Becoming Less Valuable: S Corporation “Reasonable Compensation” in Light of IRC 199A

Author: Evan Fox, J.D., LL.M.

Under Internal Revenue Code (IRC) Section 1366, shareholders of S Corporations report their share of net income as if it were directly earned. Included in the computation of net income is a deduction for wages (and withholding taxes) paid to the shareholder(s), along with related payroll taxes. Conversely, the shareholder reports these wages as ordinary income. For a variety of reasons, taxpayers and the IRS have been engaged in a tussle over what level of wages are appropriate. Following the enactment of IRC 199A (see Section 199A Pass: Treasury Regulations Answer Many Questions by Joseph Most for a detailed description of IRC 199A), taxpayers have a new and extremely important variable to consider in determining their “reasonable compensation.” And much to the chagrin of the IRS, the economics will typically suggest a further trend towards wage reductions.

Why the “Tussle”?

Before delving into the implications of IRC 199A, a little background on the aforementioned “tussle” is helpful. Historically, S Corp shareholders have attempted to use compensation as a means to achieve various ends. For example, a group of family shareholders may allocate wages in a manner inconsistent with ownership percentages (and actual services contributed) such that lower tax rate taxpayers, with small stock ownership, are receiving higher wage income, and the higher tax rate shareholders, with greater stock ownership, are receiving a brunt of the wage deduction included in S Corp distributive share.

As you would imagine, the IRS doesn’t appreciate these arrangements and may act to remedy any deemed inequities. Additionally, taxpayers may use the wage deduction as a corporate tax reduction mechanism in jurisdictions where S Corp status is non-existent, such as New York City; although shareholder compensation is an addback for NYC Alternative Tax (NYC AT).

The IRS and Reasonable Compensation

While the income shifting issue is a point of contention, the real rub the IRS has on the topic of “reasonable compensation” is payroll taxes. When a taxpayer receives payment from a partnership for services, the corresponding guaranteed payment results in self-employment taxes paid on the individual’s Form 1040. The same is not true for S Corp shareholders, who absent wage income, as they do not have to pay such taxes.

Even still, when it comes to S Corp shareholders, payments related to payroll can have conflicting taxpayer desires. On one hand, taxpayers often attempt to structure their S Corps’ income and expenses in a manner that allows the shareholders to receive payments as tax free distributions, or even corporate dividends, opposed to wages. This structure is implemented because of the imposition of FICA, FUTA, and payroll withholding taxes on any wages.

However, on the flip side, some S Corp shareholders are willing to bear these payroll costs and will utilize a substantial bonus near the close of the calendar year as a method of making their estimated tax payments (rather than actually making payments quarterly, withholding is allocated evenly among the year regardless of when the related wages were paid).

Enter IRC 199A

The new wrinkle added by IRC 199A has made S Corp shareholder compensation levels perhaps more economically significant than ever before. The basic premise of IRC 199A is that business owners (whether operated via pass-throughs such as S Corps or partnerships or as sole proprietors) in certain non-excluded industries are eligible to receive a 20% deduction of their Qualified Business Income. This maximum 20% deduction is capped at the greater of:

  • 50% of the wages paid by the business, or
  • the sum of 25% of the wages and 2.5% the unadjusted tax basis of depreciable property. Wages, paid by an S Corp to its shareholder, are ineligible for the 20% deduction.

Example

Imagine an S Corp, operating solely in New York City (for a 100% apportionment factor), owned in an 80/20 ratio between Cindy and her daughter Linda. Historically they have taken wages of $800,000 for Cindy and $200,000 to Linda and the S Corp distributable share after wage deduction is $1,000,000. While the same considerations mentioned earlier (income shifting, NYC tax limiting, payroll fees, estimated tax backdating) all may have applied, the 199A provision has created a new opportunity to potentially reduce their federal tax rate by almost 7.4% of any wage reduction.

There are quite a few moving parts in play here, but the following will help clarify the situation for the purposes of this article.

At total compensation of $1,000,000, assuming both Cindy and Linda are taxed at the highest marginal rate in effect prior to tax 2018 of 39.6%, this single item resulted in $396,000 of tax, and similarly contained a tax benefit of $396,000 thru its reduction to the distributable share of S Corp income. There may have been slight leakage for payroll taxes, but the wages also may have reduced New York City corporate taxes (assuming they weren’t subject to the NYC AT). Overall, a small effect.

Now, let’s roll this forward to tax year 2018.

The same $1,000,000 of wages is now taxed at the reduced rate of 37% for 2018, resulting in $370,000 of tax. The distributable share of income, $1,000,000, takes the 199A deduction of $200,000 (20% of $1,000,000, which is supported by 50% of wages as a limit). Accordingly, the $800,000 share is taxed at 37% for another $296,000 in tax. Total federal taxes paid in this scenario are $666,000.

If we cut the wages in half, watch what happens.

$500,000 of wages taxed at a 37% rate results in $185,000 of tax. Our distributable share of income rises to $1,500,000 and receives a 20% 199A deduction of $300,000. The resulting $1,200,000 of income, taxed at 37%, results in a liability of $444,000. Total federal taxes paid with reduced wages is now only $629,000, a savings of $37,000, or 7.4% of the $500,000 in reduced wages. Put more simply, only 80% of the S Corp income is taxed at 37%, leading to an effective rate of 29.6%.

In this stylized example, the results are portrayed very simplistically, not taking into account any savings from payroll taxes or detriment from a potential increase in local taxes (and the corresponding, but lesser benefit of a decrease in Federal income for these taxes). If we expounded upon the example and utilized a detail model inputting the payroll and NYC tax implications, the savings in this scenario drop to approximately $22,000. Not quite the full 7.4% but certainly good savings.

Going further, if wages are reduced beyond a certain point, the 199A deduction could become limited due to a lack of wages/property. And finally, if taxpayer’s took extremely drastic wage reduction measures (perhaps wages reduced to $100,000 total in the example above), what would the IRS think?

With so many moving parts, and the economic implications never greater, now is the right time to contact your tax advisor and revisit your S Corp compensation.