CONSULTING AND PLANNING WITH IRC §199A
Original Article by Jay Knighton Board Certified Estate Planning and Probate - Texas Board of Legal Specialization
As we transition deeper into 2018, more and more clients are seeking our advice
regarding strategies involving IRC §199A. One common theme that I want to bring to your
attention (personally and professionally) involves the interplay between owner salary and profits.
My goal for you in reading this paper is to provide you with consulting tools that will help your
clients not only reduce their taxes, but also to create additional cash flow that will help them
accomplish personal and business goals. This paper:
- Provides you with perspective regarding owner salary vs. profits
- Explains the important concepts necessary and helpful to the analysis
- Sets forth an Example to apply the concepts
- Lists issues for you to spot and enhance your services that you provide to clients.
Perspective
This year I seem to have one meeting after another whereby the client measures business
success by how much they, as an owner, pay themselves. Practically every week of the year this
year, I have met with a business client, reviewed the client’s Profit and Loss statement, and
realized that the client is paying himself a significant amount in salary. I explain that if the client
owns the business, the client should focus more on profit than salary. The client typically looks
at me very confused and states something along the lines that he needs $300,000 to live on, so he
takes $300,000 as salary, leaving little to nothing for profit.
That reasoning is backwards. I am sure that everyone reading this realizes that a business
should manage to profit and not to an expense number like salary. Yet I have met with dozens of
businesses in the first five months of the year, successful businesses, mind you, that do not
manage to profit, but instead manage to a set salary.
Managing to a salary is a poor business management strategy regardless of this new IRC
§199A, but in general, is poor strategy looking forward due to several other reasons that I will
briefly list as follows:
- Volunteering for employment taxes. If an entity is taxed as an S corporation, and the owner-employee pays himself a reasonable salary, the Internal Revenue Code does not apply employment taxes to distributions of net income (distributions of net income = profit). If an owner-employee pays himself more than a reasonable salary, the owner is volunteering to pay $2,900 in employment taxes for every $100,000 of additional salary over and above the reasonable salary standard.
- Managing the business to pay a high salary often requires owners to pull from lines of credit, extend credit card payments, and make other credit decisions that incur interest expenses – all in order to maintain sufficient cash flow to pay the high salary.
- The skewed, higher salary understates profit, which is a key consideration for bank loans and eventual sale of the business.
- Managing the business finances (revenue and expenses) in order to achieve a high salary rather than managing the business finances to achieve a solid profit creates an inefficient and narrow-minded focus for business decisions.
We are focused on the new IRC §199A, so I will not delve much into the above points.
So what does IRC §199A have to do with salary and its interplay with profits?
IRC §199A
In order to understand how clients can utilize IRC §199A in a way to maximize its
benefits, below I will explain 5 concepts. Each concept leads into the next concept, so beginning
with the fundamental business equation is the foundation for understanding the end result of the
planning.
Concept #1 – Fundamental Business Equation
- Revenue
- Expense
- Profit
Every business taxpayer should have a good idea of its industry Profit Margin (Profit divided by
Revenue), then manage the business in a way to attain that average Profit Margin or exceed it.
Likewise, every business taxpayer should at least roughly understand the percentage of revenue
necessary to cover payroll, as well as the industry average for the business.
Concept #2 – Reasonable Salary
Every business owner who is also an employee should pay himself a reasonable salary.
The pertinent case is David E. Watson, P.C. v. United States, whereby the IRS established that
businesses must pay owner-employees a reasonable salary. Historically, the IRS has generally
accepted the wage base amount for social security as a reasonable salary. The 2018 wage base
amount is $128,400. Various industries may require adjustment to that amount, but for
discussion purposes, I shall focus on that amount.
Concept #3 – Medicare Tax of 2.9% Applies to Salary in Excess of Reasonable Salary
The combined employer/employee Medicare Tax of 2.9% applies to all salary in excess
of the $128,400 wage base. If a client is both an owner and employee, that 2.9% tax reduces
profit. In simple math, for every $100,000 of salary that exceeds the reasonable salary threshold,
the owner’s profit reduces by $2,900.
For entities taxed as an S corporation, if the owner-employee pays himself a reasonable
salary, the Internal Revenue Code does not levy employment taxes upon distributions of net
income (distributions of net income = profit). If an owner-employee pays himself more than a
reasonable salary, the owner is volunteering to pay employment taxes.
Assume for purposes of discussion that a reasonable salary is $128,400, which means that
for every $100,000 of additional salary over and above the reasonable salary standard, the owner
is paying $2,900 in employment taxes.
Concept #4 – Four Simplified Rules for Understanding and Applying IRC §199A
The analysis under Section §199A strictly applies to entities taxed as partnerships, S
corporations, and disregarded entities (LLCs or sole proprietorships). Entities taxed as C
corporations already received their tax benefit in the form of the 21% flat income tax rate.
(although for closely held C corporations, that 21% flat rate is often not a benefit). I am reluctant
to disrupt the flow of this paper, so I included the IRC §199A phase-out analysis and examples to
an Exhibit attached to this paper. Yet, for comprehension purposes as it pertains to this topic,
below please find the relevant rules.
Rule One:
The business must be taxed as a partnership, S corporation, or disregarded
entity. Businesses taxed under one of those three methods are known as “Qualifying
Businesses”. The planning contemplated by this paper focuses only on S corporations.
Rule Two:
If the business is a Qualifying Business, the business is entitled to a
deduction equal to 20% of the business’s Qualified Business Income (“QBI”). QBI is defined as
the net amount of items of income, gain, deduction, and loss with respect to the business. For
discussion of QBI, think “profit”.
Rule Three:
Phase-outs apply! The above two rules sound fantastic until you get to the
limitations. For individual taxpayers with taxable income greater than $157,500 ($315,000 for
joint filers), QBI from a “Specified Service” business begins to phase-out. A “Specified Service”
business is a business involving the performance of services in the fields of health, law,
consulting, athletics, financial or brokerage services. If the business is not a “Specified Service”
business, Rule Four provides the applicable phase-out.
Rule four:
For non-“Specified Service” businesses, Individual Taxable Income is
greater than the threshold of $207,500. For joint filers, Taxable Income is greater than $415,000.
For taxpayers with taxable income more than those thresholds, as long as those taxpayers are not
determining their QBI from a Specified Service Business, we must apply a completely different
phase-out. This phase-out is based either on: (1) wages paid; or, (2) wages paid plus a capital
element.
In this situation, the deduction for QBI cannot exceed the greater of:
- 50% of the W-2 wages paid with respect to the Qualifying Business; or
- 25% of W-2 wages + 2.5% of the unadjusted basis immediately after acquisition
of depreciable property used in the business (including real estate).
Concept #5 – IRC §199A Applies to Profit
Consider our friendly client who pays himself a large amount in wages and salary, which
reduces profit. By paying himself a large salary, the client is negating the benefit of the 20%
reduction of Qualified Business Income via the new IRC §199A.
Example
Based on the five Concepts above, let us apply the Concepts to the following real life
example:
Client owns an LLC taxed as an S corporation. Client is a professional service provider such that
his business falls squarely in the possible exclusion of Rule Three under IRC §199A. Client is
married and files jointly with his wife. He gave himself a raise this year to $300,000, and strives
to receive profits of approximately $15,000. When asked why client pays himself such a high
salary, Client informed me that $300,000 in salary is the amount he needs to make in order to
sustain his lifestyle with profit, if any, going toward savings.
Assume Client’s income tax rate is 25%.
- Current Tax Effect:
- Client pays employment tax on $300,000 of wages and salary, which equals $24,621.60.
- Client pays income tax on $300,000 wages and salary, which equals $75,000.00.
- Client pays no employment taxes on profits.
- Client gets to reduce his profits from his S corporation by 20%, thus pays income tax
only on $12,000 of profits. - Client’s income tax on $12,000 of profits equals $3,000.
- Client’s earnings equaled $315,000. After taxes, Client was able to deposit in his bank
$212,354.80.
- Adjusted Facts to Fully Utilize §199A:
- Instead of the above, let’s consult with the client and encourage him to pay himself
$130,000 as a reasonable salary with the remainder managed to produce a profit of $185,000. - Client pays employment tax on $130,000 of wages and salary, which equals $19,691.60.
- Client pays income tax on $130,000 of wages and salary, which equals $32,500.
- Client pays no employment taxes on profits.
- Client gets to reduce his profits from his S corporation by 20%, thus pays income tax
only on $148,000 of profits. - Client’s income tax on $148,000 of profits equals $37,000.
- Client’s earnings equaled $315,000. After taxes, Client was able to deposit in his bank
$225,808.40.
- Instead of the above, let’s consult with the client and encourage him to pay himself
The above example illustrates a difference of $13,453.60 AFTER TAXES. As my wife
says, you can do a lot of things with an extra $13,453.60! In fact, the client could use that
$13,453.60 to fund an IRA, acquire key-man life insurance for business succession planning, pay
down lines of credit, position the business (due to increased profit) for a future sale, a nice family
vacation, or a host of other possibilities.
