Reasonable Compensation: The X Factor in the QBI

Tax Reform- Reasonable Compensation

If you’ve sat down with pencil and paper or an Excel spreadsheet and attempted to map out what Section 199A deduction for Qualified Business Income (QBI) means to your pass-through business clients, then you’ve likely encountered circular logic, or with Excel – the circular reference error. And if you’ve been paying attention, even a little bit, to the conversations regarding Section 199A, then you have heard (over and over again) that this section of the Tax Cut and Jobs Act (TCJA) is arguably one of the most, if not the most challenging provision.

Since the TCJA passed, Jack and I have been fielding countless calls and emails from advisors wondering what affect Reasonable Compensation will have on entity selection and the Section 199A deduction. And without doubt (and with good reason) advisors are frustrated with the way Section 199A was crafted, and hungry for Congress and the IRS to clarify the provision.

Jack and I are fortunate to have built a vast network of thought leaders across many spectrums –   including top educators, former IRS examiners & appeals agent’s, valuation experts and niche practitioners specializing in closely-held businesses. The conversations we’ve had so far are, for the most part, inconclusive. To share much of what we have discussed would be irresponsible because most of what is being discussed right now are speculation. Speculation on what Congress’s intent was, what regulations the IRS will put into place, and what changes will be made this year.

There are, however, three points that just about everyone we have talked with agrees upon.

  • First: Reasonable Compensation is the X-factor when it comes to entity planning.
  • Second: A successful IRS Reasonable Compensation challenge will have shocking consequences to the taxpayer and their preparer.
  • Third: All Reasonable Compensation figures should be documented using an independent, unbiased source (and the TCJA gives advisors the perfect opportunity to require that documentation if they’re not already doing so).

The consensus on these three points comes from the same circular logic we referenced at the start:

The 199A deduction relies on the business’s profit and the taxable income of the taxpayer as reported on their 1040 (which includes W-2 income AKA Reasonable Compensation). If filing a married filing joint tax return this would be the joint taxable income. Therefore a change to the business’s income or the amount of Reasonable Compensation paid will cause changes on the taxpayers 1040, and those changes on the 1040 will impact the 199A deduction, that in turn may impact the optimum entity type for that taxpayer for that tax year… Ouch, my head is aching again.

Now if it were a simple process to select the optimum entity type each year by just checking a box when filling out the tax return, then the impact of section 199A may not be as severe. However, that’s not the case and most of us are also quite aware of the wide swings in income that most closely-held businesses experience.

Most experts agree that ball-parking, estimating or otherwise guessing at a Reasonable Compensation figure for an S Corp. owner is both irresponsible and reckless. Because of the circular logic built into section 199A, being unreasonably low or unreasonably high could negatively impact your client’s 199A deduction, so there is no simple rule of thumb or safe harbor that advisors can use (and there never was – don’t get us started…) The best course of action is an independent, unbiased Reasonable Compensation Report that protects both the tax preparer and their client.

While we all wait for better direction, rules, and regulations from Congress and the IRS, you have the perfect opportunity to sit down with your clients (or if a meeting isn’t feasible, to send them an issue letter) and explain the new realities of Reasonable Compensation, the QBI and its effects on their overall tax position.

Below are links to a few of the better thought-out articles on section 199A:

What Is a Pass-Through Entity?

Entity Planning April 17, 2024

A Guide to Salary Benchmarking

Best Practices March 20, 2024

S Corp Salary 50/50 Rule: A Complete Guide

Entity Planning March 8, 2024

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