The Tax Cuts and Jobs Act (TCJA) tax reform gives you a valuable 20 percent deduction on your pass-through business income if you have the right business and the right taxable income.
The S corporation is a pass-through entity. That’s one step in the right direction.
In addition, the S corporation gives you some ability to maneuver your 20 percent deduction. One strategy involves lowering your S corporation salary to realize both a reduction in payroll taxes and the new Section 199A 20 percent deduction.
But beware: not paying yourself an appropriate salary as an S corporation owner can torpedo your deductions, causing extra taxes and penalties.
Reasonable compensation is now more important than ever.
Reasonable Compensation 101
If you own your S corporation and provide services to your S corporation, the law says:
- You are an employee of your S corporation.
- Your corporation must pay you reasonable compensation as wages for the services that you perform. Reasonable compensation is generally what you’d pay a third party to perform the services that you perform.
- If you fail to pay yourself reasonable compensation, the IRS can re-characterize your S corporation distributions as wages, making you and your S corporation liable for all payroll taxes.
And now, thanks to tax reform, Section 199A is an important factor in your reasonable compensation decisions.
What Section 199A Says
Your W-2 wages factor into your Section 199A deduction in two key ways:
- Reasonable compensation doesn’t count as qualified business income for calculating your Section 199A deduction.
- Your corporation’s total wages (including your reasonable compensation) increase your Section 199A deductions when you are in the phaseout ranges (and above the phaseouts if you are in an in-favor business).
In light of tax reform, you might be thinking about increasing your Section 199A deduction by not paying yourself correct reasonable compensation. Incorrect, unsupported compensation is a no-no.
If you reduce your salary, you increase your S corporation’s pass-through income, and that can increase your Section 199A deduction if you have the right taxable income and the right business. But that comes with significant risks:
- The IRS can re-characterize your S corporation distributions into wages, hitting you with retroactive payroll taxes, penalties, and interest.
- IRS re-characterization would also reduce your pass-through income, reducing your Section 199A deduction.
- IRS re-characterization of your S corporation distributions as wages prevents them from counting toward the Section 199A wage limitations because you didn’t report them on a timely Form W-2.
- You pay less into Social Security, ultimately reducing your monthly benefit in retirement.
There’s one limited circumstance where you can legally pay yourself zero reasonable compensation as an S corporation owner.
If you don’t provide any services to your S corporation (or only minimal services) and you neither receive nor are entitled to receive any remuneration from your S corporation, then you aren’t an employee of your S corporation—and you don’t have to pay yourself reasonable compensation.
By arranging your S corporation operations to meet the zero-salary requirement, you can
- eliminate FICA taxes on your salary,
- maximize your S corporation pass-through income (and your Section 199A deduction), and
- use the wage income you pay your employees to run the company for Section 199A limitation purposes.
- Make sure you know the numbers before making big changes to win the new Section 199A tax deduction.
- Tax reform makes paying yourself reasonable compensation as an S corporation owner more important than ever.
Tax reform creates a new urge to look at your business entity and the net taxes you pay because of that entity.