Calculating Reasonable Compensation for an S Corp; C Corp; Small or Closely-Held business owner is not just about making the IRS happy. There are many unintended consequences of not having reasonable compensation. They can be broken down into current; long-term; valuation; entity choice; and preparer issues. In Part 1 we discussed the current and long-term issues. This month we take a look at valuation issues; entity choice; and the potential impact on the tax preparer.
Some reasonable compensation issues can be fixed after the fact if the amount paid was unreasonable. Most businesses change ownership based on a multiplier of earnings before interest, taxes, depreciation, and amortization (EBITDA). Compensation is a reduction in that EBITDA number. If compensation is low, EBITDA will be overstated, therefore the valuation will be overstated. If compensation is high, EBITDA will be understated, therefore the valuation will be understated. This issue is corrected by a technique known as recasting or normalizing the information. Caution; recasting can send a message to the other party that it is acceptable to do things wrong or bend reality as the seller sees fit.
If the business owner dies, unreasonably low compensation means the value of the business is overstated, creating an estate tax liability. If compensation was unrealistically high, the business will be undervalued, creating a lower basis in the business for the beneficiaries. This, in turn, will create more capital gains when the business is sold.
Divorce / Dissolution
In a divorce, whether a marital divorce or a business “divorce,” one side could argue that the compensation was unrealistic and should be adjusted. Nobody wants to be on the witness stand, sworn under oath, and asked the question: “Did you lie on your tax return, or are you lying now?”
All entity choices have good and bad points. Each business has to be analyzed on its own merits. This is the methodology for comparing a sole proprietor and an S corporation.
A sole proprietor pays self-employment tax on all the profits of the business. An S corporation pays Social Security and Medicare tax on the amount of Reasonable Compensation paid to its shareholder(s). The balance of the profits is not subject to Social Security and Medicare Tax. So if the Social Security and Medicare tax savings on the corporate profits after reasonable compensation is greater than the expense of maintaining the corporation it makes sense to incorporate as an S corporation. Let’s look at a couple of examples:
- Business income before reasonable compensation is $100,000. Reasonable compensation is $55,000. The tax savings is $100,000-$55,000 or $45,000 times 15.3% or $6,885. Since the cost of maintaining the corporation is less the $6,885 the business should be an S corporation.
- Business income before reasonable compensation is $200,000. Reasonable compensation is $170,000. Since wages are above the Social Security maximum, the only savings is Medicare tax. That savings is calculated as follows; $200,000-$170,000or $30,000 times 2.9% or $870. In this situation, the tax benefits are marginal at best.
Knowing what your client’s reasonable compensation figure is, will help you guide them to the entity most appropriate for their tax situation. Nothing says ‘Trusted Advisor’ like a tax savings of $6,800!
Potential effects on the tax Preparer
When an overstated or understated reasonable compensation figure leads to a getting zapped by the IRS, zinged by a divorce attorney, or mudslinging among heirs, eventually the wrath can be turned on the tax or financial advisor. Why didn’t you tell me I was overstating/understating my compensation? Why didn’t you tell Dad to calculate his true worth? Why didn‘t you have my husband amend his tax returns?
When the IRS makes a determination that an S Corp owner’s salary needs to be adjusted they will assess tax, penalties, and interest. There will also be a need to amend the corporate and individual tax returns as well as payroll tax returns. There is a high probability that the client will want the preparer to pay the penalties and interest under the theory that we should have kept them better informed. They may also demand the amended returns be prepared at no charge. None of us like the idea of a malpractice claim, but this is a real possibility. Additionally, if the case is egregious, the IRS could also assess preparer penalties. The key to self-preservation is documentation of conversations with clients, and documentation of how reasonable compensation was determined.
There are some circumstances where the malpractice claim can far exceed the penalties and interest. One situation would be if there was an involuntary revocation of the Selection that was discussed in Part 1. The damages, in this case, could be extreme. Another situation is a construction company that goes out of business where a financial statement was prepared for a bonding company, and the compensation was not reasonable. In these cases, the bonding company will use any reason to go after the accountant to recoup their losses. Again the losses can be extreme.
Just when you thought it could not get any worse
Take the same construction company as above. FIN 48 mandates that uncertain tax positions are disclosed in the financial statements. Now the financial statements are substandard. In addition to potential damages, the preparer’s license to practice is now at risk.
Documentation is the name of the game. Document the reasonable compensation conversation with the client. Document how reasonable compensation was determined. Attach the documentation to the yearly corporate minutes. Make sure the officer’s compensation is consistent with the determination of reasonable compensation. If we perform proper due diligence and have appropriate documentation we will keep our clients as well as ourselves protected from harm.