Tax Reform Doubles Down on Reasonable Compensation for S-Corporations
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.
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.
