You’ve probably heard of the 20% deduction to Qualified Business Income (QBI) afforded by Section 199A created by the Tax Cuts and Jobs Act of 2017. What you probably haven’t heard of is how to legally maximize your pass-through income subject to the QBI deduction because you’re still obligated to pay yourself Reasonable Compensation as a corporate officer.
The IRS doesn’t allow you to arbitrarily decide your minimum salary; the IRS requires that you’re able to prove your pay is reasonable every year. Reasonable Compensation is defined by §162-7(b)(3) as the “amount as would ordinarily be paid for like services by like enterprises under like circumstances.” This means the specific tasks you perform, your time spend on each task, and your proficiency level (among other experience factors) must be benchmarked against market rates for other employees within your industry who hold a similar position.
For instance, in the David E Watson, P.C. V. United States of America (2010) case, Mr. Watson was an accountant who had paid himself a salary of $24k in 2002 while he realized a profit of $203,651. Due to Mr. Watson’s facts and circumstances, his Reasonable Compensation was deemed to have been $91,044. A similar scenario occurred for 2003 as well. He had no documentation and had conducted no research, thus a portion of his income was reclassified and over $48k in taxes, penalties and interest were assessed as a result. He would’ve only paid about $20k in taxes had he originally paid himself a Reasonable Compensation.
Likewise, if we simplify a bit and assume Mr. Watson had realized the same combined profit and salary in 2018 totaling $227,651 while paying himself a Reasonable Compensation of $91,044, he would be entitled to a QBI deduction of $27,321. However, if he overpaid himself to the halfway mark ($159,348) between Reasonable Compensation and his combined profit and salary, his QBI deduction would only result in a deduction of $13,660.70. Assuming Mr. Watson would be in the 2018 married filing jointly tax bracket of 24%, this difference would represent an avoidable tax liability of $3,279 just due to an excessive salary causing a decreased QBI deduction.
How does this relate to you? If you’ve maintained status quo and you’re overpaying yourself excess salary to provide for lifestyle expenses in lieu of periodic distributions, your tax bill is far bigger than what it should be. Thus, you need to upgrade your accounting relationship and work with us to conduct a Reasonable Compensation test and help you create a tax plan to save you thousands of dollars in taxes every year going forward.