Qualifying a High Income S Corporation Under the New Tax Act

This post is in: Blog, Business

One of the best new strategies for most business owners is the 20% pass through income reduction, aka Section 199A, reduction.

As long as your taxable income on your tax return is under $315K (married, filing jointly) or $157.5 (single), taking the 20% income reduction is pretty straightforward.

If your taxable income is higher than that, you are subject to a wage limitation. The amount will depend on whether you are a service or a product company. Here’s just one of the many strategies from my new book, “Taxmageddon 2018”.

Now let’s assume you are the sole owner and employee of a product-based S Corporation that has $500,000 in profit. Your overall taxable income is above the first threshold ($315K for married, filing jointly, $157,500 for single) and because you have a product-based business and not a service-based business, the second threshold doesn’t matter.

Your 20% pass-through income reduction will be subject to wage limitation rules. That means you will be limited by the greater of either 50% of wages paid or 25% of wages paid and 2.5% of qualifying depreciable assets.

Based on that, let’s run through 3 alternatives.

#1: You take all of the income out in the form of salary. Salary is not subject to the pass-through reduction and the income is now reduced to zero. There is no pass-through income reduction because there is no pass-through income.

#2: You decide to take zero out in the form of salary. Let’s assume your qualified business income is $500,000. If your taxable income was below the threshold, you would have a $100,000 reduction ($500,000 * 20%). However, since your taxable income is above the threshold and so the wage limitation rules need to be considered.

You have no employees in this example and paid yourself no wages. There are no capital improvements in the business in this example. That means your wage limitation amount is zero. Your income deduction in this case is zero.

#3: The more likely case is that you pay yourself a reasonable salary, in accordance with the IRS guidelines. Let’s say that amount is $150,000.
Your profit would then be $350,000 ($500,000 – $150,000). Your initial pass-through income reduction would be $70,000 (20% of $350,000).

However, you are subject to the wage limitation. You are allowed up to 50% of wages paid, which would be $75,000.

The total amount of $70,000 is less than the limitation, so you would have a Section 199A (pass-through income reduction) of $70,000. Not bad.

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  1. Diane Kennedy says:

    The 20% income limitation applies only to pass-through income. It cannot be used as an offset for earned income, like W-2 wages from your S Corporation. The qualifying SEP (or other pension) deduction is determined based on earned income, not pass-through income.

    The 199A income limitation would not impact the qualifying pension contribution.

  2. Linda Czechowski says:

    Will the 20% reduction further limit the amount of SEP deductions and SE Health Care costs which is limited to the Schedule C net profit? Is this deduction above the line for states that source from AGI?

  3. Diane Kennedy says:

    If you are a service company and your taxable income is over the second threshold ($415K/$207.5K), there is no reduction. In that case, find a way to reduce your taxable income or possibly blend products with your service company to qualify as a product company.

  4. Steven says:

    How about if your a service company? any alternatives?

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