The Tax Cuts and Jobs Act (TCJA), effective January 1, 2018, has made the issue of reasonable owners’ compensation for pass through entities (PTE) more complicated. TCJA’s new deduction, Section 199A, allows owners of PTEs to write-off 20% of qualified business income (QBI) when reporting their proportionate share.
C Corporation taxpayers attempt to maximize owners’ compensation to reduce their taxable income. S Corporation and other PTE owners seek to minimize their compensation to reduce self-employment taxes. IRS reasonable compensation regulations prevent owners from setting their compensation too high or too low.
TCJA limits the 20% QBI deduction based on the taxpayer’s taxable income.
Under TCJA, PTE owners must strike the right balance to maximize the QBI deduction and minimize self-employment taxes. This may also influence the decision to select C or S corporation status.
With the passage of TCJA, reasonable compensation will invite more IRS scrutiny. Tax courts use the “multi-factor test” and/or the “independent investor” test to determine the reasonableness of owners’ compensation. Setting a reasonable level of owners’ compensation requires analysis of numerous factors particular to the company, its industry, and market area. Chaffe has many years of experience in performing reasonable compensation studies.
Chaffe can assist business owners and their tax and financial advisors in setting owners’ compensation to maximize tax savings while falling within the IRS reasonable compensation guidelines.