Reasonable Compensation Past, Present & Future

By Paul S. Hamann & Jack Salewski, CPA, CGMA

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.

So what are you telling your clients?

According to an RCReports poll, only 12% of S Corp Owners research and document how they reached their reasonable compensation figure. This means every S Corp owner who does not research and document their reasonable compensation figure is at risk of having distributions reclassified as wages, if the IRS believes the wages paid were not reasonable for the services provided.

What defense do the other 88% have, if examined?  Not much.  If an S Corp Owner did not research and document their RC figure, the IRS will do its own calculation, and stick the S Corp Owner with a tax bill for the reclassification of the difference between the S Corp Owners guesstimate and the IRS’s number.

The prudent 12% who did research and document their reasonable compensation figure will fare much better, having a defensible position to the IRS’s inquiry.  And if they adopted the research and documentation into their corporate minutes, their reasonable compensation figure will be all but untouchable.

How should you advise your S Corp clients on the issue of reasonable compensation in 2017?  Start by telling them:

  • 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 solutions you can provide to your clients that help a shareholder-employee of an S Corp determine their Reasonable Compensation figure.

How do you convince your clients to heed your advice?

  • Start by sending them an Issue Letter on reasonable compensation. RCReports provides an issue letter template that our subscribers can download and customize.
  • Talk with them about the importance of being in compliance. In an RCReports poll, the majority of CPA’s (90+%) said the best way to persuade their clients to research and document their reasonable compensation figure is to advise and educate them on the high cost and the risks of an IRS audit.
  • Add the requirement and cost of a Reasonable Compensation Report from RCReports to your annual engagement letter, and build the cost into your 1120S fee.
  • Notify them you cannot start their return until the Reasonable Compensation research and documentation has been provided to you; protect yourself from IRS preparer penalties.

Tax Season is upon us and provides an ideal opportunity to advise your clients on Reasonable Compensation.

S Corp Audits up along with Preparer Penalties

The number of S corporation tax returns examined has increased more than 14% over the last year. Source: IRS Trends in Tax Compliance.

In response to a recent government report, the IRS will be improving its procedure for determining and enforcing penalties on paid tax preparers. Source: TIGTA

Yoga Instructor

This month we highlight yoga instructors, and thank them for their dedication to helping us stay healthy and flexible.

What Yoga Instructors make around the country:

  • Miami, FL ~ Average pay – $14.96 /hour*
  • Manhattan, NY ~ Average pay – $28.81 /hour*
  • Dallas, TX ~ Average Pay – $24.54 /hour*
  • Los Angeles, CA ~ Average Pay – $22.75 /hour*

~Each month we highlight an occupation from the more than 6,000 occupations included within the RCReports proprietary database of wages~