The new IRS proposed regulations confirm that the S corporation treats as wages the reasonable compensation that it pays to its shareholder-employees. That’s good, and it opens planning opportunities. Even better! There had been some commentators who claimed that wages of an S corporation did not count for the Section 199A wage calculation or that it was necessary for the IRS to clarify in its regulations whether such wages were wages for the 199A calculation. Now the tax code and the regulations are aligned with clarity as to the wages paid to the shareholder-employees.
What the Legislators Said
IRC Section 199A(c)(4)(A) states: “Qualified business income shall not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.” For the 199A deduction, you treat wages paid to the S corporation’s shareholder-employees as a wage deduction for determining the S corporation taxable income, which is the starting point for the calculation of qualified business income.
Now What the IRS Says
In its explanation of how the proposed regulations apply, the IRS on page 39 states:
- The phrase “reasonable compensation” is a well-known standard in the context of S corporations. Under Rev. Rul. 74-44, 1974-1 C.B. 287, S corporations must pay shareholder-employees “reasonable compensation for services performed” prior to making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation under section 1368.
The legislative history of Section 199A confirms that the reasonable compensation rule was intended to apply to S corporations. Here’s another excerpt that is of value to this discussion. It’s from page 40 of the IRS explanation, and it states:
- The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in qualified business income.
And in the new proposed regulations, the IRS has issued a warning: fail to pay a reasonable wage and the IRS will deduct what it thinks is the reasonable wage from your Section 199A qualified business income—and, of course, that would create big trouble on the wages not paid.
Final Thoughts
Say thanks to the IRS for its proposed regulations that further clarify how the S corporation treats wages paid to shareholder-employees. You have to like the planning opportunities. For some of the planning opportunities you might see, take a moment to check out the S corporation opportunities in Don’t Let The Cliff Kill Your New Section 199A Deduction, 5 Strategies to Consider.
Also, make sure that you carefully consider reasonable compensation as we discussed in Did Tax Reform Put More Pressure on S Corporation Reasonable Compensation?.