When the proposed Section 199A regulations were released in August, the IRS received well over 300 comments. One of the comments concerned itself with the interplay of qualified business income deduction, W-2 wage limitations and S Corp reasonable shareholder salary. Furthermore the concern was that this interplay would cause disparities between different entity structures and elections.
For example, let’s assume a business makes a $100,000 net business income after expenses and deductions. As a garden-variety LLC, the entire $100,000 would be eligible for the Section 199A deduction. However, if the business owner elects S Corp status on the LLC he or she must pay a reasonable salary; let’s assume a shareholder salary of $45,000 which includes the employer’s portion of payroll taxes. Now this same $100,000 is reduced to $55,000 and as such the Section 199A is nearly halved (spoiler alert: the reduction of Section 199A deduction is eclipsed by the savings of self-employment taxes).
The converse problem occurs where a garden-variety LLC makes $500,000 net income after expenses and deductions. Let’s also assume taxable income is $500,000 for the sake of illustration. Since an LLC cannot pay wages to its owner, this $500,000 would not be eligible for the Section 199A deduction because of the W-2 wage limitation. Furthermore, let’s assume this business operates in New York City or Tennessee, and the local S Corp taxation rate kills whatever federal tax savings are in play. In this case, the business owner would be compelled to elect S corporation status and pay wages just to receive a Section 199A deduction.
The Treasury Department and the IRS recognized this issue, but declined to make any changes when the final regulations were published.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition