S-Corp Reasonable Compensation — The Math Changed With OBBBA

The advice most S-corp owners have heard for a decade — “pay yourself a reasonable salary, take the rest as distributions to dodge payroll tax” — is a rule of thumb from a different tax code. It got the answer right most of the time when the QBI deduction was scheduled to sunset. It gets the answer wrong for a nontrivial share of S-corp owners under the code we actually file under now.

OBBBA made § 199A permanent and raised the SSTB phase-in thresholds materially. That single change turns S-corp compensation from a payroll-tax exercise into a two-variable optimization: minimize payroll tax and maximize the QBI deduction. The two levers pull in opposite directions, and getting it wrong now compounds across every year of a permanent deduction rather than washing out in a sunset.

Here’s the math we run.

The three-lever tradeoff nobody drew for you

Every dollar an S-corp owner takes as W-2 wages instead of distribution does three things at once:

1. Costs 15.3% in combined payroll taxes up to the Social Security wage base (roughly $170K, indexed) and 2.9% Medicare plus 0.9% Additional Medicare above that. Net cost to the owner is roughly 14.1% below the SS base and 3.8% above it.
2. Reduces QBI dollar-for-dollar. Owner-employee wages are not QBI, so every wage dollar shrinks the base for a 20% deduction. Below the phase-in threshold, that’s a real 7.4% loss on the margin at the top bracket.
3. Adds to the W-2 wage limit used above the phase-in threshold — roughly $400K for MFJ under current indexing, with OBBBA meaningfully widening the top of the phase-in range. Above the threshold the QBI deduction is capped at the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of UBIA. Below it, that limit doesn’t apply. Above it, wages unlock the deduction rather than shrink it.

The third lever is the one the rule of thumb was built to ignore — and it’s why the answer flips at the threshold.

Below the phase-in threshold, wages are a drag

For a single S-corp owner under roughly $200K of taxable income — or a couple under roughly $400K — the W-2 wage limit doesn’t apply. The QBI deduction is a clean 20% of qualified business income, capped only by 20% of taxable income minus net capital gains. In that zone, every wage dollar you pay yourself is pure QBI drag.

Stylized case: a solo consultant S-corp with $300K of net income before owner compensation, MFJ filers with a spouse earning $75K — well inside the below-threshold zone. Move $75K from salary to distribution and payroll taxes drop by roughly $9K while the QBI deduction rises by roughly $15K, worth another $3,500 in federal tax saved at the applicable marginal rate. Net: a swing of $10K–$12K just from repositioning the wage number.

The IRS still requires a defensible reasonable-comp number. The point isn’t to zero out wages — it’s that below the threshold, the reasonable-comp number is the floor of the optimization, not the anchor of it. Most owners we inherit in this bracket are overpaying wages and shrinking their own deduction.

Above the phase-in threshold, the answer flips

Above the phase-in threshold, the W-2 wage limit binds. Draw zero wages and the 50% W-2 test is zero, the 25% + 2.5% UBIA test is likely zero for a service business with no depreciable property, and the QBI deduction collapses to nothing. Wages now buy the deduction.

Every dollar of W-2 wages allows up to $2 of QBI to clear the 50% test. If the business has $2 of QBI available for every wage dollar, wages unlock a 20% deduction — a federal tax saving of up to 7.4 cents on the QBI dollar. Payroll tax on the wage above the SS base is 3.8% net. The QBI unlock beats the payroll cost, but only up to the point where wages fully satisfy the 50% test on the residual QBI base. Beyond that, incremental wages are pure drag again.

For a non-SSTB business with $1M of pre-comp income, the crossover sits somewhere around $250–300K of W-2 wages. The exact number depends on state tax, retirement plan contributions, and whether the business is an SSTB (specified service trade or business — health, law, accounting, consulting, financial services, and others). SSTB phase-out is complete above the top of the phase-in range, at which point the wage optimization collapses back to a pure payroll-tax exercise.

SSTB status changes the shape entirely

OBBBA moved the SSTB phase-in thresholds up, but the SSTB machinery itself is unchanged. Above the top of the phase-in range, an SSTB owner gets zero QBI deduction. Below the bottom, an SSTB owner gets a full deduction like anyone else. Inside the range, the deduction phases out linearly.

For a CPA firm, a law firm, a consulting practice, or a financial-services shop, the wage decision interacts with SSTB status. Higher wages reduce QBI and reduce taxable income, which can pull the owner back down inside the phase-in range or below it. We’ve seen SSTB owners chase a wage number designed to minimize payroll tax and, in doing so, push themselves into the full SSTB phase-out. The right answer is often the opposite: raise wages, reduce taxable income, keep the QBI deduction alive on the remaining pass-through. The QBI savings dwarf the extra payroll tax.

Where the IRS actually looks

Reasonable comp isn’t a math problem in isolation — it has to survive audit. The IRS applies a facts-and-circumstances test rooted in Rev. Rul. 74-44 and the case law that followed: training and experience, duties and responsibilities, time and effort devoted, comparable compensation for similar roles, payment and distribution history.

Two audit signals matter more than the rest. First, distributions substantially in excess of wages — a $30K wage against a $500K distribution invites scrutiny. Second, wages below industry compensation surveys for the owner’s role. The IRS will pull salary.com or Bureau of Labor Statistics data and rebuild the number themselves.

RCReports methodology — the tool most CPAs and IRS field agents actually reference — builds a defensible number from role, industry, geography, and time-allocation surveys. We run it for every S-corp client at year-end. The output is a wage range, not a single number, which is the honest way to think about it. The optimum wage inside that range is where the QBI math sits — usually near the top of the range for above-threshold non-SSTB owners and near the bottom for below-threshold owners.

California adds a second layer

For California S-corp owners, the 1.5% CA franchise tax on entity net income under § 23802 applies to the S-corp’s income after wages — so higher wages reduce that tax. Small effect at 1.5%, but real on a high-income S-corp.

The California PTE election under Rev. & Tax. Code § 19900 pulls the other way. Qualified net income for the PTE election is calculated after owner-employee wages, so higher wages shrink the PTE base and reduce the federal SALT-workaround benefit. For an owner in the top federal bracket, that’s roughly 37 cents on every wage dollar that would otherwise have flowed through PTE.

Net California effect: the optimum usually sits slightly lower on wages than the federal-only answer. Not by a lot — but enough to move the number by $10–20K on a typical HNW S-corp filing.

What we’re doing for S-corp clients under OBBBA

Every S-corp client gets a three-scenario projection at Q4: current-run comp, payroll-tax-minimized comp, and QBI-optimized comp — the last being the number where marginal QBI benefit equals marginal payroll cost inside the RCReports defensibility range.

Roughly one in three sees a materially different number than what they’ve been running. For owners near the SSTB phase-in threshold or the top of the wage-limit range, the swing is often $15–40K a year in federal tax alone. Over the permanent life of § 199A, that compounds.

If your S-corp comp number was set before OBBBA and nobody’s rerun the QBI-vs-payroll trade against the current thresholds, that’s a conversation worth having. And for the broader question of whether an S-corp is even the right structure — versus a business-management or family-office setup — we cover that here.

David Meyer, CPA is a Partner at Laléa & Black and leads the firm’s tax strategy practice for HNW individuals, closely held businesses, and S-corp owners navigating the § 199A optimization under OBBBA.