Eileen Shaw, ERISA Consultant
The 20% income exclusion for pass-through entities enacted as part of tax reform has created an
incentive for business owners to shift their income from W-2 compensation to pass-through income
with a potential tax relief of nearly 12%. However, the IRS will be scrutinizing what is “Reasonable
Compensation.”
The IRS focuses on Reasonable Compensation because it wants to ensure that salaries paid to owners
correlate to the services which they provide. Pass-through entities are often audited to determine
whether they have underpaid their shareholder-employees by shifting compensation to profit
distributions in an attempt to avoid paying payroll taxes. The tax arbitrage opportunity of the Tax
Reform Bill only increases the incentive for pass-through business owners to shift compensation to
profit distributions. However, because the IRS will be looking closely at these types of businesses, it will
be important for business owners to do their homework. They will need to support their compensation
with market data such as a Reasonable Compensation analysis.
Once the Reasonable Compensation issue is satisfied, the pass-through business owners must be aware
of the limitations and phase-outs for the 20% deduction. Pass-through business owners in any type of
profession, except architects and engineers, with income above $157,500 for a single filer and $315,00
for a person married filing jointly will have the 20% deduction reduced as their income increases. It will
be completely phased out for income above $207,500 for a single and $415,000 for someone married
filing jointly.
An option for those business owners to consider is utilizing retirement plans to defer income to keep
them below these thresholds. Qualified retirement plans, both 401(k)s and cash balance plans are
above the line tax deductions which will reduce a small business owner’s adjusted gross income. For
example, a 55-year-old business owner could contribute as much as $166,000 per year to a cash balance
pension plan thus substantially reducing his personal income. In some cases, this is enough of a
reduction to allow the business owners to qualify for the full 20% deduction.
Something else to consider is that many small business owners’ profits are passed through and taxed at the
owners’ individual rates which tax reform reduced from 39.6% to 37%. Although this is an
immediate tax reduction, there still may be a significant benefit to deferring the income and taxes. This can be
complicated! That is why it is important for pass-through business owners to work with their advisors to
analyze whether saving in a qualified retirement plan makes sense for them.
