Generally, when business owners think about tax planning, paying themselves additional taxable compensation does not sound like much of a strategy. For certain S corporation owners, however, paying an additional year-end bonus can actually reduce their overall federal tax obligation. The reason lies in the interaction between shareholder compensation and the Section 199A qualified business income, or QBI, deduction.
Under Section 199A, eligible owners of pass-through businesses may generally deduct up to 20% of their qualified business income. For higher-income taxpayers, however, the deduction can be limited based on factors that include the W-2 wages paid by the business and its investment in certain qualified property.
For a profitable S corporation with relatively low payroll, that wage limitation can significantly reduce an otherwise valuable deduction. That is why, in the right circumstances, paying the shareholder an additional year-end bonus can help unlock more of it.
How the Strategy Works
For taxpayers subject to the W-2 wage limitation, the QBI deduction for a qualifying business generally cannot exceed the greater of:
- 50% of the business’s W-2 wages; or
- 25% of W-2 wages plus 2.5% of the cost, before depreciation, of certain qualified property.
That creates an interesting trade-off for an S corporation shareholder.
Additional compensation reduces QBI, which can reduce the potential QBI deduction. But it also increases W-2 wages, which can increase the amount of deduction allowed under the wage limitation.
Under the right circumstances, the second benefit can outweigh the first.
An Example
Assume John owns 100% of an S corporation. Before considering a year-end bonus, the company has approximately:
- $600,000 of QBI
- $120,000 of W-2 wages
We’ll assume John is subject to the W-2 wage limitation and that the other Section 199A limitations do not affect this simplified example.
Twenty percent of John’s $600,000 of QBI is $120,000.
However, 50% of the company’s $120,000 of W-2 wages is only $60,000. As a result, John’s QBI deduction is limited to approximately $60,000.
Now assume the company pays John an additional $100,000 year-end bonus.
The bonus reduces the company’s QBI to approximately $500,000, while increasing its W-2 wages to $220,000.
Now the numbers look very different:
- 20% of $500,000 of QBI = $100,000
- 50% of $220,000 of W-2 wages = $110,000
The wage limitation is no longer restricting the deduction. John’s QBI deduction has increased from approximately $60,000 to $100,000, creating an additional $40,000 deduction.
For a taxpayer in the 37% federal income tax bracket, that additional deduction could potentially save $14,800 in federal income tax, before considering the additional payroll taxes and other tax consequences of the bonus.
In other words, John paid himself more wages but may have reduced his overall tax obligation.
There Is a Cost
This strategy isn’t as simple as running an extra payroll at year-end. Additional compensation is subject to payroll taxes and reduces the S corporation’s QBI. The increase in the QBI deduction therefore needs to be weighed against those additional costs.
S corporation shareholders who perform services for their companies also remain subject to reasonable-compensation requirements. The IRS may recharacterize excessive compensation to distributions (or, for compensation that is considered by the IRS to be too low, they may recharacterize distributions to compensation). The reasoning for determining shareholder compensation should be documented by the business contemporaneously.
The objective then is to determine an appropriate compensation level and then model whether additional compensation produces an overall tax benefit after considering:
- Reduction in QBI
- Increase in the W-2 wage limitation
- Federal, state, and local income taxes
- Social Security and Medicare taxes
- Reasonable compensation requirements
- Retirement plan implications
- Overall taxable income
Not Every S Corporation Owner Will Benefit
This strategy won’t work for every S corporation owner. For example, an additional bonus may provide little or no Section 199A benefit when the business already has enough W-2 wages to support the full deduction. Likewise, the economics can change when qualified property supports the alternative 25%-of-wages-plus-2.5%-of-property limitation.
But for a profitable S corporation whose QBI deduction is being restricted by the W-2 wage limitation, shareholder compensation deserves a closer look before year-end.
Reach Out to Learn More
Year-end planning for an S corporation owner should look beyond simply projecting taxable income. Year-end planning for S corporations should include modeling the shareholder’s compensation, business income and available Section 199A deduction together to determine whether there are opportunities to improve the overall result. The important part is figuring that out before December 31 rather than after the return is being prepared. For tax planning assistance, reach out to the Tax Strategy Group at H2R CPA.
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