Reasonable compensation is a critical tax issue that owners of S-Corporations must consider.
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.” However, the calculation of reasonable compensation is frequently subject to debate.
In practice, S-corporation owners prefer to be paid through distributions. This will minimize their tax burden. In contrast, the IRS prefers that S-corporation owners be paid through payroll. This will maximize taxes. Therein lies the conflict.
IRS Audits of S-Corporations
Shareholder compensation is frequently the subject of IRS audits. Auditors will ask if the company paid sufficient wages to the owners to meet the reasonable compensation standard. This standard hinges on replacement cost, fair market value, job title, and location.
An unsuccessful audit results in additional taxes, interest, and penalties on businesses that fail to meet the reasonable compensation test. This is a risk that few business want to bear.
Therefore, we recommend that our S-corporation clients carefully calculate owner compensation in order to meet the IRS standards. Also, we ask clients to proactively maintain a “reasonable compensation file” in order to explain compensation amounts. This file can be brought out in the event of an audit.
Is There a 50/50 Rule of Thumb?
The IRS and the courts do not recognize a “rules of thumb” related to reasonable 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.
Instead of a rule of thumb, an actual calculation is required. The calculation is based on two factors:
- Replacement Cost: If you had to go out into your community and hire someone to replace yourself and perform all the services and tasks that you perform, what would you have to pay them?
- Fair Market Value: If you were to close your business, and go across town and work for a competitor performing the same services and tasks for your competitor that you currently perform, what would the competitor pay you for those same services?
Additional Considerations for Reasonable Compensation
Finally, maximum contributions to retirement plans are based on wages. If wages are too low, the business owner may miss out on valuable tax deductions and retirement planning.
Call our Atlanta accounting firm today to discuss a compensation plan that best suits your needs. We will keep you 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 throughout Georgia.