Law in the Marketplace: When will your LLC be an S Corporation?

  • John Cunningham

For the Monitor
Published: 1/14/2022 1:52:26 PM
Modified: 1/14/2022 1:51:33 PM

To individuals who have ownership interests in pass-through businesses (whom I’ll refer to here as “qualified taxpayers”), Internal Revenue Code Section 199A provides huge annual federal income tax deductions. These deductions can amount to up to 20% of their shares of the “qualified business income” of their business. (For most qualified taxpayers, “qualified business income” means net business income. Pass-through businesses comprise businesses taxable as sole proprietorships, S corporations or partnerships). Thus, qualified taxpayers should do all they can to maximize their Section 199A deductions.

However, many New Hampshire qualified taxpayers conduct their businesses through single-member LLCs, and most of these individuals have accepted the default federal tax regimen of sole proprietorship taxation. This is, in fact, the best regimen for many of these taxpayers. However, it may be the worst if their taxable income exceeds their Section 199A “threshold amount.” For 2022, the Section 199A threshold amount for qualified taxpayers who are married and file joint returns is $340, 100 and, if they file separately, it is $170,050. If these qualified taxpayers want to maximize their Section 199A deduction, they must elect to have their LLCs taxed as S corporations.

I should note here that “LLC” is a purely legal term and that “S corporation” is a purely federal tax term. Under the relevant IRS rules, an LLC may elect to be an S corporation. If it does, it remains an LLC for all legal purposes but it is an S corporation for federal tax purposes.

To understand why many high-income qualified taxpayers should make S elections, it will first be useful to briefly review the applicable federal tax provisions. To make things concrete, I’ll refer the qualified taxpayer who will serve as our example as “Mary Jones.”

■ If Mary’s taxable income does not exceed her threshold amount, the federal tax provisions determining Mary’s Section 199A deduction will be Section 199A(b)(2)(A). Under this provision ... her section 199A deduction will be 20% of her net business income.

■If Mary’s taxable income does exceed her threshold amount, the provisions that will determine her Section 199A deduction will be Sections 199A(b)(2)(A) and (B). Under these provisions, her Section 199A deduction will be the lesser of (i) 20% of her qualified business income and, (ii) unless she owns substantial real estate, 50% of the aggregate W-2 wages that she pays to her employees (assuming that she has employees).

To illustrate:

■ Assume that Mary’s taxable income does not exceed her threshold amount and that her net business income is $100,000. In this event, her Section 199A deduction will be $20,000 (20% of $100,00), and she will owe federal income tax on only $80,000 of her net business income.

■ However, if we assume that her taxable income does exceed her threshold amount—even if only by one penny—and if we assume that she has no employees and thus no W-2 wages, the Section 199A provisions that will govern her section 199A deduction will be Section 199A(b)(2)(A) and (B). Since, under these provisions, her section 199A deduction will be the lesser of 20% of her net business income and 50% of her aggregate W-2 wages; and since her aggregate W-2 wages will be zero (because under sole proprietorship taxation, she cannot treat herself as an employee), she will receive no Section 199A deduction.

However, if Mary makes an S election for her single-member LLC, then, to the extent her aggregate W-2 wages are less than her net business income, her section 199A deduction will be 50 percent of these wages. And if Mary’s single-member LLC is an S corporation, she can treat herself as an employee of her LLC. If she does so, her employee salary will constitute W-2 wages and thus may enable her to obtain a potentially substantial Section 199A deduction.

Here is the lesson of this column: If you conduct your business through a single-member LLC, you’ve got to consult as soon as possible with a tax professional with expert knowledge of Section 199A, and you must ask this tax professional whether your federal tax regimen should be sole proprietorship taxation or taxation under Subchapter S. If you don’t properly resolve this question, you could be forgoing thousands of dollars of Section 199A deductions in 2022 and every year thereafter. Don’t make that mistake.

John Cunningham is a lawyer licensed to practice law in New Hampshire and Massachusetts. He is of counsel to the law firm of McLane Middleton, P.A. Contact him at 856-7172 or lawjmc@comcast.net. His website is llc199a.com. For access to all of his Law in the Marketplace columns, visit concordmonitor.com.




Concord Monitor Office

1 Monitor Drive
Concord,NH 03301
603-224-5301

 

© 2021 Concord Monitor
Terms & Conditions - Privacy Policy