Tax Reform Doubles Down on S Corporation Reasonable Compensation

Tax Reform Doubles Down on S Corporation Reasonable Compensation

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.

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