To reduce state taxes, historically at this time of year S corporation owners are making their shareholder bonus lists and checking them twice; however, tax reform means a bonus may result in higher 2018 federal taxes.
The Tax Cuts and Jobs Act (TCJA) of 2017 established a 20% deduction for S corp. owners as operators of pass-through entities.
Any amount qualifying for the 20% deduction reduces gross income. For example, if the marginal before-deduction tax rate is 37%, the 20% deduction means an S corp. owner pays taxes on 80% of the end-of-year distribution, an actual rate of 29.6%.
A 29.6% rate is 10% below the maximum 2017 rate, a huge benefit for S corp. owners - except those in specified service businesses, including health; law; consulting; accounting; and financial services. Also, income earned as a salary isn’t eligible for the deduction.
In the past, when the federal tax rate was the same on both salary and pass-through income, an owner only needed to compare state income taxes to the payroll tax. The Tennessee excise tax on S corp. income was 6.5%, and the payroll tax was a combined 15.3% (or 2.9% once the social security maximum was reached). For owners that paid the Social Security maximum it would be tax-efficient to pay the Medicare tax on a bonus instead of the excise tax on the S corp. income. In Tennessee, bonuses and salaries were not subject to income tax.
Today, a bonus is subject to a federal tax rate up to 7.4% higher; the Medicare tax of 2.9%; and possibly an additional Medicare surcharge of 0.9% if in excess of $250,000. This combines for a 40.8% bonus cost in the maximum 37% tax bracket. The same income taxed at pass-through rates is 29.6% federal; 6.5% Tennessee excise; and 3% Tennessee Hall dividend tax - provided the owner takes a distribution equal to what would have been a bonus. With the deductibility of the excise tax, the combined rate is 37.1%, a more than 3% savings.
An additional consideration is that the maximum tax bracket does not kick in until $600,000 for married couples and $500,000 for singles. Since the pass-through benefit is 20% of an S corp. tax bracket, the answer may be different than in a lower bracket.
If an S corp. qualifies for the full 20% deduction, it’s advantageous to not pay big owner bonuses, as it subjects the money to higher tax liability. Instead, take them out as a distribution. And in terms of end-of-year decisions, try to delay the distribution until January because the Hall Tax drops to 2% in 2019 from its present 3%.
Procrastination in this case is your ally: don’t do in December what you can put off until January.