Optimal choice of entity for the QBI deduction

By Beth Y. Vermeer, CPA, Ph.D.; Brian R. Greenstein, Ph.D.; and Mark B. Persellin, CPA, Ph.D.

 PHOTO BY BAONA/ISTOCK
PHOTO BY BAONA/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • The enactment of the Sec. 199A qualified business income (QBI) deduction has introduced a new factor into the choice-of-entity determination for a business because the form of entity can have a significant effect on the QBI deduction available to the owners of the business.
  • The QBI deduction is subject to a W-2 wages/qualified property limitation that phases in over a $50,000 ($100,000) range for taxpayers with taxable income over a threshold amount. Certain businesses that are specified service trades or businesses (SSTBs) are subject to another limitation (the SSTB limitation) that phases in over the same range starting at the same taxable income threshold.
  • A business owner with taxable income at or below the threshold amount for the SSTB and W-2 wages/qualified property limitations threshold will generally obtain a larger QBI deduction if the business is an LLC.
  • An SSTB owner that has taxable income at the lower end of a limitations phase-in range will generally obtain a larger deduction using the LLC form of entity; however, this advantage reverses at the upper end of the phase-in range. Owners of non-SSTB businesses that are LLCs generally have a higher QBI deduction throughout the phase-in range.
  • Owners of businesses that are SSTBs with taxable income above the phase-in range are ineligible for any QBI deduction, regardless of the type of entity of the businesses. Owners of non-SSTBs with substantial owner compensation will generally have a larger QBI deduction if the business is an S corporation.

On Dec. 20, 2017, Congress passed the law known as the Tax Cuts and Jobs Act (TCJA)1 to stimulate the economy and help create jobs. Although the corporate tax rate reduction from 35% to 21% has been emphasized as the TCJA's change with the greatest economic impact, the legislation also enacted new Sec. 199A, which allows a sole proprietorship or an owner in a passthrough entity to claim a deduction of 20% of qualified business income (QBI) for each qualified business owned by the taxpayer. Rather than an across-the-board tax rate cut like that provided for C corporations, the QBI deduction relies instead upon complex rules that favor certain sizes and types of businesses over others.

The QBI deduction introduces an additional layer of complexity to the choice of business entity where, depending on a taxpayer's circumstances, different forms of business entities will have significantly different QBI deduction amounts. This article illustrates the impact that differences between two types of passthrough entities can have on the amount of the QBI deduction and identifies situations in which a limited liability company (LLC), limited liability partnership, general partnership, or sole proprietorship2 would provide a larger Sec. 199A deduction than an S corporation. Several factors may give rise to these differences, including S corporation shareholder/employee compensation, the taxpayer's income, the amount of W-2 wages paid by the business, the amount of capital investments made by the business, and whether the business qualifies as a specified service trade or business (SSTB). Many examples illustrate how these factors affect the calculation of the QBI deduction and how the choice of either S corporation or LLC form can maximize the deduction amount.

Overview of the QBI deduction

The QBI deduction is taken on the individual income tax return after the calculation of adjusted gross income, similar to itemized deductions or the standard deduction. An owner in a passthrough entity takes the deduction at the owner/partner/shareholder level rather than at the entity level. For an estate or trust, the deduction is taken either by the beneficiaries or by the entity itself if income is retained. The QBI deduction has no effect on the amount of income subject to self-employment tax.3

The first step in computing the deduction is determining the amount of QBI, which is the net amount of income (or loss) from any U.S. trade or business (including in Puerto Rico), other than one conducted by a C corporation or as an employee. QBI does not include investment items such as capital gains or losses, dividends, or interest income that is not properly allocable to a trade or business.4 QBI is also reduced by reasonable W-2 compensation to employees (including S corporation shareholder/employees) and by guaranteed payments to partners. In addition, QBI must be reduced by the deductible portion of the self-employment tax, the self-employed health insurance deduction, the self-employed retirement contribution deduction, unreimbursed partnership expenses, charitable contributions related to the business, and interest expense incurred to buy entity assets or an interest in the entity.5

The second step in applying the QBI rules is determining whether the taxpayer's taxable income before the QBI deduction is: (1) at or below a limitations threshold amount ($321,400 for married filing jointly or $160,700 for single and head of household); (2) within the limitations phase-in range (between $321,400 and $421,400 for married filing jointly or between $160,700 and $210,700 for single and head of household); or (3) over the limitations phase-in range.6

Once the threshold amount is exceeded, the taxpayer must also determine whether a trade or business meets the definition of an SSTB. An SSTB is any trade or business providing services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading/dealing in securities, partnership interests, or commodities; or any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees.7 If a trade or business meets the definition of an SSTB, the QBI deduction is fully permissible when taxable income is at or below the threshold amount, reduced when taxable income falls within the phase-in range, and eliminated when taxable income exceeds the phase-in range.

The third and final step in applying the QBI rules is determining the QBI deduction, which depends on a taxpayer's taxable income calculated prior to the inclusion of net capital gains8 and the type of business (i.e., SSTB or non-SSTB). Taxpayers with taxable income at or below the threshold amount (i.e., $321,400 for married filing jointly or $160,700 for single and head of household) have no limitations to the deduction (other than an overall taxable income limitation). For these taxpayers, the QBI deduction is the lesser of: (1) 20% of QBI; or (2) 20% of modified taxable income.9 When taxable income is at or below the threshold amount, the QBI deduction is fully allowed without regard to whether the trade or business is an SSTB and without application of the wages/qualified property limitation (discussed below).

Once taxable income exceeds the threshold amount, the QBI deduction is the lesser of: (1) 20% of QBI with respect to any qualified trade or business; or (2) the greater of: (a) 50% of the taxpayer's share of W-2 wages with respect to the qualified trade or business; or (b) the sum of 25% of the taxpayer's share of W-2 wages with respect to the qualified trade or business, plus 2.5% of the taxpayer's share of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.10 For purposes of this calculation, qualified property is any tangible depreciable property that: (1) is held by, and available for use in, the qualified trade or business at the end of the tax year; (2) is used to produce QBI at some point during the tax year; and(3) has a depreciable period that does not end before the close of the tax year. All assets used in calculating UBIA have a minimum depreciable period of 10 years from the date placed in service.11

When a taxpayer with an SSTB has taxable income within the phase-in range (i.e., $321,400 to $421,400 for married filing jointly or $160,700 to $210,700 for single and head of household), the calculation of the QBI deduction becomes increasingly more complex, as the deduction is subject to both a phase-in of the SSTB limitation and a phase-in of the wages/qualified property limitation.

The choice of entity, along with the taxpayer's income, can affect the allowable QBI deduction. The flowchart "Steps in Determining QBI Deduction for a Married Couple Filing Jointly" (below) highlights the various steps involved in QBI deduction computations for both SSTBs and non-SSTBs. The following examples illustrate how these computations can result in a significantly different QBI deduction for an LLC than for an S corporation. The first seven examples illustrate the outcomes for SSTBs, and the latter six examples illustrate the outcomes for non-SSTBs. For each example, it is assumed that the taxpayers have only one trade or business and a nominal amount of UBIA.

Steps in determining QBI deduction for a married couple filing jointly

QBI calculations

Example 1. SSTB using an S corporation — under the threshold amount: A married couple filing jointly have $300,000 of taxable income and a business that is an SSTB with $225,000 of QBI before considering $125,000 of W-2 wages paid to the shareholder/employee. Since these taxpayers are under the threshold amount, the only limitation that applies is the overall modified taxable income limitation.

Determination of the QBI deduction: The lesser of $20,000 (20% of QBI [$225,000 - $125,000 = $100,000]); or $60,000 (20% of modified taxable income [$300,000]).

QBI deduction: $20,000.

Example 2: SSTB using an LLC — under the threshold amount: A married couple filing jointly have $300,000 of taxable income and a business that is an SSTB with $225,000 of QBI (no W-2 wages or guaranteed payments). Since these taxpayers are under the threshold amount, the only limitation that applies is the overall modified taxable income limitation.

Determination of the QBI deduction: The lesser of $45,000 (20% of QBI [$225,000]); or $60,000 (20% of modified taxable income [$300,000]).12

QBI deduction: $45,000.

As illustrated in Examples 1 and 2, when taxable income is below the threshold amount and S corporation shareholder/employee compensation is present, the LLC results in a larger QBI deduction. The difference in the deduction is due solely to the difference in the owner compensation (shareholder/employee compensation of $125,000, versus partner guaranteed payment of $0). To the extent guaranteed payments are made, the LLC-related QBI deduction (and the LLC's advantage over the S corporation) is reduced. It is important to note that when taxable income is less than the threshold amount, whether a trade or business is an SSTB is of no consequence in calculating the QBI deduction.13

Example 3: SSTB using an S corporation — within the phase-in range: A married couple filing jointly have $381,400 of taxable income and a business that is an SSTB with $225,000 of QBI before considering $125,000 of W-2 wages paid to the shareholder/employee. For an SSTB and taxable income within the phase-in range, the calculation becomes more complex. Steps 1 and 2 calculate the phase-in of the SSTB limitation to determine the includible amount ("applicable percentage") of QBI. Steps 3 to 6 then apply the phase-in of the wages/qualified property limitation to determine the QBI deduction.

Step 1 (calculation of phase-in percentage): $381,400 - $321,400 = $60,000; $60,000 ÷ $100,000 = 60%. So, 60% of the QBI is disallowed by the phase-in of the SSTB limitation, and 40% is allowed (the "applicable percentage").

Step 2 (determination of QBI deduction, taking into consideration the applicable percentage)QBI = $225,000 - $125,000 = $100,000; QBI of $100,000 × 40% allowed = $40,000; W-2 wages of $125,000 × 40% allowed = $50,000.

Step 3: QBI of $40,000 × 20% = $8,000; W-2 wages of $50,000 × 50% = $25,000.

Step 4: QBI of $8,000 - W-2 wages of $25,000. Excess amount: $0.

Step 5: Excess amount $0 × 60% = $0.

Step 6: QBI deduction equal to the lesser of: QBI of $8,000 ($8,000 from Step 3 - $0 from Step 5); or modified taxable income × 20% = $76,280.

QBI deduction: $8,000.

Example 4: SSTB using an LLC — within the phase-in range: A married couple filing jointly have $381,400 of taxable income and a business that is an SSTB with $225,000 of QBI (no W-2 wages or guaranteed payments). These facts are identical to those in Example 3, except that this scenario involves an LLC and there is no owner compensation (guaranteed payments).

Step 1 (calculation of phase-in percentage): $381,400 - $321,400 = $60,000; $60,000 ÷ $100,000 = 60%. So, 60% of the QBI is disallowed by the phase-in of the SSTB limitation, and 40% is allowed (the "applicable percentage").

Step 2 (determination of QBI deduction, taking into consideration the applicable percentage): QBI of $225,000 × 40% allowed = $90,000; W-2 wages of $0 × 40% ­allowed = $0.

Step 3: QBI of $90,000 × 20% = $18,000; W-2 wages of $0 × 50% = $0.

Step 4: QBI of $18,000 - W-2 wages of $0. Excess amount: $18,000.

Step 5: Excess amount $18,000 × 60% = $10,800.

Step 6: QBI deduction equal to the lesser of: QBI of $7,200 ($18,000 from Step 3 - $10,800 from Step 5); or modified taxable income × 20% = $76,280.

QBI deduction: $7,200.

A comparison of Examples 3 and 4 — each involving an SSTB and taxable income within the phase-in range — reveals that the S corporation can obtain a larger QBI deduction than the LLC. The difference in the deduction between the two entities results from the phase-in of the SSTB and wages/qualified property limitations. Within the phase-in range, the presence of W-2 wages (and/or qualified property) can mitigate or eliminate the impact of the wages/qualified property limitation. In Example 3, the S corporation shareholder/employee wages eliminated any impact of the wages/qualified property limitation on the QBI deduction. In Example 4, however, with no W-2 wages (or qualified property) for the LLC, the phase-in of the wages/qualified property limitation results in a reduced QBI deduction (see Step 5 above).

The preference of an S corporation for an SSTB and taxable income within the phase-in range is not a hard-and-fast rule, however. When taxable income is at the lower end of the phase-in range, an LLC is often the passthrough entity that generates the larger QBI deduction. This preference results from the interaction of the phase-in of the SSTB limitation with the phase-in of the wages/qualified property limitation. Consider the results in Examples 5 and 6, which mirror the facts of Examples 3 and 4, respectively, with the exception of a lower taxable income.

Example 5: SSTB using an S corporation — within the phase-in range: A married couple filing jointly have $341,400 of taxable income and a business that is an SSTB with $225,000 of QBI before considering $125,000 of W-2 wages paid to the shareholder/employee.

Step 1 (calculation of phase-in percentage): $341,400 - $321,400 = $20,000; $20,000 ÷ $100,000 = 20%. So, 20% of the QBI is disallowed by the phase-in of the SSTB limitation, and 80% is allowed (the "applicable percentage").

Step 2 (determination of QBI deduction, taking into consideration the applicable percentage)QBI = $225,000 - 125,000 = $100,000; QBI of $100,000 × 80% allowed = $80,000; W-2 wages of $125,000 × 80% allowed = $100,000.

Step 3: QBI of $80,000 × 20% = $16,000; W-2 wages of $100,000 × 50% = $50,000.

Step 4: QBI of $16,000 - W-2 wages of $50,000. Excess amount: $0.

Step 5: Excess amount $0 × 20% = $0.

Step 6: QBI deduction equal to the lesser of: QBI of $16,000 ($16,000 from Step 3 - $0 from Step 5) or modified taxable income × 20% = $68,280.

QBI deduction: $16,000.

Example 6: SSTB using an LLC — within the phase-in range: A married couple filing jointly have $341,400 of taxable income and a business that is an SSTB with $225,000 of QBI (no W-2 wages or guaranteed payments).

Step 1 (calculation of phase-in percentage): $341,400 - $321,400 = $20,000; $20,000 ÷ $100,000 = 20%. So, 20% of the QBI is disallowed by the phase-in of the SSTB limitation, and 80% is allowed (the "applicable percentage").

Step 2 (determination of QBI deduction, taking into consideration the applicable percentage)QBI of $225,000 × 80% allowed = $180,000; W-2 wages of $0 × 80% allowed = $0.

Step 3: QBI of $180,000 × 20% = $36,000; W-2 wages of $0 × 50% = $0.

Step 4: QBI of $36,000 - W-2 wages of $0. Excess amount: $36,000.

Step 5: Excess amount $36,000 × 20% = $7,200.

Step 6: QBI deduction equal to the lesser of: QBI of $28,800 ($36,000 from Step 3 - $7,200 from Step 5) or modified taxable income × 20% = $68,280.

QBI deduction: $28,800.

A comparison of the results in Examples 5 and 6 reveals that an LLC generates a larger QBI deduction than an S corporation for an SSTB and taxable income at the lower end of the phase-in range. This preference stems from the mitigated impact of the SSTB limitation phase-in when taxable income is at the lower end of the phase-in range and the reduction in the S corporation's QBI for shareholder/employee compensation.

Example 7: SSTB using an S corporation or an LLC — over the phase-in range: A married couple filing jointly have $421,400 of taxable income. Once taxable income exceeds the phase-in range with respect to an SSTB, no QBI deduction is allowed. In such cases, the wages/qualified property limitation is irrelevant. Thus, the S corporation and the LLC produce the same result.

Calculation of phase-in percentage: $421,400 - $321,400 = $100,000; $100,000 ÷ $100,000 = 1. So, 100% of the QBI is disallowed.

QBI deduction: $0.

As illustrated in the examples above, for an SSTB, whenever taxable income is below the threshold amount or at the lower end of the phase-in range, an LLC will usually have the same or higher QBI deduction than a similarly situated S corporation. As illustrated in Example 7, however, when taxable income exceeds the phase-in range, the QBI deduction for an SSTB is eliminated, regardless of the choice of passthrough entity.14 At those taxable income levels, the advantage of the LLC over the S corporation relative to owner compensation and its effect on the QBI deduction is irrelevant.

As initially envisioned, the deduction for QBI was to be calculated on the net income of a business entity after a reduction for reasonable compensation paid to the owners. While W-2 wages and guaranteed payments explicitly reduce the operating income of an entity (and therefore the amount of the QBI deduction), the initial legislative language for the provision required a reduction to the operating income of all entities for a reasonable payment to owners for services rendered. Mechanically, this would be difficult to put into practice, as there are no mechanisms by which sole proprietors pay themselves, nor is an LLC legally required to make guaranteed payments to partners. Conversely, an established body of law requires reasonable compensation to be paid to S corporation shareholders who provide services to their entities. As a result of this disparate treatment of owner compensation, and as illustrated in the examples above, the QBI deduction for a business that is an SSTB will often be larger for LLCs than for S corporations.

QBI calculations for non-SSTBs

For a non-SSTB and taxable income at or below the threshold amount or within the phase-in range, the QBI deduction will generally be the same or larger for an LLC than for an S corporation. A key difference in the Sec. 199A rules for SSTBs and non-SSTBs applies when taxable income exceeds the phase-in range. When taxable income exceeds the phase-in range, no QBI deduction is allowed with respect to an SSTB (see Example 7), but a non-SSTB with W-2 wages or qualified property can still qualify for a QBI deduction.

Another key difference in the Sec. 199A rules for SSTBs and non-SSTBs applies when the taxable income is within the phase-in range. For an SSTB with taxable income within the phase-in range, the QBI deduction is subject to both a phase-in of the SSTB limitation as well as a phase-in of the wages/qualified property limitation (see Examples 3 through 6), while non-SSTBs are only subject to the phase-in of the wages/qualified property limitation (see Example 10 below).

In the case of a non-SSTB, when taxable income exceeds the threshold amount, the QBI deduction is calculated by taking the lesser of:

  1. 20% of QBI; or
  2. The greater of:
    1. 50% of the W-2 wages; or
    2. The sum of 25% of the W-2 wages plus 2.5% of the UBIA of all qualified property.15

As evidenced by the limitation above, once the threshold amount is exceeded, the QBI deduction for a non-SSTB depends on the existence of W-2 wages (for either nonowners or owners) and/or qualified property. As illustrated below, when taxable income exceeds the threshold amount, the passthrough entity that generates the larger QBI deduction for a non-capital-intensive business depends primarily on whether the business has sufficient W-2 wages paid to nonowners.

Example 8: Non-SSTB using an LLC with adequate nonowner W-2 wages — within the phase-in range: A married couple filing jointly have $375,000 of taxable income and a business that is a non-SSTB with $170,000 of QBI (net of $150,000 of W-2 wages paid to nonowners). Because the initial QBI deduction of $34,000 (20% × QBI) is less than the wages/qualified property limitation of $75,000, the full QBI deduction of $34,000 is allowed, and the wages/qualified property limitation does not apply.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI ($170,000 × 20%) = $34,000; or
  2. The greater of:
    1. 50% of W-2 wages ($150,000 × 50%) = $75,000; or
    2. 25% of W-2 wages ($150,000 × 25%) + 2.5% of UBIA of $0 = $37,500.

QBI deduction: $34,000.

Example 9. Non-SSTB using an S corporation with adequate nonowner W-2 wages and shareholder/employee compensation of $125,000 — within the phase-in range: A married couple filing jointly have $375,000 of taxable income and a business that is a non-SSTB with $170,000 of QBI (net of $150,000 of W-2 wages paid to nonowners but before considering shareholder/employee compensation) and $125,000 of W-2 wages paid to a shareholder. Because the initial QBI deduction of $9,000 (20% × QBI) is less than the wages/qualified property limitation of $137,500, the full QBI deduction of $9,000 is allowed, and the wages/qualified property limitation does not apply.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI [($170,000 - $125,000) × 20%] = $9,000; or
  2. The greater of:
    1. 50% of W-2 wages [($150,000 + $125,000) × 50%] = $137,500; or
    2. 25% of W-2 wages ($275,000 × 25%) plus 2.5% of UBIA ($0) = $68,750.

QBI deduction: $9,000.

As illustrated in Examples 8 and 9, when taxable income is within the phase-in range and a non-SSTB has adequate W-2 wages paid to nonowners, an LLC generates a larger QBI deduction than an S corporation. This difference is due to the reduction in QBI for the reasonable compensation required to be paid to S corporation shareholder/employees. As noted earlier, there is no analogous provision requiring LLC members to take reasonable guaranteed payments.

Example 10: Non-SSTB using an LLC with no W-2 wages — within the phase-in range: A married couple filing jointly have $381,400 of taxable income and a business that is a non-SSTB with $170,000 of QBI and $0 W-2 wages paid. Because the initial QBI deduction of $34,000 (20% × QBI) is not less than the wages/qualified property limitation of $0, the phase-in of the wages/qualified property limitation applies. While the wages/qualified property limitation of $0 would generally indicate that no QBI deduction is allowed, the phase-in rules actually allow for a partial recovery of the QBI deduction as illustrated below.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI ($170,000 × 20%) = $34,000; or
  2. The greater of:
    1. 50% of W-2 wages ($0 × 50%) = $0; or
    2. 25% of W-2 wages ($0) + 2.5% of UBIA of $0 = $0.

Calculation for phase-in of wages/qualified property limitation:

Step 1: $381,400 taxable income - $321,400 = $60,000; $60,000 ÷ $100,000 = 60%. So, 60% of the "excess" amount is disallowed by the phase-in of the wages/qualified property limitation, and 40% is allowed ("the applicable percentage").

Step 2: QBI of $34,000 - wage limit (above) of $0. Excess amount: $34,000.

Step 3: Excess amount (from Step 2) $34,000 × 60% (from Step 1) = $20,400; excess amount is disallowed.

Step 4: Excess amount of $34,000 - excess amount disallowed (from Step 3) ($20,400) = allowable QBI deduction (also $34,000 × 40%) of $13,600.

QBI deduction: $13,600.

Example 11. Non-SSTB using an S corporation with no employees other than a shareholder — within the phase-in range: A married couple filing jointly have $381,400 of taxable income and a business that is a non-SSTB with $170,000 of QBI (before considering shareholder/employee compensation) and $125,000 of W-2 wages paid to a shareholder. Because the initial QBI deduction of $9,000 (20% × QBI) is less than the wages/qualified property limitation of $62,500, the full QBI deduction of $9,000 is allowed, and the wages/qualified property limitation does not apply.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI [($170,000 - $125,000) × 20%] = $9,000; or
  2. The greater of:
    1. 50% of W-2 wages ($125,000 × 50%) = $62,500;
    2. 25% of W-2 wages ($125,000 × 25%) + 2.5% of UBIA of $0 = $31,250.

QBI deduction: $9,000.

As illustrated in Examples 10 and 11, due to the phase-in of the wages/qualified property limitation, the LLC produces the larger QBI deduction. As noted earlier, this difference relates to the reduction in QBI for S corporation shareholder/employee compensation.

Example 12: Non-SSTB using an LLC with no W-2 wages — over the phase-in range: A married couple filing a joint return have $481,400 of taxable income, one business that is a non-SSTB with $170,000 of QBI, and $0 W-2 wages paid. For a non-SSTB, once taxable income exceeds the phase-in range, the wages/qualified property limitation is fully phased in and there is no "excess" calculation.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI ($170,000 × 20%) = $34,000; or
  2. The greater of:
    1. 50% of W-2 wages ($0 × 50%) = $0; or
    2. 25% of W-2 wages ($0 × 25%) + 2.5% of UBIA of $0 = $0.

QBI deduction: $0.

Example 13: Non-SSTB using an S corporation with no employees other than a shareholder — over the phase-in range: A married couple filing a joint return have $481,400 of taxable income and a business that is a non-SSTB with $170,000 of QBI (before considering shareholder/employee compensation) and $125,000 of W-2 wages paid to a shareholder.

Determination of QBI deduction: The lesser of:

  1. 20% of QBI [($170,000 - $125,000) × 20%] = $9,000; or
  2. The greater of:
    1. 50% of W-2 wages ($125,000 × 50%) = $62,500; or
    2. 25% of W-2 wages ($125,000 × 25%) + 2.5% of UBIA of $0 = $31,250.

QBI deduction: $9,000.

As illustrated in Examples 12 and 13, when taxable income is over the phase-in range and a non-SSTB has neither W-2 wages paid to nonowners nor substantial qualified property, an S corporation obtains the larger QBI deduction because compensation paid to a shareholder/employee qualifies as W-2 wages for purposes of the QBI deduction.

Planning considerations

As illustrated in the examples, Sec. 199A adds complexity for tax planning, especially as it relates to the choice of entity structure. The passthrough entity that generates the larger QBI deduction depends on many factors, including the taxpayer's taxable income, whether the business is an SSTB or a non-SSTB, the amount of owner compensation (W-2 wages or guaranteed payments), and/or the amount of qualified property owned by the business. In general, the planning opportunities as to the best choice of passthrough entity for the highest QBI deduction are best revealed by levels of taxable income under the Sec. 199A rules: (1) taxable income at or below the threshold amount; (2) taxable income within the phase-in range; and (3) taxable income over the phase-in range. While this discussion focuses on how the QBI deduction affects the choice-of-entity decision, planners should also consider the self-employment tax implications of any entity choice.16

Taxable income at or below the threshold amount

When taxable income is at or below the threshold amount, neither the SSTB limitation nor the wages/qualified property limitation applies, and the QBI deduction is equal to 20% of QBI (subject to the overall modified taxable income limitation). As such, at this taxable income level, an LLC will always obtain a QBI deduction that is equal to or greater than that of an S corporation, regardless of whether the entity is an SSTB or a non-SSTB. This preference is related to the requirement that the QBI of an S corporation be reduced by reasonable compensation to shareholder/employees. While guaranteed payments similarly reduce QBI, there is no requirement under the Sec. 199A rules (or other law) that guaranteed payments be made to owner-operators (see Examples 1 and 2 and the discussion thereunder).

Taxable income within the phase-in range

When taxable income is within the phase-in range, the planning opportunities are less clear-cut. This is a result of the phase-in rules for both the SSTB limitation and the wages/qualified property limitation. Within the phase-in range, planning must be done on an entity-by-entity approach; however, some general planning guidelines apply in the selection of the passthrough entity that will generate the larger QBI deduction. For an SSTB and taxable income at the lower end of the phase-in range, an LLC can result in a larger QBI deduction than a similarly situated S corporation (compare Examples 5 and 6).

For taxable income at the higher end of the phase-in range, however, the SSTB limitation is mostly phased in, and the effect of the wages/qualified property limitation phase-in becomes more pronounced. In such cases, S corporation shareholder/employee compensation helps mitigate the phase-in of the wages/qualified property limitation and results in a larger QBI deduction than for an LLC (compare Examples 3 and 4). (While guaranteed payments reduce QBI, guaranteed payments are not "W-2 wages" and do not count toward the wages/qualified property limitation.)

For a non-SSTB and taxable income within the phase-in range, the focus is solely on the phase-in of the wages/qualified property limitation. When there are adequate nonowner wages for a non-SSTB, an LLC will generally provide a larger QBI deduction than an S corporation. For both types of passthrough entities, the phase-in of the wages/qualified property limitation is mitigated or eliminated by the nonowner wages. However, an S corporation's QBI must be reduced by reasonable shareholder/employee compensation, thus resulting in a lower QBI deduction (see Examples 8 and 9 and the discussion thereunder).

Finally, for taxable income within the phase-in range and a non-SSTB with minimal nonowner wages, the LLC again will generally provide the greater QBI deduction, especially at the lower end of the phase-in range. This is due to the mechanical operation of the wages/qualified property limitation that allows an LLC to partially recover the QBI deduction at the lower end of the phase-in range (see Examples 10 and 11 and the discussion thereunder).

Taxable income over the phase-in range

When taxable income exceeds the phase-in range, there is no QBI deduction for an SSTB and, thus, there is no difference between an S corporation and an LLC (see Example 7 and the discussion thereunder). However, a QBI deduction is available when taxable income exceeds the phase-in range for a non-SSTB that has W-2 wages and/or qualified property. In such cases and assuming nominal qualified property, an S corporation will usually obtain a larger QBI deduction than an LLC when there are substantial owner compensation and minimal nonowner wages. Again, this is because S corporation shareholder/employee compensation counts as W-2 wages for purposes of the wages/qualified property limitation, while guaranteed payments do not. However, with adequate nonowner wages, an LLC will usually result in a larger QBI deduction because LLCs are not required under the Sec. 199A rules to pay reasonable compensation or guaranteed payments to owners (see Examples 12 and 13 and the discussion thereunder).

One of many considerations

This article provides some general guidance to tax professionals when determining the impact of entity choice on the QBI deduction. In addition to planning opportunities for maximizing the QBI deduction, tax professionals must consider many other factors in the selection of a business entity, including the extent of shareholder/employee wages and nonowner wages, Social Security tax savings for passthrough S corporation distributions (after reasonable compensation), and the marginal tax rate of the taxpayers. Overall, the QBI deduction introduces an additional layer of complexity to the choice of business entity.  

Footnotes

1P.L. 115-97.

2For purposes of this discussion, "LLC" is used to refer to all four of these forms of entity.

3Regs. Sec. 1.199A-1(e)(3).

4Sec. 199A(c)(3)(B).

5For a more detailed explanation of the QBI components, see Regs. Sec. 1.199A-3(b) and the instructions to Form 8995-A, Qualified Business Income Deduction.

6The threshold amount for married filing separately is $160,725, with a limitations phase-in ceiling of $210,725. All amounts here and in the discussion and examples that follow are for tax years beginning in 2019. See Rev. Proc. 2018-57, Section 3.27. For 2020, the threshold amounts are $326,600 for married filing jointly and $163,300 for married filing separately, single, and head of household, with corresponding limitations phase-in ceilings of $426,600 and $213,300, respectively.

7Sec. 199A(d)(2) and Regs. Sec. 1.199A-5(b)(1).

8Regs. Sec. 1.199A-1(b)(3).

9Sec. 199A(a)(2). A deduction is also allowed for 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income (Sec. 199A(b)(1)(B)).

10Sec. 199A(b)(2) and Regs. Sec. 1.199A-1(d).

11Sec. 199A(b)(6).

12For this and subsequent LLC examples, we use entity QBI before reduction by the deductible portion of self-employment taxes and retirement contributions taken on an individual's Form 1040, U.S. Individual Income Tax Return.

13Note that reasonable compensation for this example is set at $125,000. If a lower level of reasonable compensation to the S corporation shareholder/employee could be justified, the related reduction in Federal Insurance Contributions Act (FICA) taxes could offset the value of the LLC's increased QBI deduction.

14Regs. Sec. 1.199A-1(d)(2)(i).

15Sec. 199A(b)(2) and Regs. Sec. 1.199A-1(d).

16See, e.g., Baily and Schneider, "The Importance of Being Flexible: Choice-of-Entity Considerations," 46 The Tax Adviser 164 (March 2015).

 

Contributors

Beth Y. Vermeer, CPA, Ph.D., is an assistant professor of accounting, and Brian R. Greenstein, Ph.D., is an associate professor of accounting, both in the Department of Accounting and MIS at the University of Delaware in Newark, Del. Mark B. Persellin, CPA, Ph.D., is a professor of accounting in the Department of Accounting at St. Mary's University in San Antonio.

 

Newsletter Articles

50th ANNIVERSARY

50 years of The Tax Adviser

The January 2020 issue marks the 50th anniversary of The Tax Adviser, which was first published in January 1970. Over the coming year, we will be looking back at early issues of the magazine, highlighting interesting tidbits.

PRACTICE MANAGEMENT

2019 tax software survey

This annual survey shows how CPAs rate the tax preparation software they used during last tax season and how it handled the recent tax law changes.