819 / How does the 2017 tax reform legislation impact the choice of entity decision between sole proprietorship form and an S corporation?

Sole proprietors and S corporations with only a single shareholder may wish to examine their choice of entity decisions to more fully take advantage of the Section 199A deduction for QBI. Generally, reasonable compensation paid by an S corporation to its shareholder is included in the W-2 wage limit and excluded from QBI.¹ A sole proprietor is not subject to similar requirements (the Section 199A proposed regulations clarified that the reasonable compensation rule applies only in the S corporation context).²

If the business’ income for the year exceeds the relevant threshold levels, these rules would maximize the QBI deduction if the business was organized as an S corporation. If income fell below the relevant thresholds, the sole proprietor would obtain the larger QBI deduction, as illustrated in the examples below.

Example 1: A sole proprietorship and S corporation with one shareholder each generate $500,000 in QBI for the year, and neither business has any qualified property. The S corporation shareholder pays himself reasonable compensation for the year of $100,000. The sole proprietor is not required to pay himself a wage. Both businesses are subject to the W-2 and UBIA limitations because their income exceeds the relevant threshold levels. The S corporation’s QBI deduction for the year is limited based on the statute’s W-2 limitation, so is limited to $50,000 (50 percent of W-2 wages, i.e., the shareholder’s reasonable compensation). The sole proprietor’s QBI deduction (also phased out) is zero, because wages and UBIA both equaled zero.

Example 2: If each business described in the example above instead earned $100,000 (i.e., below the income thresholds), the W-2 wage and UBIA limitations would not apply. Assume the S corporation shareholder paid himself $40,000 in reasonable compensation for the year. The sole proprietor’s QBI deduction is $20,000 (simply 20 percent of $100,000). The S corporation shareholder must reduce his QBI for the year by the amount of reasonable compensation ($40,000) before calculating the deduction. Thus, his QBI deduction for the year is only $12,000.

1. IRC § 199A(c)(4)(A).