S Corporation Reasonable Compensation and §199A
Lena is the sole shareholder-employee of L Consulting Inc., an S corporation. In 2025 the corporation has net profit before any salary to Lena of $300,000. Lena takes no salary and withdraws $300,000 as a distribution. She works full time as the only consultant, controls her own schedule, has no written employment agreement, and has 15 years of experience. Her CPA warns that the IRS may reclassify part of the distribution as wages. Lena proposes a $60,000 salary to reduce payroll taxes. Assume reasonable compensation for her services is $120,000. Her taxable income before the §199A deduction is below the threshold, and the business is an SSTB. The payroll tax rate is 15.3% on wages up to the Social Security wage base and 2.9% for Medicare. Lena asks how the $0, $60,000, and $120,000 salary options affect payroll tax, income tax, and her §199A deduction.
1. Assess the reasonable-compensation risk of the $0 and $60,000 salary options.
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Reasonable compensation is based on all facts: Lena's training, 15 years of experience, full-time services, control, responsibilities, and comparable pay for consultants. Paying $0 or $60,000 while taking $300,000 as distributions is a classic reclassification risk. The IRS can treat part of the distribution as wages, assess the employer and employee payroll taxes, and add penalties and interest. A written employment agreement and board minutes documenting $120,000 would support the position. The $60,000 proposal is better than $0 but still below the assumed $120,000 reasonable compensation, so it does not eliminate the risk. Lena should adopt $120,000, run payroll, and pay the employer and employee shares.
2. Compute the payroll tax and §199A deduction for each salary option, ignoring the employer payroll tax deduction.
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Using the stated 15.3% rate and ignoring the employer payroll tax deduction: $0 salary: payroll tax $0; QBI = $300,000; §199A deduction = 20% × $300,000 = $60,000. $60,000 salary: payroll tax = 15.3% × $60,000 = $9,180; QBI = $300,000 − $60,000 = $240,000; deduction = $48,000. $120,000 salary: payroll tax = 15.3% × $120,000 = $18,360; QBI = $180,000; deduction = $36,000. The salary reduces the QBI deduction by $12,000 at $60,000 and by $24,000 at $120,000. At a 24% marginal rate, the income tax cost of the lost QBI deduction is $2,880 and $5,760, respectively, before considering the employer payroll tax deduction. The $120,000 salary costs more payroll tax but is the defensible reasonable-compensation position.
3. How would the analysis change if Lena's taxable income were above the §199A threshold and phase-in range?
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Above the §199A threshold and within the phase-in range, the SSTB limitation phases out the QBI deduction. If Lena's taxable income is high enough that the deduction is fully phased out, the $36,000 or $48,000 QBI deductions disappear, so the salary's QBI cost is reduced or eliminated. Payroll tax remains a real cost. The reasonable-compensation requirement does not disappear: the IRS can still reclassify distributions, and the payroll tax exposure plus penalties may exceed the QBI benefit. At high income, Lena should set a defensible salary, such as $120,000, and document it, rather than sacrificing compliance for a QBI deduction that may be unavailable. If the business were not an SSTB, the wage limitation and QBI analysis would differ.