This is Part 3 of a four-part series on the qualified business income deduction. Missed the first two? Read Part 1 and Part 2 — they're here.
Still on paychecks this week. Last week I told you which side of the line you're probably on. If you're over it, this is the post that matters to you.
Dev's problem was that his business didn't pay out enough in wages for the deduction to work — the 20% one your CPA calls the QBI deduction. So the fix looks easy: put yourself on payroll. Set the business up as an S corporation. Pay yourself a real salary, and watch the deduction go up.
It does go up. Dev's — the business owner in our example — almost doubled. In real money, depending on his bracket, that was worth about $15,000 a year.
One thing didn't change. All that work Dev contracts out — the fulfillment, the ads, the developer who runs the site — still isn't payroll. Those invoices didn't turn into paychecks because he incorporated. The only number that moved was his own. For a business that runs lean on contractors, the owner's S-corp salary is often the only lever there is to move. That makes getting it right worth more, not less.
But if you keep raising your salary, the deduction starts coming back down. That catches people off guard. I like to camp on it for a minute, so you really understand it.
Your salary is an expense to your business. Every dollar you move out of profit and into your own paycheck does two things at the same time. It raises the wage number, which helps you. And it lowers the profit, which is what the 20 percent comes out of. And that hurts you.
Pay yourself too little and the wage rule caps your deduction. Pay yourself too much and there isn't much profit left to take 20 percent of. There's a number in between that beats both.
You can find that number. It's probably not the round figure somebody picked years ago because it sounded fair. $150,000. $200,000. $250,000. Nobody got to those by doing math.
You don't get to pick whatever S-corp salary makes your deduction biggest, though. The IRS expects you to pay yourself a reasonable amount for the work you actually do, at a business like yours, in a market like yours. Paying yourself too little to chase a bigger deduction is a good way to get your return looked at.
So when somebody asks me what salary gets them the biggest QBI deduction, I tell them that's the wrong question. What's fair for the work you actually do? Then, inside that range, what works best?
Timing is also crucial. You set this up going forward. You can't decide in April how you were paid last year — as normal as your CPA might make that feel. Same as that $90,000 I told you about last week; it was already final on December 31.
Has anybody ever checked that for you? Most of the time when I ask, the answer is no. Not because your CPA was careless — because nobody ever asked them to look, and it doesn't come up on its own.
If you want someone to actually run the numbers on your S-corp salary and QBI deduction before year-end closes the door on it, let's talk.
Next week, the last one: two owners, the same income, and $100,000 between them.
Your salary works in two directions at once. It raises the W-2 wage figure that the deduction is capped against, which helps if you were under-paying yourself. But because salary is a business expense, it also lowers your profit — and the 20% deduction is calculated on that profit. Too little salary and the wage cap limits you; too much and there isn't enough profit left to deduct against.
There is a middle number that beats both extremes, but you don't get to simply pick whatever salary makes the deduction biggest. The IRS requires reasonable compensation for the work you actually perform. The right approach is to find the fair range for your role first, then optimize within it.
No. Compensation is set going forward. The wages on your employees' and your own W-2s are final at year-end, so you can't decide in April how you were paid the prior year. This is a planning move you make before December 31, not a filing-season fix.
Not by itself. Putting the owner on payroll can raise the wage figure the deduction is capped against, which often helps lean, contractor-heavy businesses. But contractor invoices still don't count as wages, and setting the salary too high can erode the profit the deduction is based on. The benefit depends on getting the salary level right.
Paying yourself an unreasonably low salary to inflate the QBI deduction can trigger IRS scrutiny. The agency can reclassify distributions as wages and assess back payroll taxes, interest, and penalties. Reasonable compensation isn't optional — it's the boundary you optimize within.
This is Part 3 of the series. Catch up on the earlier parts:
These are composites and I've rounded the numbers to keep them readable. Your situation depends on things I cannot possibly know without a conversation with you. So take this as a reason to ask your own tax advisor a question — not as advice about your return.
Disclaimer: This article is for general educational purposes only and does not constitute tax, legal, or accounting advice. The interaction between your S-corp salary, reasonable compensation, and the QBI deduction depends on your specific facts and circumstances. Please consult a qualified tax professional before setting or changing your compensation.