Want to Switch to an S-Corp? Don’t Forget Reasonable Compensation

Are you considering forming an S-corporation as you look to take your business to the next level or try to take advantage of changes to the tax code? Don’t forget about the reasonable compensation rules.

What Are Reasonable Compensation Rules?

Owners of an S-corporation must pay themselves a reasonable salary for the services they perform for the corporation. This salary must be classified as W-2 wages rather than as an owner’s draw or dividend payment.

Why Are There Reasonable Compensation Rules?

Although both wages and most S-corporation dividends are taxed as ordinary income, wages are subject to additional Social Security and Medicare taxes. To avoid the extra taxes, S-corporation owners have tried to take no or very low salaries so that their income would be taxed as dividends.

The IRS believes that anyone working for a corporation would receive a salary, so trying to reclassify this income as dividends is a loophole that should not be allowed.

How is Reasonable Compensation Calculated?

There is no fixed formula for reasonable compensation. Instead, it’s based on industry norms such as average salaries, the size of the business, and each individual’s position and experience.

When you set your salary, you should write down how you determined it and keep copies of any data you relied on.

What Happens If You Don’t Pay Yourself Reasonable Compensation?

If you don’t pay yourself reasonable compensation, the IRS may reclassify a portion of your income as wages. You would then have to pay any additional taxes that you owe as well as possible interest and penalties for under-reporting your taxes.

How Did the Tax Cuts and Jobs Act Change Things Beginning in 2018?

The Tax Cuts and Jobs Act added a new deduction for sole proprietors and S-corporations known as the Section 199A deduction. This allows business owners who meet certain criteria to take a deduction equal to up to 20% of their business profits. The catch is that S-corporation salaries are subtracted from business profits, so that portion of your income is not eligible for the deduction.

Section 199A Deduction Sole Proprietorship vs. S-Corporation

For example, assume a solo business owner making $100,000 with no employees.

  • A sole proprietor filing a Schedule C would pay Social Security and Medicare taxes on the full $100,000 but would only pay income taxes on $80,000 after a $20,000/20% deduction.
  • An S-corporation owner who has to take the full $100,000 as wages due to reasonable compensation would pay Social Security, Medicare, and income taxes on the full $100,000.
  • An S-corporation owner who can classify their income as $75,000 wages and $25,000 dividends would pay Social Security and Medicare taxes on $75,000. They’d pay income taxes on $95,000 ($75,000 + 80% of $25,000).

You’d have to break out your calculator to figure out which scenario is best, because it depends on your other income, overall tax bracket, and how much you have to classify as reasonable compensation.

High-Income Section 199A Deduction Sole Proprietorship vs. S-Corporation

There’s also a second catch if you make at least $157,500 as a single filer or $315,000 as a joint filer. Instead of a simple 20% deduction, your deduction is based in part on the total wages you pay.

  • Sole proprietors with no employees will almost always lose at these income levels because none of their income counts as wages.
  • S-corporation owners may be able to increase their deduction by increasing their wages. In addition, Social Security taxes only apply to the first $128,400 in income for 2018, so the only extra tax on wages versus dividends is the much smaller Medicare tax.

Conclusion

Whether an S-corporation makes sense under the current tax law will vary based on your income level, what you would have to take as reasonable compensation, and your overall tax situation. Ask your accountant to help you go over the numbers.

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