Reasonable Compensation Planning

smiley There are 3 types of accountants. Those who can count and those who can’t.

Reasonable Compensation Planning

It doesn’t seem that long ago that the best advice for determining reasonable compensation was a rule of thumb or safe harbor figure; boy, have things changed.  Beginning in 2005 the IRS launched a study of S Corp compliance.  Since launching this study the IRS has:

  • Modified Audit Selection Criteria: The IRS has systematically improved the methods for selecting S Corps for audit, and has more than doubled the average recommended adjustments from $50k for TY 2003-2004 to $105k for TY 2007-2011.
  • Reaffirmed its Authority: From 2007-2012 the very public case of David Watson went through the tax courts, putting an exclamation point on the IRS’s authority to reclassify distributions as wages if they believe the wages paid were not reasonable for the services provided.
  • Provided Guidelines: In 2008, the IRS issued Fact Sheet 2008-25 which provided guidelines and criteria that S Corps and their advisors can use to help determine reasonable compensation; we no longer needed to guess at a reasonable compensation figure.

As a CPA and professional tax advisor, I need to alert you to your responsibility to accurately determine and document your Reasonable Compensation for the services you provide to your business.  Reasonable Compensation is the salary or wage that you, a shareholder-employee of an S Corp, pay yourself for the work you perform for your company.

The IRS requires that all shareholders of S Corps who perform services for their company pay themselves Reasonable Compensation, and it should be paid prior to taking any distributions.  There are two ways to think about Reasonable Compensation:

  1. Replacement Cost:  What would it cost your company to pay another person(s) to provide all the services you currently provide?
  2. Fair Market Value:  What would other businesses in your community pay you for the services you currently provide to your company?

The IRS has updated its guidelines. It is more important than ever that you research and document how you determined your Reasonable Compensation figure.

  • The landscape has changed and the IRS is looking much more closely at S Corps and reasonable compensation.
  • The IRS has stepped up its enforcement of S Corps: Audits are up 14% over last year and are expected to continue increasing.
  • The cost of an IRS reclassification is high – total cost is typically more than double the original tax that would have been due.
  • There are easy-to-use service I can provide to you at an affordable flat fee that will help you as a shareholder-employee of an S Corp determine your Reasonable Compensation figure.

I have the professional tools and knowledge to make it easy to accurately determine your Reasonable Compensation figure.  Please contact me if you would like to discuss this issue further or to have me complete a Reasonable Compensation Report for you.

A Reasonable Compensation Report is a detailed report that establishes your Reasonable Compensation using criteria outlined by the IRS and Courts and provides a defensible position to an IRS challenge.

The best time to establish your Reasonable Compensation figure is now, before an IRS examination.  Reasonable Compensation has become an IRS hot button and we have been told to expect an increase in examinations of S Corps:

A Reasonable Compensation challenge can be costly.  Typically, taxes, penalty, and interest are more than double the original tax that would have been owed – plus costs for amending returns.

Please call me at your convenience so we can discuss this issue further.