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.
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 Primer
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.
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. And now, thanks to tax reform, Section 199A is an important factor in your reasonable compensation decisions.
What Section 199A Tells Us
Your W-2 reasonable compensation factors 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).
Warning! A little-known provision in the law says that your corporation’s wages won’t count for the Section 199A 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.
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 Risks
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 into 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.
Can I Do 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 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.
Most Critical Step
Make certain that you have a reasonable basis for your S corporation salary. For ideas on how to go about this, give us a call for a no charge consultation anytime,