S Corp Maximizing the QBI deduction

[Malum Prohibitum]

Online resources about the QBI mainly focus on getting income under the threshold.  I am in a service business, but I am well under the QBI threshold (MFJ).  I own an S corp, so I pay myself a salary.  As I understand it, the QBI 20% deduction applies to my income less my w-2 salary.

Am I correct?

Hypothetical - say I have $180,000 income and pay myself $96,000.  180-96=$84,000 x 20%.  QBI deduction equals $16,800.

So what if I lower my salary for the rest of 2021?  This helps me, right?  $96K is essentially $4k per paycheck.  If I cut my paycheck in half for the rest of the year to $2000 per paycheck, I get two savings, right?  First, I save on payroll tax, and, second, the QBI goes up. 

So here is how that hypothetical would work. There are 7 paychecks left in 2021.  So cutting them to $2,000 would lower salary by $14,000.  Instead of $96,000, it would be $82,000.   

QBI is $180,000 - $82,000= $98,000.   QBI deduction increases from $16,800 to $19,600, almost $3000 of increased QBI deduction.


Obviously, playing around with lowering salary can get many different numbers.  Cut salary to $0 for the remainder of the year, and salary is only $68,000 for the year.  180-68=112,000 x 20% =$22,400 QBI deduction, which is $5600 more than the first example.


Am I missing something, or can I keep increasing my payroll tax savings and QBI deduction all the way to the point that the IRS says the compensation is not "reasonable" for a person in my position.  Is that the only concern?

Assume no other employees for 2021.


I realize the actual tax savings is not huge, as my overall tax burden is not high, but every bit of payroll tax and income tax I can save is now money for my and my family.

So, punch me in the face if I am not seeing everything I should be seeing.

[SeattleCPA]

You are correct that if you can zero out your wages you save.

You would avoid payroll taxes if you paid zero wages to your shareholder-employee, for example.

You would also increase the size of your QBI deduction because your QBI increases by not paying wages.

The real problem or obstacle, and you probably know this already, you can't just zero out your wages. The rule is you need to pay the shareholder-employee reasonable wages.

BTW I've got a bunch of content about 199A (the qualified business income deduction) at my blog. Dozens of articles I bet:

https://evergreensmallbusiness.com/?s=199A

[Malum Prohibitum]

Thank you!  I will definitely visit that link and look around at your articles.

For clarification, though, I would not be "zero" wages for the year.  If I stopped paying wages for the remainder of the year, my wages would still be $68,000, as that is the amount already paid.  So the only question is whether $68,000 is reasonable to generate $180,000 of income.

Thank you for your response.

[bacchi]

Thank you!  I will definitely visit that link and look around at your articles.

For clarification, though, I would not be "zero" wages for the year.  If I stopped paying wages for the remainder of the year, my wages would still be $68,000, as that is the amount already paid.  So the only question is whether $68,000 is reasonable to generate $180,000 of income.

Thank you for your response.

Won't the IRS computers take a second glance if you had a lower salary this year, with more distributions, but had a similar income as last year? If that's the case.

[Malum Prohibitum]

Thank you!  I will definitely visit that link and look around at your articles.

For clarification, though, I would not be "zero" wages for the year.  If I stopped paying wages for the remainder of the year, my wages would still be $68,000, as that is the amount already paid.  So the only question is whether $68,000 is reasonable to generate $180,000 of income.

Thank you for your response.

Won't the IRS computers take a second glance if you had a lower salary this year, with more distributions, but had a similar income as last year? If that's the case.

I do not know the answer to this question.   

[Johnny]

Depending on the situation, QBI has made the traditional S corp tax election not so advantageous anymore. There are instances where a single-member LLC makes more sense now that QBI is in the picture (at least through 2025 unless it gets extended).

The Tax Advisor also has extensive details on this. Fair warning through, the rules are really convoluted. It took me hours to scour internet resources and playing with my specific tax situation to see what's best:

https://www.thetaxadviser.com/issues/2020/mar/optimal-choice-entity-qbi-deduction.html

[Malum Prohibitum]

Depending on the situation, QBI has made the traditional S corp tax election not so advantageous anymore. There are instances where a single-member LLC makes more sense now that QBI is in the picture (at least through 2025 unless it gets extended).

The Tax Advisor also has extensive details on this. Fair warning through, the rules are really convoluted. It took me hours to scour internet resources and playing with my specific tax situation to see what's best:

https://www.thetaxadviser.com/issues/2020/mar/optimal-choice-entity-qbi-deduction.html

Like you said, depending on the situation.

It gets even more complicated when you try to determine overall tax savings, including payroll taxes.

For example, the payroll tax cap is $142,800.  That cap is for social security only, not medicare, but that is 12.4%.  If your income is $150k, you can as an S Corp pay yourself $75k in salary and $75k in distributions without drawing too much undesirable attention to yourself.  This move saves the 12.4% on the difference between $75 and $142.8, which is a savings of $8,407.20 in payroll taxes.

The QBI also applies to that $75k, a $15,000 deduction, worth about $3300 in tax savings (this is why my question was posed originally, above, as a higher salary would cost more payroll tax and lower the QBI, which increases income taxes, too, a double whammy).

In an LLC, isn't the entire $142,800 subject to the 12.4% social security tax?  If I am right, then that $8407.20 of payroll tax savings disappears.  Does the increased QBI make up for it?

I don't think so. 20% of 150k is a $30,000 deduction, but that would save a person less in income taxes than the extra payroll tax would cost (assuming married filing jointly, etc.).

So I guess there is no one right answer, but for my situation it appears S corp and lower salary is the way to go for overall savings from the tax man.  None of the above numbers are exactly mine, but I am well below the threshold for QBI and in the range of income where I can save some payroll tax on social security by using the S corp to pay a part of my income as profit distributions to me, the shareholder.

[SeattleCPA]

Depending on the situation, QBI has made the traditional S corp tax election not so advantageous anymore. There are instances where a single-member LLC makes more sense now that QBI is in the picture (at least through 2025 unless it gets extended).

The Tax Advisor also has extensive details on this. Fair warning through, the rules are really convoluted. It took me hours to scour internet resources and playing with my specific tax situation to see what's best:

https://www.thetaxadviser.com/issues/2020/mar/optimal-choice-entity-qbi-deduction.html

I think this possibility has been greatly exaggerated by some.

In most situations--and I taught thousands of CPA firms about 199A via our technical whitepaper and blogging--the thing that gets missed is the QBI deduction equals 20% of the lessor of your taxable income or of your QBI.

Accordingly someone who, to make the numbers easy, compares $200K in business income from a sole proprietorship versus $50K in W-2 wages and $150K in business income from an S corporation hasn't really lost out.

I.e., they didn't get to choose between 20% of $150K or 20% of 200K.

The reason is that $200K of sole proprietorship profit got reduced for the following items:
-Their SEP-IRA which was say $40K
-Their SE health insurance which was say $20K
-Their standard deduction which was say $25K

The sole proprietor actually got a QBI deduction of, using numbers above equal to 20% of $200K-$85K, so $23K

That saves maybe $5K-$6K in federal income taxes. Which is good. But when you work on the 199A number for the S corporation, it's very similar. If complicated to calculate.

And then the S corporation we're comparing that to probably saves about $12K in payroll taxes.

[SeattleCPA]

Thank you!  I will definitely visit that link and look around at your articles.

For clarification, though, I would not be "zero" wages for the year.  If I stopped paying wages for the remainder of the year, my wages would still be $68,000, as that is the amount already paid.  So the only question is whether $68,000 is reasonable to generate $180,000 of income.

Thank you for your response.

So you determine whether you meet the reasonable compensation threshold by looking at what an employer would pay someone to do the job you're doing.

That $68K might be fine. Especially if you have (say) generous fringe benefits and a nice big fat pension.

This blog post provides some tips that may be useful: https://evergreensmallbusiness.com/s-corporation-reasonable-compensation/