What did we do here? We assumed a $200,000 net business income before shareholder salary is paid. Let’s say we were paying $40,000 and we read this amazing article on WCG (formerly Watson CPA Group)’s website that suggests a salary of $55,800 would maximize Section 199A deduction. How does that convert into cash in pocket?
By having a salary too low we lost $2,499 assuming a 22% marginal tax rate. In other words, since our Section 199A deduction is limited by our W-2 of $40,000, we lost $2,499 in tax benefit. The calculation is 22% x the difference in Section 199A calculations between W-2 limit and net business income limit ($11,360 x 22% is $2,499).
But the cost of increasing reasonable S Corp shareholder salary to $55,800 also increased Social Security, Medicare and other payroll taxes by $2,195. A quick note of caution here- the employer portion was assumed to be 8% however, there is an income tax deduction since this 8% decreases the net business income and therefore reduces income taxes. In other words, 8% is truly 8% x (1 – 22%) or about 6.24%. We are getting deep into the weeds here, but you get the idea.
All these gyrations end up with $305 in your pocket. Not bad. A night at Gallagher’s on the house!
Also keep in mind that as salaries increase beyond the social security wage and unemployment wage caps, the payroll tax portion will change resulting in a different equilibrium percentage. This is why we suggest that the 28.57% number floating around out there on the internets, yes, plural, is practical but not exact.
If you are sitting there scratching your head and saying, “What is this Section 199A deduction you speak of?” you are in good hands. We have a massive article on the topic with some cool examples with Fred, Barney, Wilma and Mr. Slate-
