The Payroll Tax and QBI Deduction Trade-Off in High Income S-Corps

For high‑income S‑corporation owners, the qualified business income (QBI) deduction under section 199A is computed on Form 8995‑A when taxable income exceeds the threshold, and it becomes subject to the “W‑2 wage and UBIA limits.” Above the threshold, the QBI deduction for each qualified trade or business is limited to the lesser of 20% of QBI or the greater of (a) 50% of W‑2 wages, or (b) 25% of W‑2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property. Importantly, shareholder‑employee wages do not count as QBI at the shareholder level, creating a trade‑off between increasing wages (to raise the wage limit) and preserving pass‑through QBI (to maximize the 20% base), all while considering added payroll taxes on higher wages (see the 2024 Instructions for Form 8995 and IRS employment tax guidance) Instructions for Form 8995, Understanding employment taxes.

When Form 8995‑A Applies and Baseline Thresholds
Individuals and eligible estates and trusts use the simplified Form 8995 only if their taxable income (before the QBI deduction) is at or below the annual threshold; otherwise they must use Form 8995‑A. For 2024, the thresholds (before the QBI deduction) are $383,900 for joint filers and $191,950 for other filers; above these amounts, the W‑2 wage/UBIA limits apply and specified service trades or businesses (SSTBs) may be phased out entirely. The 8995 instructions outline the thresholds, phase‑ins, and when Form 8995‑A is required Instructions for Form 8995.

How the Wage Limitation Interacts with S‑Corp Compensation

• Wage‑limit mechanics. For each qualified trade or business, once you are above the income threshold, the QBI component is capped at the greater of 50% of W‑2 wages, or 25% of W‑2 wages plus 2.5% of UBIA of qualified property. This can be particularly binding for service businesses with limited payroll and little qualified property Instructions for Form 8995.

• Shareholder wages aren’t QBI. “Reasonable compensation” paid to an S‑corp shareholder as an employee doesn’t count as QBI, and those wages also reduce the entity’s pass‑through income—thus shrinking the 20% base even as they can raise the wage cap (see treatment of wages and QBI in the IRS instructions) Instructions for Form 8995.

• W‑2 wage definition and compliance. Only wages properly reported on Forms W‑2 to the Social Security Administration count for the wage limit. The instructions provide the mechanics for what counts and how to report required items for owners to compute §199A (ensure timely and accurate W‑2/SSA reporting) Instructions for Form 8995.

Payroll Tax Impacts of Increasing S‑Corp Salaries
Raising shareholder‑employee salaries increases federal employment tax exposure (withholding and employer FICA/Medicare, and FUTA where applicable) and simultaneously reduces pass‑through QBI. S corporations must withhold and pay employment taxes and file employment tax returns (for example, Forms 941/943/944 and 940). Employees may also be subject to Additional Medicare tax withholding on higher wages. Conversely, properly characterized shareholder distributions are not wages and do not incur payroll taxes; they preserve pass‑through QBI to the extent they reflect business profits. The “reasonable compensation” standard for S‑corp officers must be respected (see the IRS pages on employment taxes, S corporations, and paying yourself) Understanding employment taxes, S corporations, Paying yourself.

The Optimization Trade‑offs

• Binding wage cap vs. shrinking QBI base. With low wages, the 50% (or 25% + 2.5% UBIA) limit often binds and constrains the deduction; with higher wages, the cap increases but the QBI base shrinks because wage expense lowers pass‑through income and wages aren’t QBI. The practical “sweet spot” is where the marginal increase in the wage cap outweighs the marginal reduction in QBI and added payroll tax cost—subject to “reasonable compensation” requirements Instructions for Form 8995, Paying yourself.

• UBIA can reduce wage dependence. Capital‑intensive businesses can benefit from the alternative limit (25% of wages + 2.5% of UBIA of qualified property). Investing in qualified property increases the alternative cap even when payroll is lean Instructions for Form 8995.

• Aggregation and multi‑entity planning. Where permitted by the §199A regulations, aggregating trades or businesses can combine wages and UBIA to reduce binding limitations and improve the deduction across an aggregated group. Owners should review how their S‑corp reports QBI, W‑2 wages, and UBIA to owners (K‑1 attachments) and consider if aggregation applies under the rules summarized in the IRS instructions Instructions for Form 8995.

• SSTB constraints at high income. If the S‑corp operates an SSTB and taxable income exceeds the phase‑in range, none of the SSTB’s QBI, W‑2 wages, or UBIA are counted—potentially eliminating the deduction regardless of salary structure. Owners should monitor phase‑in thresholds on Form 8995‑A Schedule A (discussed in the instructions) Instructions for Form 8995.

• Reasonable compensation and compliance risks. Paying too little salary risks IRS adjustments (reclassifying distributions as wages, with back payroll taxes and penalties); paying too much increases payroll taxes and reduces QBI without proportionately increasing the §199A cap. Maintain documentation of roles, hours, market pay data, and follow officer compensation rules (see IRS “Paying yourself” and S‑corp resources) Paying yourself, S corporations.

A Structured Approach to the Salary/QBI Decision

• Step 1: Confirm you must use Form 8995‑A (taxable income above the threshold) and determine whether the business is an SSTB. Then determine QBI, W‑2 wages, and UBIA for each trade or business (or aggregated group) using the methods summarized in the instructions Instructions for Form 8995.

• Step 2: Model scenarios. Compute the QBI deduction under different salary levels: (i) 20% of QBI (noting wages reduce pass‑through income and are excluded from QBI at the shareholder level), and (ii) the wage cap: greater of 50% of W‑2 wages or 25% of wages + 2.5% of UBIA. Include employer/employee payroll taxes on incremental wages in your analysis Instructions for Form 8995, Understanding employment taxes.

• Step 3: Evaluate aggregation or property investments. If wages are low and the cap binds, consider lawful aggregation or qualified property investments to increase UBIA (as summarized in the IRS instructions) Instructions for Form 8995.

• Step 4: Set compensation at a documented “reasonable” level, balancing the marginal §199A benefit against the marginal payroll tax cost, and maintain proper payroll filings and W‑2 reporting (see IRS employment tax and S‑corp guidance) Understanding employment taxes, S corporations, Paying yourself.

Numeric Illustration (Conceptual)
Assume an S‑corp’s pre‑owner‑salary income from a qualified trade or business is $800,000; the owner’s salary is variable; there is minimal qualified property. If salary is $150,000, pass‑through QBI might be roughly $650,000 (ignoring other adjustments), so 20% of QBI is $130,000. But the wage limit (50% of W‑2 wages) is $75,000, which would cap the deduction at $75,000. If salary is increased to $300,000, QBI might be roughly $500,000 (20% = $100,000), while the wage cap rises to $150,000; the deduction would then be $100,000—an increase of $25,000 compared to the lower salary—at the cost of materially higher payroll taxes. The “optimal” salary is where the wage cap no longer binds and the 20%‑of‑QBI amount governs, subject to reasonable compensation and overall tax cost. Always run this analysis on your facts using Form 8995‑A computation rules and the definitions in the IRS instructions (recognizing that wages are excluded from QBI and only properly reported W‑2 wages count) Instructions for Form 8995, Understanding employment taxes.

Reporting and RPE Coordination
S corporations, as relevant passthrough entities, must determine and report QBI, W‑2 wages, and UBIA attributable to trades or businesses on Schedule K‑1 attachments so owners can compute the §199A deduction. If a passthrough fails to report required items, an owner’s share of QBI, W‑2 wages, or UBIA may be treated as zero until corrected; the IRS instructions discuss required owner‑level inputs and entity reporting expectations Instructions for Form 8995.

Takeaways

• Above the thresholds, §199A is a constrained optimization problem: increasing salary raises the wage cap but reduces QBI and increases payroll taxes; decreasing salary preserves QBI and lowers payroll taxes but risks binding the wage cap. Use Form 8995‑A and the wage/UBIA tests to identify which limit binds, and compare marginal benefits to payroll tax costs Instructions for Form 8995, Understanding employment taxes.

• Ensure shareholder wages are “reasonable,” wages are calculated and reported properly (SSA W‑2 reporting), and consider UBIA or aggregation where permitted. Coordinate with your S‑corp’s K‑1 reporting so owners can complete §199A without losing the deduction due to missing data (see IRS S‑corp and “Paying yourself” pages) S corporations, Paying yourself, Instructions for Form 8995.

This essay is not tax advice. Always consult a qualified tax professional for your specific situation.