Paying Yourself More to Lower Your Tax Bill
Let’s talk about when paying yourself a higher salary can actually save you money.
Small business owners love S corporations. There are many reasons for this, the biggest one being that it is a great way to lower your self-employment tax. Income from sole-proprietors and partnerships is generally subject to a 15.3% self-employment tax (on top of the income tax), while income from an S corporation is not. There is a catch, however: an active owner of an S corporation must pay themselves a reasonable salary which is subject to the same 15.3% tax rate. While it is not possible to eliminate employment taxes completely using an S corporation, it is a great way to drastically reduce the amount owed each year. Our clients save thousands of dollars every year (individually) using this strategy.
In most cases, our goal as tax advisors is to help our S corporation clients reduce their salary to the lowest level possible while still satisfying the IRS requirement that the salary be “reasonable.” But the recent changes to our tax laws have created a scenario where it might actually make sense to pay yourself a higher salary instead. To understand how you can benefit from raising your salary you must first understand the Qualified Business Income Deduction (or QBI deduction).
Before diving into the details, we want to save everyone some time by outlining who can benefit from paying themselves a higher salary.
Who Can Benefit?
Business owners
Who pay themselves a salary out of their S corporation
Who have a taxable income of greater than $426,600 (married filing jointly or MFJ) or $213,300 (single, head of household, etc)
Who are not a specified service trade or business (see note)
A specified services business is any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. However, real estate agents and direct sellers are not considered to be in a specified services business.
If you read the list above and said, “Yup, that’s me” or “That might be me one day soon” then please continue reading. Everyone else can ignore the rest of this article. (See, told you we would save you some time!) But for the sake of closure, we’ll briefly explain why. If you are an employee and not a business owner your income does not qualify for the QBI deduction. If don’t pay yourself a salary out of an S corporation then you can’t manipulate your salary in order to maximize the deduction. If your income is lower than the amounts listed above, then good news, you are not subject to any QBI limitations. Finally, if you are a specified services business your deduction simply disappears at higher income levels—game over for you.
What is the QBI Deduction?
When the Tax Cuts and Jobs Act was passed, the corporate tax rate was reduced to 21%. This mostly affected big businesses. Congress also wanted to throw a bone to small businesses so they created a 20% deduction on income for small business owners. For most business owners the deduction is very straightforward and simple – you get a 20% deduction on your qualified business income (QBI). For example, a business owner with net income of $100,000 gets a $20,000 deduction. If that individual is in the 25% tax bracket that adds up to $5,000 in tax savings.
The deduction was designed for the “little guy”. As long as you make little guy money you get the deduction. Once you start making “big guy” money, the calculation starts to change. See below for a chart outlining how the deduction is calculated.
Okay, so when does it make sense to pay myself more?
The relationship between a reasonable salary and the QBI deduction comes into play when an owner of a business that is not a specified service business (e.g. a real estate agent or a door to door salesman) has taxable income over $426,600 ($213,300 if not married filing jointly). When taxable income has reached that threshold, the deduction is limited to 50% of W-2 wages paid, including wages paid to the owner.
Side note: For simplicity’s sake we are ignoring situations where taxable income is in the phase-out range (between $326,600-$426,600 for married filing jointly and $163,300 – $213,300 for all other filers) as well as situations where 2.5% of unadjusted basis affects the calculation. Diving into these scenarios, although important, would bore everyone to death and are beyond the scope of this article.
Let’s go through an example.
Ernesto owns an S corporation that sells solar panels door to door. In 2020 his company will earn $700,000 in net income (before owner’s salary). Ernesto decides to pay himself a salary of $137,700. He chooses this salary because it is the maximum amount of earnings subject to social security tax – a common safe haven for reasonable salaries. Assuming this is his only income his QBI deduction would be as follows:
QBI would be $562,300 ($700,000 – $137,700).
QBI deduction would be $68,850 – the lesser of $112,460 ($562,300 QBI x 20%) or $68,850 ($137,700 x 50%). Rather than 20% of QBI his deduction will be limited by 50% of W-2 wages.
Now let’s say before finalizing his salary he speaks with a tax advisor at Welch Olsen LLP who tells him to instead pay himself a salary of $200,000. His new QBI deduction would be as follows:
QBI would be $500,000 ($700,000 – $200,000).
QBI deduction would now be $100,000 – the lesser of $100,000 ($500,000 QBI x 20%) or $100,000 ($200,000 x 50%).
Ernesto paying himself a higher salary created an additional $31,150 deduction. It’s true that paying himself a higher salary will subject himself to additional Medicare tax, but even when netted against the additional tax his tax savings still add up to about $10,000 in taxes! $9,718 if you want to be exact.
If you made it this far into the article, we applaud you.
This topic is not for the faint of heart, but for certain business owners it is an idea that can save thousands. If you are one of those business owners who could benefit (refer to the “Who Can Benefit?” section at the top of this article), we would love to meet with you to discuss how to maximize your savings. Give us a call or contact us.