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.

With so many internet tax gurus advising to pay yourself as little as possible, some may have forgotten this rule.

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.

If you want to discuss your business entity choice and options, please don’t hesitate to call me on my direct line at 240-929-1040 or book a consultation @ advisory calendar.

Published On: March 6, 2023 / Categories: Accounting, Bookkeeping, Self Employed /

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