The 2018 tax reform known as the Tax Cuts and Jobs Act (TCJA) allows for a new 20 percent deduction on certain business income, known as the Section 199A deduction. One should have the right type of business and the right taxable income.
In our past blog article Christmas Came Early In 2018, we discussed different choices in conducting business when it came to taxation and the new tax legislation in great detail. We also explained the differences in taxation of each business entity structure, and if you have been paying attention, you will recall that the S corporation is a pass-through entity which is typically a great choice for most small business owners.
Additionally, the S corporation gives some ability to maneuver the new 20 percent deduction and perhaps even qualify for it for those that would think they do not due to the limitations on certain industries.
There is a basic strategy that lowers 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 eliminate your deductions, causing additional tax and potential penalty exposure.
Below we dive into why a reasonable compensation is so crucial.
Reasonable Compensation: S Corporation Shareholders – The Basics
If you are the owner of the S corporation and provide services to your S corporation, the law states that:
- You are deemed an employee of your S corporation (Reg. Section 31.3121(d)-1(b)))
- Your corporation must pay you reasonable compensation as wages for the services that you perform (Rev. Rul. 74-44)
- If you do not provide a reasonable compensation for yourself, then you stand to have the IRS recharacterize the S corporation distributions you took as corrected wages, and inflict on you and your S corporation back payroll taxes for the statute of limitations time period (Ibid; IRM 22.214.171.124.2(2) ).
For more information and to best determine what is a correct reasonable salary for your specific situation, please inquire with us, as no two scenarios are alike and more so, what would fit your set of circumstances would completely not apply to the next. And now, due to the TCJA, the new Section 199A deduction plays an important role in the amount you pay yourself as a reasonable compensation.
Simon Section 199A Says
The W-2 compensation factors into your Section 199A deduction in the following crucial ways:
- The S corporation’s owners compensation doesn’t count as qualified business income (QBI) for calculating the Section 199A deduction on their individual tax return filing (IRC Section 199A(c)(4)(A))
- The S corporation’s total wages increase an individual’s Section 199A deduction when in the elimination stage and above the elimination stage for those in specific industries (IRC Section 199A(b)(2)).
Caution: a provision in tax law states that a corporation’s wages won’t count for the Section 199A limitations if the reporting on them via Form W-2 isn’t completed within the 60 days of the Form W-2 due date including extensions (IRC Section 199A(b)(4)(C)).
The Porridge Is Too Hot, Too Cold, Or Is It, Just Right?
At this point you might be thinking about increasing your Section 199A deduction by not paying in a reasonable amount and fiddling around with the amount of compensation you issue yourself as W2 income.
Wrong – baseless payment to yourself is a huge no-no in the tax compliance world for S corporation owners and not in accordance with tax law.
Salary Reduction In Hopes To Game The System Scenario
By knowingly reducing the S corporation payout to yourself in W2 income, you in tandem do the opposite for your S corporation’s pass-through net income, and potentially increase your Section 199A deduction. However, salary reduction significantly increases the risk of a salary audit. Here is what you risk in case of the IRS challenging your compensation as reasonable and recharacterizing what is deemed shareholder distributions as hidden compensation:
- In an IRS salary audit the IRS could recharacterize the S corporation shareholder personal distributions to wages, which can lead to IRS assessments causing back payroll taxes to accrue along with their counterparts, the penalties and interest – and this hits you hard, that’s right, the wallet
- A salary audit can easily put a business out of business. Back payroll taxes are very costly, as the payroll tax is a trust tax, and is penalized heavily, as opposed to other types of back taxes
- Recharacterization of personal spending in the form of distributions by the IRS would also reduce your net S corporation pass-through income, which leads to a reduction of the Section 199A deduction you have received. This means a loss-loss situation for the taxpayer
- The Section 199A wage deduction would be lost because they are considered not field timely via Form W-2
- You end up short changing yourself in the form of less Social Security benefits counting in towards your retirement income stream
Rev Up The Salary, My Good Man!
At this point you may be justifying to yourself an increase in salary, but alas, hold your horses my friend, there is danger lurking doing that as well. Nothing is simple in the tax world. It’s true that by increasing your salary, you may be boosting your Section 199A deduction if you are in certain income categories. The drawbacks, though, are an overstated payroll tax bite, and a smaller pass-through income, and therefore a smaller Section 119A deduction.
Low Or No Compensation To The Shareholder Of An S Corporation
There are limited circumstances where it can be rationalized to pay little to no compensation.
If you provide no or limited services to your S corporation and neither receive nor are entitled to receive any remuneration from the S corporation, then you aren’t an employee of your S corporation — and there would be no need to pay yourself a reasonable compensation (Reg. Section 31.3121(d)-1(b)).
By arranging your S corporation operations to meet the zero-salary requirement, you can:
- Avoid the Social Security and Medicare payroll taxes on your W2 income
- Construct a maximized net S corporation pass-through income along with your Section 199A deduction
- Achieve the benefit of paying wages to the employees for the company operations and bypass the Section 199A limitation on wages
To gauge the optimal salary you should be paying yourself as an S corporation owner, contact our office or simply call 904-330-1200 to arrange for a specialized tax plan geared to your circumstances.