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TAX TIP: Reasonable Compensation for S Corps

The Tax Cuts and Jobs Act, in force from 2018 to 2025, offers a 20 percent deduction on pass-through business income, but there’s a catch. This deduction hinges on specific eligibility rules, making it crucial for business owners to ponder: Should they be a sole proprietorship or opt for the S corporation status?

The Importance of Reasonable Compensation

When operating your business as an S corporation, you must pay yourself “reasonable compensation.” Essentially, reasonable compensation is deemed to be a paycheck comparable to what other employers would pay for similar services. If there’s additional profit in the business, you can take those as distributions, which come with a lower tax bill.

Attempting to avoid taxes by masking your salary as a distribution may result in significant penalties and a substantial retroactive tax liability if an IRS audit reclassifies your S corporation earnings as salary. In such cases, you may face tax penalties of up to 100%, in addition to negligence penalties.

The S Corp “reasonable salary” requirement only comes into play if you (and other shareholders) take distributions from the company’s profits. The IRS can’t impose a minimum salary requirement, so don’t fret if your business isn’t earning enough yet to pay yourself a salary comparable to others in your field.

Balancing Act for S Corporation Owners

Lowering salary. Trimming your salary might seem like a shortcut to boost pass-through income and snag that Section 199A deduction. But beware: It could mean penalties and fewer perks down the line.

Increasing salary. Conversely, a higher salary increases payroll taxes and potentially reduces your Section 199A deduction. It’s a trade-off that demands careful consideration.

Rare Scenario: Zero Salary
In some rare cases, you might not need a salary from your S corporation. Maybe you’re not actively working for the company. While this setup can beef up your pass-through income and snag you a sweet Section 199A deduction, it’s not without risks. It calls for meticulous planning to stay on the right side of tax law.

S Corporation versus Sole Proprietorship

Choosing between an S corporation or a sole proprietorship isn’t a black-and-white decision. You’ve got to factor in the cost benefit of the Section 199A deduction, payroll taxes, and the whole “reasonable compensation” scenario. S corporations can mean savings on Social Security and Medicare taxes, but sole proprietorships boast a simpler tax setup and, under certain conditions, might provide you with larger Section 199A deductions.

If you would like help determining the best entity structure for your business, contact Saunders Tax & Accounting at www.SaundersTax.com or call us at 301-714-2071. Open Monday – Thursday 9 am to 5 pm. Awarded the Hagerstown Chamber of Commerce “2023 Small Business of the Year” and Hagerstown Hotlist 2024, we have been providing a Less Taxing Life and More Prosperous Solutions for 40 years!

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Earl L. Crawford, Jr. 1937-2024

Earl worked for Goodyear Tire and Rubber Company for 30 years before going into business for himself at Crawford Tire from 1981 until 2019.

Dennis W. Flythe 1953-2024

Denny attended Greencastle Antrim High School and graduated from Delaware State University. He focused on providing for his family and creating a legacy.

Arnold W. Wagaman 1939-2024

Arnie was employed at Mack Truck as a quality control specialist until his retirement; a total of 39 years. In his free time, he enjoyed fishing and gardening.

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