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Section 199A Pass-Thru Salary Optimization

Article ID: 395
Last updated: 17 Jan, 2019
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By Jason Watson ()
Posted January 17, 2019

Speaking of W-2s, there is some optimization that is necessary for a small business owner to get the most from the Section 199A deduction. On one hand we want to reduce W-2 salaries to shareholders to minimize self-employment taxes. This was obvious in an early chapter on the benefits of an S Corp. On the other hand, we want to increase W-2 salaries so they do not limit the amount of Section 199A that is deducted.

You might have seen a number of 28.57% on the internets. This is practically correct, but technically incorrect since it does not factor in employer payroll taxes. We say practically correct since the difference is immaterial.

Let’s look at the data-

Biz Income

415,000

415,000

415,000

Salary

83,000

145,250

115,930

Payroll Tax (Employer)

6,640

11,620

9,274

Net Biz Income

325,360

258,130

289,795

Section 199A W-2 Limit

41,500

72,625

57,965

Section 199A NBI Limit

65,072

51,626

57,959

Salary %

20.0%

35.0%

27.9%

We assumed that the employer payroll tax portion is 8% of the salary. This includes Social Security, Medicare and unemployment taxes. This might be higher in some states, but let’s play along with 8%.

As you can see, the $83,000 salary (or 20%) results in Section 199A deduction being limited by W-2 amount. Next, the $145,250 salary results in Section 199A deduction being limited by net business income (NBI). Recall that the Section 199A deduction is the lower of these two numbers.

Using Excel’s solver plug-in, or manually changing the salary to bracket the two limits, results in a salary of $27,935 or 27.9%. This magical W-2 optimization for maximizing Section 199A deduction means that both W-2 and net business income limits are the same, and neither is specifically controlling.

Keep in mind that this is all wages paid! If you have employees besides yourself then you have do a few more steps in determining the optimized salary-

Biz Income After Wages

500,000

All Wages

125,000

Biz Income Before Wages

625,000

Section 199A Optimized Wages @ 27.9%

174,375

less Wages Already Paid

125,000

Deficit

49,375

In this example, wages paid needs to increase $49,375. In other words, the owner(s) should take a bonus so that the Section 199A deduction is not wage-limited. We recently consulted with a retailer who made about $9M after wages. We did the above computation, and concluded that he needed to bonus out another $1,1M to himself as wages. After factoring in the additional Medicare taxes and the cost for the payroll amendments (since it was the prior year), he put $245,000 in his pocket. We proved this with before and after tax returns. Yeah, he was playing around with some big numbers, but you get the idea.

Our tax software is very expensive, and it has a wonderful worksheet that sorts through the limits, and we can easily make adjustments of salary based on the limiting factor. However, keep in mind that most S corporations are paying anywhere from 30% to 40%, and sometimes as high as 60%, in salary to the shareholders. So, the 27.9% Section 199A optimization percentage is somewhat theoretical, and primarily reserved for only a handful of S Corps such as retailers.

Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition
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