Let's start with the basics and explain how the Section 199A deduction works for S Corps. The 199A deduction flows through your individual tax return, but it depends on your taxable income from your S Corporation and other streams of income reflected on your personal return. Here’s a simplified explanation of the Qualified Business Income (QBI) deduction formula for S Corps:
Whatever is lesser between #1 and #2
#1. 20% x (Qualified Business Income - Shareholder W-2 Wages)
or (whatever is lesser)
#2. Whatever is greater between a and b
a. 50% of S Corp wages or
b. 25% of wages plus 2.5% of qualified property.
Let's work though this formula. For example, if you earn $100K, pay yourself $10K in wages, and have no assets in your S Corp, the calculation would be:
#1. The QBI deduction would be $18K (20% x ($100K - $10K) = $18K) or
#2. The QBI deduction would be $5K (50% x $10K = $5K).
Since the main rule is the lesser between #1 and #2, $5K is less than $18K, your QBI deduction on your Form 1040 will be only $5K.
So, you notice that the QBI deduction gets significantly smaller if you issue yourself a tiny W-2 wage. Without wages, there’s no QBI deduction because the lesser of #1 and #2 will be always #2, resulting in zero wages and, consequently, a zero deduction. With extremely small salaries you will save on self employment taxes, but in return you may expose yourself to an audit on reasonable compensation and also lose that tax benefit from the QBI deduction.
Although there are nuances to consider, you get the idea. In our experience, the ideal percentage for salary versus net income is 27-28%. However, you can't simply start paying yourself that amount because it offers the best tax benefit. Your salary must comply with reasonable compensation rules, which we describe here.
Other tax planning options include:
- Employing your children or spouse to increase your S Corp wages.
- Investing in property, as referenced in 2.b above.
- Aggregating QBI activities: If an owner has multiple operating companies, and only one pays W-2 wages, aggregating them could allow you to maximize the 20% QBI deduction, by "stealing" W-2 wages. Without aggregating, entities without W-2 wages will have zero QBI deductions. Aggregation allows you to use the W-2 wages of one entity to benefit others.
An additional twist comes into play if you earn too much and your business is considered a Specified Service Trade or Business (SSTB). Your QBI deduction will phase out. I won’t clutter the blog with the definition of an SSTB, but you can read about it here. I will only focus on how the SSTB category affects the QBI formula above. The main point here is that your S Corp is classified as an SSTB and exceeds certain income thresholds, the deduction phases out.
So, what tax planning options do we have for SSTB businesses operating as S Corps?
- Separate Income Streams: For high-profit SSTBs nearing the threshold, consider splitting your business income into two parts: SSTB and non-SSTB. For instance, a doctor’s practice is an SSTB, but selling medical devices is not. By separating these income streams, you could still claim a portion of the QBI deduction.
- Defined Benefit Plans: Consider setting up a retirement plan, such as a solo 401K, to reduce taxable income and stay under SSTB phase-out thresholds.
- Income Deferral: Consider deferring income (e.g., delaying contracts or sales) to remain under the SSTB income thresholds and avoid the deduction phase-out.