Legal Bulletins

When Internal Revenue Code (“Code”) Section 199A (“199A”) was enacted at the end of 2017, it created many questions that would be left unanswered until the Internal Revenue Service (the “Service”) provided guidance.  One of the many questions was whether the 199A deduction would vary based upon the type of entity (e.g., a wholly-owned limited liability company taxed as a sole proprietorship vs. a wholly-owned S corporation).

The issue arose specifically from Code Section 199A(c)(4), which states that “Qualified business income shall not include . . . reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.”  Subject to certain limitations, a taxpayer’s 199A deduction is equal to twenty percent (20%) of the taxpayer’s qualified business income.  Without any guidance from the Service, there could be two ways to interpret this provision.

The most obvious reading of the provision would be that, in the case of an S corporation, the wages received by a shareholder from the S corporation would not be included in the shareholder’s qualified business income, and, more importantly, such wages would be deducted in determining the S corporation’s qualified business income for 199A purposes.  This interpretation would result in disparate 199A treatment between a wholly-owned S corporation and a wholly-owned limited liability company, as illustrated by the following example. 

Assume Taxpayer A operates a business as a wholly-owned limited liability company and Taxpayer B operates the same business as a wholly-owned S corporation.  Because Taxpayer A will be taxed as a sole proprietorship, Taxpayer A does not (and cannot) pay himself any wages.  Accordingly, his qualified business income is $100,000, resulting in a 199A deduction of $20,000.

By operating as an S corporation, Taxpayer B is required to take reasonable compensation and, therefore, the S corporation pays Taxpayer B $40,000 of wages.  Based upon the interpretation of Code Section 199A(c)(4) as set forth above, Taxpayer B’s wages would be deducted in determining the S corporation’s net income for 199A purposes.  Accordingly, Taxpayer B’s qualified business income is only $60,000, resulting in a 199A deduction of only $12,000.  Thus, based on the most obvious interpretation of Code Section 199A(c)(4), the taxpayer operating as a wholly-owned limited liability company will receive a greater 199A deduction as compared to the taxpayer operating the same business as a wholly-owned S corporation.

Example 1

Because of the disparate treatment with respect to 199A between different types of entities as illustrated above and because of legislative history to 199A that may suggest such inequitable treatment was not intended, some commentators have suggested that there may be an alternative interpretation of Code Section 199A(c)(4).  This interpretation would take the position that Code Section 199A(c)(4) means that wages paid to the shareholder of an S corporation are not permitted to reduce the qualified business income of the S corporation, or, stated differently, Code Section 199A(c)(4) requires the add back of wages paid to the shareholder in computing qualified business income.

Now, revisit Example 1 under the alternate reading of Code Section 199A(c)(4).  By adding back the $40,000 of wages paid to the S corporation shareholder, the qualified business income of both taxpayers is the same, thereby resulting in equal 199A deductions.

Example 2

So, with only the 199A statute and without the benefit of any guidance from the Service, the question, up until now, was how to interpret Code Section 199A(c)(4).  That question has now been answered by the 199A Proposed Regulations issued on August 8, 2018 (the “Proposed Regulations”).

The Proposed Regulations contain an example in which a taxpayer owns all of the stock of an S corporation.  The S corporation’s net income is $100,000 and the S corporation paid the shareholder $150,000 in wages. The example states that the wages paid by the S corporation to the sole shareholder “are considered to be a qualified item of deduction for purposes of determining” the S corporation’s qualified business income and, therefore, the S corporation’s qualified business income is $100,000.  In other words, the $150,000 of wages paid to the sole shareholder are not added back in determining the S corporation’s qualified business income.  Accordingly, the taxpayer’s 199A deduction is $20,000 ($100,000 x 20%).

Thus, the example in the Proposed Regulations confirms that the proper interpretation of Code Section 199A(c)(4) is the interpretation described in Example 1 above that produced a greater 199A deduction for the taxpayer operating as a wholly-owned limited liability company as compared to the taxpayer operating the same business as a wholly-owned S corporation.

Note that Example 1 above, which produced a greater 199A deduction for the wholly-owned limited liability company, involved taxpayers that are below the 199A taxable income thresholds and, therefore, the 199A deduction is not limited by the amount of wages paid by the business.  For taxpayers above the thresholds, however, the 199A disparate treatment may swing in favor of the wholly-owned S corporation.  For taxpayers above the threshold, the 199A deduction may be limited to the amount of wages paid by the business.  Thus, because an S corporation must pay reasonable compensation to its owner, and because a sole proprietorship cannot pay compensation to its owner, the owner of a wholly-owned limited liability company above the 199A taxable income thresholds may not receive a 199A deduction, while the owner of the S corporation may receive a 199A deduction.

Thus, the Proposed Regulations now confirm that the amount of the 199A deduction may differ based upon the choice of entity, thereby adding another issue for consideration in choosing a type of entity.