Reasonable compensation is a critical tax issue that owners of S-Corporations must consider.
Reasonable Compensation: What is the Problem?
Reasonable compensation is the perennial audit issue for S corporations. What exactly is the problem?
Owners of S-corporations are both shareholders and employees. They are compensated in two ways:
- The business pays distributions to the owners. Distributions are subject to income tax, but not Social Security tax or Medicare tax.
- The business pays wages to the owners. Wages are subject to income tax, Social Security tax and Medicare tax.
The IRS requires that wages, at a minimum, meet the standard of “reasonable compensation” for services provided to the business. However, the calculation of reasonable compensation is frequently subject to debate.
In practice, S-corporation owners prefer to maximize owner distributions and minimize owner payroll. This will reduce employment taxes. In contrast, the IRS prefers that S-corporations minimize owner distributions and maximize owner payroll. This will increase employment taxes. Therein lies the conflict.
IRS Audits of S-Corporations
Shareholder compensation is frequently the subject of IRS audits. Auditors examine the books of the company to determine if the business paid sufficient wages to the owners to meet the reasonable compensation standard. This standard is a calculation that hinges on replacement cost of the worker, fair market value, job title and location of the business.
If the IRS auditor determines that an S corporation paid insufficient compensation to its owner, the IRS will reclassify distributions as wages subject to employment taxes. In such case, the business would become subject to additional employment taxes (plus interest and significant penalties), as if the business had paid the amount in question as wages. This is a risk that few business want to bear.
The expansion of IRS enforcement activity, set to begin in 2022, including massive funding increasing for IRS audit staff, will makes the situation worse. We expect that high income taxpayers and their S corporations will be the focus of IRS attention and IRS audits over the next few years. Compliance with reasonable compensation requirements will be an obvious target of these audits.
Reasonable Compensation Calculations
Reasonable compensation is a facts and circumstances determination, based on case law. Here are some of the factors that should be considered when calculating if wages paid to the owner of an S corporation are reasonable or not:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of formulas to determine compensation
As a rule, reasonable compensation is calculated as the cost to replace the employee (or owner) who is doing the work. We do not consider work in excess of 40 hours per week.
Reasonable compensation is not the same as the net income of the business. Furthermore, reasonable compensation is never an arbitrary percentage of the net income of the business.
Is There a 50/50 Rule of Thumb?
The IRS and the courts do not recognize a “rules of thumb” related to compensation of S corporation shareholders. It is a myth that a 50/50 split between distributions and wages, or any other rule of thumb, is regularly accepted by the IRS when auditing S corporations.
It is often highly advantageous to the taxpayer to determine compensation based on how much time the owner of the business spends on performing different tasks within the company. This is the “cost approach,” which is best to use when the owner provides many different services for the business.
Therefore, don’t guess and split the time down the middle between management and operational tasks. Rather, calculate compensation based on the cost of specific tasks, allocated according to the percentage of time spent doing those tasks.
Important: Reasonable Compensation Report
Businesses should proactively determine reasonable compensation well before the audit starts. It is not enough to prove reasonable compensation after the audit starts.
We require that most of our S-corporation clients have a Reasonable Compensation Report on file. The Report contains detailed calculations as to how owner compensation was determined. The Report provides proof that the compensation of the owner complies with IRS standards for reasonable compensation. The Report includes highly detailed research, based on IRS criteria, court rulings, geographic data and our database of wages.
Our clients bring out their Reasonable Compensation Report in the event of an audit. In most cases, the resolves the audit nightmare before it even begins.
Additional Considerations for the S Corporation
Wages do not only impact reasonable compensation. They also impact maximum contributions to retirement plans. If wages are too low, the business owner may miss out on valuable tax deductions and retirement planning.
Do you have an S corporation? Are you considering an S corporation for your business? Call our Atlanta accounting firm today to discuss an officer compensation plan that will withstand an IRS audit.
We will keep our clients out of IRS trouble!
Founded by Gary Massey, CPA, Massey and Company CPA is a boutique Atlanta accounting firm serving the needs of small businesses and individuals. Our clients are in Georgia and across the county.