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Editorial 9 MIN READ

The S-corp election, post-TCJA

The 2553 did not change. The math underneath it did, and the wage number that used to be low now has a floor

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 7 sections
  1. The one line in §199A that matters here
  2. Why the old answer (minimize wage) stops working
  3. The new sweet spot, for taxpayers below the threshold
  4. Above the threshold, the map turns
  5. What this means for the 2553 decision itself
  6. What the Treasury still owes us
  7. Sources

he S-corp election, mechanically, is the same in February 2018 as it was in February 2017. You file Form 2553, you pay a reasonable wage, you take the rest as a distribution, and you save on payroll tax. What changed, on December 22, is the other side of the ledger: Section 199A, the new 20% deduction for qualified business income, treats S-corp wages and S-corp distributions differently. The wage is out of QBI. The distribution is in. That one asymmetry has rewritten the planning memo every CPA is trying to finish before April.

This piece revisits the S-corp election we examined in 2016 through the §199A lens. The pitch and the traps have not moved. The sweet spot has.

The one line in §199A that matters here

Section 199A(c)(4), as enacted by Pub. L. 115-97, reads, in plain form, that qualified business income "shall not include" reasonable compensation paid to the taxpayer by any qualified trade or business, any guaranteed payment under §707(c), and to the extent provided in regulations, any §707(a) payment to a partner for services. That is the whole lever. The W-2 line of an S-corp shareholder is outside QBI; the K-1 distribution line, assuming the income flows from a qualified trade or business, is inside QBI.

For a single-shareholder S-corp whose owner does the work, §199A turns the old wage-setting exercise upside down. Before TCJA, the planner's instinct was to drive the wage down to the lowest number the reasonable-compensation doctrine would tolerate. Payroll tax was paid on the wage; distributions were free of FICA; the gap was the savings. Now every dollar moved from distribution to wage costs the owner not only 15.3% FICA on the first $128,400 (the 2018 Social Security wage base set by the Social Security Administration) plus 2.9% Medicare thereafter, but also the 20% §199A deduction the owner would otherwise take against that dollar. The arithmetic on the wage dial is different now, and the direction of the optimal move is ambiguous in a way it was not a year ago. We walked through §199A in outline three weeks ago; this is the first piece where the outline actually bites on a live planning decision.

Why the old answer (minimize wage) stops working

Start with the reader who in 2017 was paying herself a $40,000 W-2 out of a $160,000 net, banking the $120,000 distribution, and saving roughly $15,000 of FICA against what a Schedule C would have cost. In 2018, if she is below the §199A threshold ($157,500 taxable income for a single filer, $315,000 for a joint return, as set in §199A(e)(2) and adjusted from the statute's 2018 amounts), she now also gets a 20% deduction on the $120,000 of QBI. That is roughly $24,000 off her taxable income.

Now watch what happens if she overcorrects. Suppose she reads the news about §199A, gets nervous about the reasonable-comp doctrine, and bumps her wage to $100,000 with $60,000 of distribution. Her FICA base goes up by $60,000, adding about $9,200 of combined employee and employer payroll tax. Her QBI drops by $60,000, shrinking the §199A deduction by $12,000. At a 24% marginal rate, that $12,000 lost deduction is worth roughly $2,880 of federal tax. Net, she has moved $60,000 of income across the line and given up roughly $12,000 in combined tax and payroll cost to do it. The old instinct (wages are expensive, move money out of them) still applies on the margin. The floor, though, has risen.

What has gone away is the case for driving the wage down to an indefensibly low number. The IRS has never told taxpayers what reasonable is, and courts have for decades imputed wage up from the distribution side when the facts looked abusive. Watson v. United States, 668 F.3d 1008 (8th Cir. 2012) is the canonical recent example: David Watson, a CPA and sole shareholder of his S-corp, paid himself $24,000 a year on $200,000 of distributions, and the Eighth Circuit affirmed the district court's recharacterization pulling the wage up to about $93,000 (roughly what an experienced accountant would have commanded in that market). The opinion reads as a cost-of-replacement analysis: what would this person be paid if a third party hired them to do this work.

After §199A, Watson matters twice. Once for the payroll-tax recharacterization it already drove, and again because the recast wage sits outside QBI. An audit adjustment that pulled $70,000 of distribution into wage in 2017 cost the taxpayer only incremental FICA. The same adjustment in 2018 costs the FICA plus the §199A deduction on the recharacterized amount. The downside of an aggressively low wage is materially larger than it was in 2017.

The new sweet spot, for taxpayers below the threshold

For an S-corp shareholder whose total taxable income stays below the §199A threshold, the planning target has two edges. Set the wage high enough that a Watson-style challenge would land roughly where you already are. Set it low enough that the distribution side still carries a meaningful QBI block. The old 40/60 wage-to-distribution heuristic, which in Watson survived on the facts, is no longer a payroll-tax heuristic alone; it is a §199A heuristic too. A wage set at what an arm's-length hire in the same role would earn is the number that survives both an IRS recharacterization and an erosion of the QBI deduction.

For most single-shareholder service S-corps in the Watson fact pattern (solo professional, solo revenue), that number lives in the range a recruiter would quote for the underlying job. A dentist running her practice pays herself what an employed dentist in her market earns, not the partnership draw; a software consultant pays herself what a salaried senior engineer at a comparable employer would earn, not the going contract rate grossed up. The rest flows through as distribution and (below the threshold) picks up the 20% block.

Above the threshold, the map turns

The §199A calculus changes again once taxable income crosses the threshold and the phase-in bites. Section 199A(d)(2) defines a "specified service trade or business," or SSTB, to include any trade or business involving performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. A taxpayer whose income puts her above the threshold, and whose business is an SSTB, begins losing the §199A deduction as income phases in over the statutory range ($50,000 single, $100,000 joint above the threshold, per §199A(d)(3)(A)). Above the top of the phase-in, an SSTB owner gets no §199A deduction at all.

For a non-SSTB above the threshold, the deduction does not phase out for SSTB reasons, but it becomes subject to the W-2-wages limitation under §199A(b)(2): the deduction cannot exceed the greater of 50% of W-2 wages paid by the trade or business, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. Above the threshold, an S-corp that pays no wages to anyone, owner included, hits this limitation and loses the deduction anyway. The wage that §199A punishes as excluded from QBI below the threshold becomes the wage §199A requires as a deduction floor above it.

This reversal is worth sitting with. Below the threshold, wages reduce QBI and the owner wants the wage moderate. Above the threshold, wages enable the deduction (through the W-2-wages limit) and the owner sometimes wants the wage higher. A construction contractor who clears $600,000 net through an S-corp and pays herself $60,000 in wages is now in a worse §199A position than the same contractor paying herself $150,000, because the 50%-of-W-2 cap on the deduction is tighter in the first case. Run the numbers.

For the SSTB above the phase-in ceiling, wages do not rescue the deduction; the deduction is simply gone. The S-corp election for that taxpayer reverts to its pre-TCJA logic: it is a payroll-tax story, and the reasonable-compensation doctrine is the only constraint on how low the wage goes.

What this means for the 2553 decision itself

The S-corp election mechanics remain what they were. You file Form 2553, signed by every shareholder, by the 15th day of the third month of the tax year you want the election to take effect, or within 75 days of formation for a new entity. Late-election relief under Rev. Proc. 2013-30 is still generous. The eligibility rules (100-shareholder cap, single class of stock, no nonresident-alien shareholders, no entity shareholders except a few narrow exceptions) did not move.

The decision of whether to elect has moved. Three buckets:

A sole proprietor below the §199A threshold, earning steadily above the $50,000-ish break-even where administrative cost is worth the payroll-tax savings, still benefits from the election, though the marginal dollar saved is smaller than in 2017 because the Schedule C now also picks up the §199A deduction. The election still helps; it helps less.

A sole proprietor of an SSTB above the threshold, where §199A is lost either way, still benefits from the S-corp election on pure payroll-tax grounds, as before.

A non-SSTB above the threshold, with meaningful net income and few employees, has a genuine new question. If the §199A limitation would bind because W-2 wages are low, the S-corp election, which formalizes a wage, may now be the preferred structure for a different reason than payroll-tax savings: it creates the W-2 base the §199A deduction requires. A partnership or Schedule C taxpayer with the same economics has a harder time generating W-2 wages to satisfy the limit, because the partner's own services are paid out as guaranteed payments or draws, both of which §199A(c)(4) excludes from QBI without helping the W-2 calculation.

What the Treasury still owes us

The statute is in force for 2018 but the regulations under §199A have not been issued. Treasury has priority-guidance listed them; the profession is expecting proposed regulations by summer. Several questions wait on that guidance. Whether aggregation across multiple S-corps owned by the same individual is allowed, and on what terms. Whether rental real estate owned in a separate entity counts as a qualified trade or business when leased back to the operating S-corp. How "reputation or skill" will be read in §199A(d)(2)(A) outside the enumerated SSTBs; a literal reading sweeps in most closely held service businesses. How the aggregation of W-2 wages works for a taxpayer above the threshold who operates through a tiered structure.

Until those regulations land, any planning memo written this month is written in pencil. The conservative move, for 2018 planning, is to set the wage where Watson would have set it, and let the §199A optimization follow the taxpayer's actual taxable-income position at year-end rather than driving it off a guess. If the regulations move the lines, there is still time to revise the wage for the second half of the year.

One footnote. The Joint Committee on Taxation's conference report on TCJA (JCX-67-17, December 2017) flagged the reasonable-compensation doctrine as the intended guardrail against wage manipulation under §199A, and Treasury has said the same. The IRS will not need a new theory to challenge a wage that looks too low; it has Watson, it has §1.162-7, and it now has a richer motive to press the fight. A 2018 audit notice asking about shareholder compensation on a 1120-S is a rather different letter than it was eighteen months ago.

Sources

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