IRS Clarifies Reasonable Comp. for S Corp. Owner’s 199A Tax Deduction

The new IRS proposed regulations confirm that the S corporation treats as wages the reasonable compensation that it pays to its shareholder-employees. That’s good, and it opens planning opportunities. Even better! Some commentators had claimed that wages to an S corporation did not count for the Section 199A wage calculation or that it was necessary for the IRS to clarify in its regulations about whether such wages were wages for the 199A calculation. Now, the tax code and the regulations are aligned with clarity as to the wages paid to the shareholder-employees.

What the Law Says

 IRC Section 199A(c)(4)(A) states: “Qualified business income shall not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.”  For the 199A deduction, you treat wages paid to the S corporation’s shareholder-employees as a wage deduction for determining the S corporation taxable income, which is the starting point for the calculation of qualified business income. The shareholder-employee wage creates planning opportunities to create and increase the Section 199A deduction, depending on taxable income and the nature of the business.

What the IRS Says

In its explanation of how the proposed regulations apply, the IRS on page 39 states:  The phrase “reasonable compensation” is a well-known standard in the context of S corporations. Under Rev. Rul. 74-44, 1974-1 C.B. 287, S corporations must pay shareholder-employees “reasonable compensation for services performed” prior to making “dividend” distributions with respect to shareholder-employees’ stock in the S Corporation under section 1368.  See also David E. Watson, P.C. v. United States, 668 F.3d 1008, 1017 (8th Cir. 2012).4 The legislative history of Section 199A confirms that the reasonable compensation rule was intended to apply to S corporations.

Here’s another excerpt that is of value to this discussion. It’s from page 40 of the IRS explanation, and it states:

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in qualified business income.

Here the IRS has issued a warning: fail to pay a reasonable wage, and the IRS will deduct what it thinks is the reasonable wage from your Section 199A qualified business income—and, of course, will create big trouble for you on the wages not paid.

Planning Opportunities

You can see planning opportunities now that you know the S corporation’s wages to its shareholder-employees

  • reduce qualified business income, and
  • qualify as wages for the Section 199A 50 percent wage deduction, which you need when if you are a specified service business (dentistry) with income greater than $157,500 (single) or $315,000 (married, filing jointly).

Takeaways

Say thanks to the IRS for its proposed regulations that further clarify how the S corporation treats wages paid to shareholder-employees. You have to like the planning opportunities. With income under the threshold of $157,500 (single) or $315,000 (married, filing jointly), you may be able to reduce your W-2 wage to both pocket more payroll taxes and increase your Section 199A deduction.