From 2018 to 2025, the Tax Cuts and Jobs Act is offering a 20 percent deduction on pass-through business income, with specific eligibility criteria. This deduction impacts the choice of entity. For instance, should you operate as a sole proprietorship or an S corporation?
The Importance of Reasonable Compensation
When operating your business as an S corporation, you must pay yourself “reasonable compensation.” Failing to do so can result in penalties, increased taxes, and missed deductions. And now, thanks to tax reform, Secton199A 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 Section 199A deductions when you are in the phaseout ranges (and above the phaseouts if you are in an in-favor business).
Balancing Act for S Corporation Owners
Lowering salary. While reducing your salary might seem attractive to increase pass-through income and the Section 199A deduction, it risks IRS penalties and reduced benefits.
Increasing salary. Conversely, a higher salary increases payroll taxes and potentially reduces your Section 199A deduction.
Unique Situation: Zero Salary
In rare cases, you might not need the S corporation to pay you a salary (e.g., you do not actively provide services to your S corporation). This setup can maximize your pass-through income and Section 199A deduction, but it requires careful planning to ensure legality.
S Corporation versus Sole Proprietorship
Choosing between an S corporation and a sole proprietorship is a nuanced decision, impacted by the Section 199A deduction, payroll taxes, and reasonable compensation requirements. While S corporations can offer Social Security and Medicare tax savings, sole proprietorships benefit from a more straightforward tax structure and potentially higher Section 199A deductions under certain conditions.
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.
- To maximize tax benefits, stick to paying yourself the least amount allowed as reasonable compensation.
- Avoid deviating from this strategy to change your Section 199A deduction.
- By doing so, you can minimize payroll taxes and avoid IRS scrutiny.
For Sole Props: Section 199A also gives a boost to your sole proprietorship:
- Unlike S Corps, sole proprietors don’t need to worry about reasonable compensation. If you’re not affected by net income thresholds, you can get a 20% deduction on up to 100% of your net business income.
- In some cases, the higher Section 199A deduction for sole proprietorships may outweigh the payroll tax savings of an S Corp.
If you want to discuss your business entity choice and options, please don’t hesitate to call us at (512) 795-0300.