Tax Reform: Entity Choice—Proprietorship or S Corporation?

The recent tax reforms have introduced new considerations for high earners in choosing their business structure, particularly regarding the benefits of operating as an S corporation. The key incentive is the Section 199A deduction, which allows qualifying business owners to deduct 20% of their qualified business income (QBI). This article delves into the implications of this deduction, specifically comparing sole proprietorships and S corporations.

The Basics of Section 199A

• For business owners filing as sole proprietors or through single-member LLCs, the eligibility for the 20% tax deduction hinges on their taxable income levels. Individuals with taxable income at or below $157,500 (or $315,000 for married couples) can claim the full deduction. However, those with income above $207,500 (single) or $415,000 (married) face restrictions unless they pay wages or own depreciable property. 

• For example, a single proprietor with $400,000 in net income but a taxable income of $370,000 would find their Section 199A deduction to be zero. This situation prompts the question of how to structure their business to take advantage of the deduction.

Transitioning to an S Corporation

• Converting a sole proprietorship to an S corporation can help high earners qualify for the Section 199A deduction. To do this, the proprietor must incorporate their business or create a single-member LLC and then file IRS Form 2553 to elect S corporation status. 

• Once the S corporation is established, the owner can pay themselves a reasonable salary. For instance, if they set their salary at $100,000, they unlock two significant benefits: savings on self-employment taxes and eligibility for the Section 199A deduction.

Tax Savings Breakdown

• As a sole proprietor, an individual pays self-employment taxes on their entire income. In our example of $400,000 in income, this results in approximately $26,634 in self-employment taxes. Conversely, with an S corporation structure, the owner would only pay payroll taxes on their salary. If they earn a $100,000 salary, the total payroll taxes (including FICA and Medicare) could be around $15,800, leading to a tax savings of about $10,834.

• Moreover, the S corporation structure enables the individual to reduce their QBI by paying themselves a salary, thereby making them eligible for the Section 199A deduction. The process involves calculating the lesser of 20% of the reduced QBI (now $300,000) or 50% of the S corporation’s wages. In this case, the S corporation’s wages of $100,000 yield a deduction of $50,000.

• Finally, when calculating the overall tax savings, the individual benefits from the Section 199A deduction, which can result in significant tax relief. In this scenario, the tax savings from the deduction at a 35% tax bracket equate to $17,500.

Total Financial Impact

By converting to an S corporation, the individual in our example adds $28,334 to their after-tax cash flow. This figure combines the savings from reduced payroll taxes and the Section 199A deduction, showcasing the financial advantages of restructuring.

Important Considerations

Individuals currently filing as Schedule C taxpayers, especially those with high taxable incomes and lacking wages or depreciable property, face a zero Section 199A deduction. If their income remains below the thresholds, they can claim the full deduction directly from their QBI without needing to consider wages or property.

Conclusion and Recommendations

The 20% deduction under Section 199A represents a significant opportunity for high earners, particularly those not classified in specified service trades. By transitioning to an S corporation, business owners can create wages that qualify for the deduction while simultaneously reducing their payroll tax burden. 

To effectively navigate these options, individuals are encouraged to consult tax professionals. They can help accurately analyze financial situations, ensuring that all potential savings and deductions are fully realized. The calculations can be complex, and having expert guidance is crucial to making informed decisions about business structure and tax strategy.