United States

Tax reform provides incentive for S corps to re-examine owner comp

INSIGHT ARTICLE  | 

Under the Tax Cuts and Jobs Act (TCJA) enacted in December 2017, a new deduction emerged for owners of pass-through businesses (such as S corporations) engaged in activities other than certain prohibited services. The legislation provides a new 20 percent deduction against “qualified business income” that can effectively reduce the tax rate owners will pay on such income from 39.6 percent under the old law to 29.6 percent starting in 2018. But there is an important limitation—the deduction is limited to the greater of: a) 50 percent of the owner’s share of the business’s W-2 wages, or b) 25 percent of the owner’s share of W-2 wages plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.

Because owners’ wages are included in the limitation calculation noted above, S corporations and their owners may now be incentivized to manipulate owners’ wages to maximize the new pass-through deduction and lower the owners’ overall tax burden. Some have seen that algebraic formulas using taxpayer factors could create the optimal owner wage.

 But such math in no way proves the amount to be “reasonable.” So support for the reasonableness is critical. Generally, this requires a comparison of the facts to the amount that similar companies would pay for comparable services under like circumstances.

So early analysis and effective planning are critical to achieving the most supportable and lowest tax liability.

 


Curious how tax reform might affect your pass-through business? Watch our video series: 

Possible tax reform benefit for partnerships, entrepreneurs

Our Washington National Tax leaders discuss the basic mechanisms of a 20 percent deduction that applies to most entrepreneurial businesses.

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