Section 199A and Choice of Passthrough Entity

In 2017, Congress drastically reduced the corporate tax rate and provided an unprecedented deduction under section 199A for qualifying passthrough business income. Although purportedly necessary to maintain tax parity between income earned in corporate and noncorporate form, section 199A encourages active high-income passthrough owners to misclassify labor income as business profit, thereby reducing both income and employment taxes. This Article considers how section 199A is likely to affect choice of entity among different passthrough forms. Prior to the 2017 legislation, S corporations had an advantage over other passthroughs because of their ability to convert owner compensation into S corporation income not subject to employment taxes (or the section 1411 tax). Under the 2017 legislation, it is unclear whether S corporations will continue to represent the superior choice of passthrough entity. Section 199A provides a perverse incentive for S corporations to understate or overstate owner compensation depending on which technique minimizes combined income and employment taxes. The Treasury’s decision to limit the reasonable compensation guardrail to S corporations highlights the anachronistic employment-tax treatment of passthrough entities, as well as the lack of any coherent rationale for preferential treatment of passthrough income. The Article concludes that section 199A offers a fertile field for income-shifting and potentially undermines the rationale for maintaining Subchapter S.