For tax years 2018-2025, 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 and perhaps even qualify for it, as we explain in Don’t Let the Cliff Kill Your New Section 199A Tax Deduction.
In the article above, we explain a strategy that 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. We’ll explain why—and what you can do to comeout ahead.
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, and
- your corporation must pay you reasonable compensation as wages for the services you perform.
If you fail to pay yourself reasonable compensation, then the IRS can recharacterize your S corporation distributions as wages, making you and your S corporation liable for all payroll taxes during the statute of limitations period.
Your reasonable compensation is generally what you’d pay a third party to perform the services that you perform. See How S Corporation Owners Can Cut Taxes by Keeping a Lid on Their Salaries for the details on how to determine that amount.
And now, thanks to tax reform, Section 199A is an important factor in your reasonable compensation decisions.
What Section 199A Says
Your W-2 reasonable compensation factors into your Section 199A deduction in two key ways:
- Reasonable compensation doesn’t count as qualified business income (QBI) for calculating your Section 199A deduction.
- Your corporation’s total wages (including your reasonable compensation) increase your Section199A deductions when you are in the phaseout ranges (and above the phaseouts if you are in an in-favor business).
We discuss this limitation to your Section 199A deduction in Tax Reform: Will Section 199A Phase In or Phase Out Your 20 Percent Deduction?
Warning! A little-known provision in the law says that your corporation’s wages won’t count for the Section199A limitations if you don’t report them on the required Form W-2 within 60 days of the Form W-2 due date with extensions.
Balancing Act
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.
Reduced Salary
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 recharacterize your S corporation distributions as wages, hitting you with retroactive payroll taxes, penalties, and interest.
- IRS recharacterization would also reduce your pass-through income, reducing your Section 199A deduction.
- IRS recharacterization 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.
Increased Salary
If you increase your salary, then you’ll have a larger wage base for the Section 199A limitation, thus increasing your Section 199A deduction if you are above the applicable taxable income threshold. But that comes at significant cost:
- You’ll overpay payroll taxes.
- You reduce your pass-through income, thus reducing your Section 199A deduction.
Zero Salary
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 if you provide 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 Social Security, Medicare, and state unemployment 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.
Critical Step
Make certain that you have a reasonable basis for your S corporation salary. For ideas on how to go about this, see
How S Corporation Owners Can Cut Taxes by Keeping a Lid on Their Salaries.
Sole Proprietorship Confusion
Reasonable compensation doesn’t apply to your sole proprietorship business—you can’t be an employee of yourself.
Some people are saying that the IRS will come up with a process to impute reasonable compensation for your sole proprietorship and limit your Section 199A deduction.
We don’t agree for two reasons:
- The conference committee report on Section 199A is crystal clear that the reasonable compensation provision applies only to S corporations.
- The conference committee report has examples that compute the Section 199A deduction for sole proprietors as simply the net business income multiplied by 20 percent.
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What’s Best—Proprietorship or S Corporation?
- As we have said many times, to know what’s the best tax entity for you, you have to put pencil to paper. That’s true in the comparison below.
- When 2024 taxable income is equal to or less than the Section 199A thresholds of $191,750 and $383,900(married),
the sole proprietorship produces the greater Section 199A deduction because of the reasonable compensation rule. - But the Social Security and Medicare tax savings generated by the S corporation with a reasonable salary will generally make the S corporation the preferred entity. That’s only true, however, when there’s a sufficient difference between the S corporation profit and the reasonable salary.
- Example. In 2024, John plans to net $80,000 in his single-member LLC business. If John elected S corporation treatment, then his reasonable compensation would be $60,000. John is in the 22 percent tax bracket and not subject to any Section 199A limitations.
- To figure out the best tax structure for John, you first compute his Section 199A deduction:
| Sch C | S Corp | |
| Total profit | $80,000 | $80,000 |
| Wages/reasonable compensation | N/A | $60,000 |
| QBI for Section 199A | $80,000 | $15,160 |
| 20% Section 199A deduction | $16,000 | $3,032 |
| Savings on 199A in 22% tax bracket | ($3,520) | ($667) |
Now let’s factor Section 199A into the overall choice of entity:
| Sch C | S Corp | |
| Net Income | $80,000 | $20,000 |
| S corp. state unemployment tax | N/A | -$250 |
| S corp. FICA (6.2% on $60,000 salary) | N/A | -$3,720 |
| S corp. Medicare (1.45% on $60,000 salary) | N/A | -$870 |
| One-half self-employment tax | -$5,652 | |
| Taxable income on John’s 1040 | $74,348 | $15,160 |
| 22% tax on taxable income | $16,357 | $3,335 |
| §199A tax reduction from above | -$3,520 | -$667 |
| Net income tax after 199A | $12,837 | $2,668 |
| 22% income tax on $60,000 salary | $13,200 | |
| Self-employment tax (14.13%) | $11,304 | |
| Social Security tax on John’s salary | $3,720 | |
| Medicare tax on John’s salary | $870 | |
| Corporate payroll taxes | $4,840 | |
| Net tax paid | $24,141 | $25,298 |
In this example, the proprietorship is the better choice of entity. It saves $1,157 in taxes. It also eliminates
- filing a separate corporate tax return, and
- processing payroll for the owner.
Key point. You need to run the numbers.
Planning tip. Had the spread between the salary and the profit been much larger, the S corporation wouldhave been the better after-tax choice of entity.
Takeaways
When making the decision on which entity gives you the best tax advantage, it’s best to run the numbers.
For S corporations. The Section 199A deduction makes paying yourself reasonable compensation as an S corporation owner more important than ever.
Don’t think about deviating from your reasonable compensation amount to change your Section 199Adeduction. To minimize payroll taxes and avoid IRS scrutiny and salary adjustment, stick with the strategy of paying yourself the least amount allowed as reasonable compensation.
For sole proprietorships. Section 199A also gives a boost to your sole proprietorship:
- You don’t have to think about reasonable compensation, meaning that if you are not affected by the net income thresholds, you get your 20 percent deduction on up to 100 percent of your net business income.
- Your higher Section 199A deduction as a proprietorship can outweigh your S corporation payroll tax savings in some circumstances, such as those you saw in this article.