on the sole proprietorship, written in December 2018 with the 2018 return being built in every CPA's office right now and Treasury's proposed §199A regulations (REG-107892-18, 83 Fed. Reg. 40884) sitting on every desk. The filing mechanics have not changed. The math underneath them has.

What §199A actually does for a Schedule C filer

Section 199A, added by the Tax Cuts and Jobs Act of 2017 (P.L. 115-97, §11011), allows an individual taxpayer a deduction equal to 20 percent of "qualified business income" from a pass-through trade or business. For a sole proprietor, the relevant qualified business income is the net profit reported on Schedule C, with some adjustments. The deduction is taken below the line (it does not reduce adjusted gross income) but above taxable income. It is claimed on the new Form 1040 Line 9 for 2018 returns, computed on Form 8995 or Form 8995-A depending on income level.

The practical effect: a sole proprietor's Schedule C net, after the deductible half of self-employment tax and before §199A, is what the Code calls qualified business income. Twenty percent of that number becomes a deduction. For a proprietor netting $100,000 with roughly $7,065 of deductible SE-tax adjustment, qualified business income lands near $92,935, and the §199A deduction is around $18,587. At a 22 percent federal marginal bracket, that is roughly $4,089 of federal income tax saved. The self-employment tax itself is untouched by §199A; SE tax is a separate computation on Schedule SE, and the 15.3 percent combined rate (12.4 percent OASDI on the first $128,400 for 2018, per the Social Security Administration's Contribution and Benefit Base, plus 2.9 percent Medicare on all net earnings) still lands on the same base it always did.

What §199A changed is one line of federal income tax, not the payroll side. The deduction is worth the taxpayer's marginal rate times 20 percent of qualified business income. At 24 percent marginal, that is a 4.8 percent reduction in effective federal income tax on the qualifying share of profit. It is not nothing. It is also not what the cocktail-party version of TCJA promised.

The two thresholds and the phase-in windows

The statute creates two income levels that matter, keyed to the taxpayer's taxable income (not business income, not AGI). For 2018, per Rev. Proc. 2018-10 and Treasury's subsequent confirmation in the proposed regs, the thresholds are $157,500 for single filers and $315,000 for married filing jointly. These are the figures indexed annually; in 2019 they move to $160,700 and $321,400.

Below the threshold, a sole proprietor computes §199A on the simple method: 20 percent of qualified business income, capped at 20 percent of taxable income less net capital gain. No wage limitation. No property limitation. No SSTB exclusion. The trade does not have to pay anyone, own anything, or do any particular kind of work. Form 8995, the simplified calculation, is the whole story.

Above the threshold, §199A(b)(2) imposes a W-2 wage and UBIA (unadjusted basis immediately after acquisition) limitation. The deduction becomes the lesser of 20 percent of qualified business income or the greater of (a) 50 percent of W-2 wages paid by the trade, or (b) 25 percent of W-2 wages plus 2.5 percent of UBIA in qualified property. A sole proprietor without employees pays zero W-2 wages to herself (the whole structural point of a sole prop is that she is not an employee of anything), so the wage limitation can wipe the deduction out entirely at high income. This is the mechanism that drives high-earning sole props toward S-corp elections: wages paid to the owner-employee count toward the §199A wage limitation.

Between the threshold and $50,000 above it for singles ($100,000 above for joint filers), the limitation phases in proportionally rather than cliffing. For a single filer with $182,500 of taxable income, the wage limitation bites at 50 percent strength. At $207,500 it bites fully. The phase-in window is narrow, and taxpayers inside it will see marginal rates on the last dollar of income that look nothing like the statutory rate table.

The SSTB problem, which is larger than the name suggests

Section 199A(d)(2) carves out a category of "specified service trade or business" and denies the deduction to SSTB income once the taxpayer is fully above the threshold. The enumerated fields, pulled forward from §1202(e)(3)(A) and then modified by TCJA itself, include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade where the principal asset is the reputation or skill of one or more of its employees or owners.

That last clause covers exactly the one-person consultancy that is the archetypal sole proprietorship. Treasury's August 2018 proposed regulations narrowed the reputation-or-skill clause to three specific fact patterns (endorsement income, licensing of one's name or likeness, appearance fees) rather than the broad reading the statute arguably permitted; the operational read of those proposed regs ran in August. But the enumerated fields themselves, read literally, still cover a large share of high-earning sole practitioners.

A lawyer operating as a sole proprietor, a CPA running a Schedule C practice, a financial planner working as a 1099 contractor to a broker-dealer, a management consultant with clients on retainer: all SSTBs. Each of them gets the full §199A deduction if taxable income lands below the $157,500 (single) or $315,000 (joint) threshold, a phased-out deduction inside the $50,000 or $100,000 window, and zero §199A benefit above it. The SSTB rules do not phase the deduction down. They eliminate it.

The cruel part of the arithmetic is that the SSTB proprietor who has done well enough to exceed the threshold is exactly the one for whom an S-corp election would have been appropriate anyway, and the S-corp election does not recover the §199A deduction either: an SSTB is an SSTB whether it files Schedule C or Form 1120-S. What the S-corp election does recover is the SE-tax savings on the distribution portion of owner compensation, which at these income levels is the larger lever.

The revised when-to-switch calculation

The 2016 and 2017 versions of this calculation said, roughly: at around $40,000 to $50,000 of net profit an LLC starts to earn its keep on liability grounds, and at around $80,000 to $100,000 of net profit an S-corp election starts to earn its keep on payroll-tax grounds. Neither anchor was a bright line. Both moved with facts.

TCJA changes the second anchor, not the first. The liability case for forming an LLC (which on default classification remains a disregarded entity for federal tax purposes, filing exactly the same Schedule C) is unaffected by §199A. A first employee, a first meaningful contract, a first lease: any one of those still argues for the LLC wrapper, and the cost of forming in most states remains a few hundred dollars and one annual filing. The 2017 article's liability analysis holds.

The S-corp anchor moves in two directions at once, and which direction dominates depends on whether the sole prop is above or below the §199A threshold and whether the trade is an SSTB.

For a below-threshold sole prop (taxable income under $157,500 single or $315,000 joint), §199A is available at full strength on Schedule C income, with no wage requirement. Electing S-corp status in this zone requires the owner to take a reasonable salary under the Watson doctrine (David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012)), which converts part of the business's profit into W-2 wages not eligible for §199A. The wages are still deductible at the entity level, so they reduce qualified business income dollar for dollar. The net of the S-corp election below threshold is: save 15.3 percent of SE tax on the distribution share, lose 20 percent of §199A deduction on the wage share. At a 22 percent marginal rate, the §199A loss on each wage dollar is 4.4 percent; the SE-tax saving on each distribution dollar is roughly 14.13 percent (SE tax on 92.35 percent of net earnings). The S-corp still wins the arithmetic at most reasonable salary-to-distribution splits, but by less than it did before TCJA. The crossover income at which the S-corp's administrative overhead is worth the savings has moved up, not down.

For an above-threshold non-SSTB sole prop, the S-corp election becomes structurally attractive in a way it never was before. Paying the owner W-2 wages creates §199A wage limitation headroom; without those wages a sole prop above threshold gets no §199A deduction at all. This is the case that drives the most dramatic restructurings.

For an above-threshold SSTB sole prop, §199A is lost either way. Watson remains inapplicable on the upside (a sole prop pays no wages to herself, so there is no unreasonably-low-wages fact pattern to attack), and the S-corp election recovers the SE-tax savings without the §199A complication (because it was already lost). This is the cleanest S-corp election in the post-TCJA world, and it is also the taxpayer most likely to have made it by the end of 2018.

The rule of thumb that fell out of all of this: under threshold, form an LLC for liability and consider but do not rush the S-corp election. Over threshold in an SSTB, elect S-corp and model the reasonable salary carefully. Over threshold in a non-SSTB, model both the C-corp flat 21 percent and the S-corp §199A-wage-limitation math before picking.

What did not change, and what to watch

The return mechanics did not change. Schedule C is still Schedule C. Schedule SE is still Schedule SE. The quarterly estimated-tax penalty under IRC § 6654 still hits proprietors who skip the April, June, September, and January payments. The deductible half of SE tax on the adjustments-to-income section of Form 1040 is still a deduction, unaffected by §199A. Publication 334 in its 2018 edition walks through the mechanics exactly as the 2017 edition did, with new references to the §199A deduction layered in.

What is still open: the proposed §199A regulations have not been finalized. The comment period closed on October 1 and Treasury held a public hearing on October 16; final regulations are expected before the 2018 filing season closes, but are not in hand as of this writing. The reputation-or-skill narrow reading may survive the comment process; the aggregation rules for common-controlled trades may not. Taxpayers may rely on the proposed regs until the final rules issue, per the preamble's statement.

The smaller change most proprietors will notice in their first post-TCJA return is the standard deduction. It nearly doubled for 2018 (to $12,000 single, $24,000 joint, per §11021 of TCJA), and that one change pulls a large share of sole proprietors below the §199A thresholds they would have otherwise been inside. A single proprietor with $170,000 of Schedule C net and no other income now has about $156,000 of taxable income after the standard deduction and the half-SE-tax adjustment, just under the threshold, and therefore gets the simple §199A computation with no wage limitation and no SSTB worry. The sole-prop consultant who ran the numbers in 2017 and concluded the S-corp was overdue may find that 2018 looks different enough to wait another year before filing the Form 2553.

Sources

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