Determining “Reasonable Compensation” For S Corporations

Choices May Impact Your Qualified Business Income 20% Deduction

One of the most discussed provisions in the 2017 Tax Cuts and Jobs Act (the “Act”) is the new qualified business income (“QBI”) deduction provision.  Excluding C corporations, Section 199A of the 2017 Act allows taxpayers a deduction of 20% of QBI earned in a qualified trade or business, subject to certain limitations.  The Section 199A deduction applies to S corporations.

An S corporation must be engaged in a “qualified trade or business” to claim the Section 199A deduction. Section 199A defines a qualified trade or business by exclusion; every trade or business is qualified, other than:

• The trade or business of performing services as an employee
• A specified service trade or business (“SSTB”)

Consider the example where there is one owner of a profitable S corporation that isn’t an SSTB – see our earlier blog on this topic dated Feb 13, 2018.  For purposes of Section 199A, the shareholder would desire to pay themselves little, or no salary or wages in order to maximize their flow through income qualifying for the 20% QBI deduction.  However, there is ample authority under tax law that requires an S corporation to pay reasonable compensation to the shareholder for services actually rendered.

It is impossible to make a general statement as to what amount of compensation is reasonable because reasonableness must be determined based on the surrounding facts and circumstances.  The following is taken from IRS Fact Sheet 2008-25 in 2008 titled “Wage Compensation for S Corporation Officers” regarding some factors considered by the courts in determining reasonable compensation:

1. Training and experience
2. Duties and responsibilities
3. Time and effort devoted to the business
4. Dividend history
5. Payments to non-shareholder employees
6. Timing and manner of paying bonuses to key people
7. What comparable businesses pay for similar services
8. Compensation agreements
9. The use of a formula to determine compensation

In the explanation of how the Section 199A proposed regulations apply, the IRS states:

“The phrase “reasonable compensation” is a well-known standard in the context of S corporations. Under Rev. Rul. 74-44, 1974-1 C.B. 287, S corporations must pay shareholder-employees “reasonable compensation for services performed” prior to making “dividend” distributions with respect to shareholder-employees’ stock in the S Corporation under section 1368.  See also David E. Watson, P.C. v. United States, 668 F.3d 1008, 1017 (8th Cir. 2012). The legislative history of Section 199A confirms that the reasonable compensation rule was intended to apply to S corporations.”

The IRS explanation goes on to say:

“The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in qualified business income.”

So from a federal tax perspective, the S corporation would generally want to pay no more than a reasonable level of compensation so that any remaining profit might be eligible for the 20% QBI deduction.  For an S corporation operating in Tennessee, the remaining corporate profit will of course be subject to the 6.5% Excise tax.

Price CPAs can assist S corporation owners in determining a compensation level that should meet the required reasonableness standard as well as other tax planning issues impacting the corporation. To schedule a conversation, contact us through http://www.pricecpas.com or at (615) 385-0686.

Blog article prepared by Mark Fly