Tax reform gives you a new 20% Section 199A deduction on pass-through income. But be aware the IRS requires that you pay yourself “reasonable compensation.” If you don’t, you can torpedo your deductions and be forced to pay extra taxes and penalties. Here are 3 tips:
Paying yourself “reasonable compensation” is so important. Reasonable compensation is generally considered to be what you’d pay for a third party to perform the services that you provide. If you fail to pay yourself reasonable compensation, the IRS can “recharacterize” your S corporation as wages. This makes you and your corporation liable for all payroll taxes.
Your salary affects your Section 199A deduction. Your W-2 reasonable compensation factors into your Section 199A deduction in two ways. It’s important that you fully understand these factors. To qualify for the full 20% deduction on your qualified business income under new tax code Section 199A, you need defined taxable income equal to or less than $157,500 (single) or $315,000 (married). If your taxable income is greater than $207,500 (single) or $415,000 (married), you don’t qualifor the Section 199A deduction unless you have wages or property.
Reducing or increasing your salary can be dangerous. Both strategies come with significant risks. What you should want to pay yourself is a Goldilocks salary. Not too much. Not too little. Creating the ‘reasonable salary’ gives you two benefits:
- A savings on your self-employment taxes
- A Section 199A deduction
The new 20% deduction on qualified business income gives high earners who
- are not in the out-of-favor specified service trades or business groups (doctors, lawyers, accountants, athetes, etc.),
- pay little or no wages, and
- own little or no depreciable property
an additional reason to switch to an S-Corp as their operating entity.
To find out how this would work for your unique situation, contact us for a Business Entity Analysis. We’ll work up all the numbers and give you the best options for you!