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. We will discuss the current and long-term issues here and follow up next month with valuation issues; entity choice; and the potential impact on the tax preparer.
Current Issues: The Obvious
The most common issue with an unreasonably low (S Corp) or unreasonably high (C Corp) compensation figure is exposure to an IRS Reasonable Compensation challenge.
S Corp: Owner-employees, who miscalculate their compensation too low, risk being required to pay additional payroll tax, penalties, and interest at the federal level. These additional taxes, penalties, and interest can be double what the cost would have been if reasonable compensation was paid in the first place. Add onto that cost – additional state payroll taxes; unemployment taxes; workers compensation insurance and their associated penalties and interest, and the costs jump again. Like a bad, late-night infomercial: “But wait, there’s more”: The IRS usually looks at 2-3 years at a time; now the costs just doubled or tripled. “But wait there’s even more…”: Don’t forget the cost of paying an accountant to prepare amended payroll reports, W-2Cs; W-3Cs, tax returns, and the possible costs of a lawyer to defend the taxpayer.
C Corp: The Reasonable Compensation issue is reversed. The IRS will want to make sure the owner-employee compensation is not unreasonably high. If they prevail, the overstated wages will be reclassified as dividends. The dividends are now taxable to the shareholder, but not deductible by the corporation. Again, the IRS usually looks at 2-3 years at a time; the cost of paying an accountant; an attorney etc…
Current Issues: The Over-looked
Retirement Benefits: A miscalculated Reasonable Compensation figure can put a taxpayer’s retirement plan, (SEP, 401(k), or a defined benefit plan), out of compliance. The penalties for being out of compliance with a retirement plan will make other penalties look insignificant. The IRS reference material on reasonable compensation states, “A Reasonable Compensation issue that includes an adjustment of a pension and profit-sharing deduction requires a referral to employee plans.”
“S” Corporation Election: If the taxpayer has two or more shareholder-employees and the IRS determines that the owners have been paid unreasonably low compensation, the ensuing reclassification of distributions as wages will result in disproportionate distributions. This could cause an involuntary revocation of the “S” election. It may be possible to have the “S” election reinstated, but not always; this is a situation no one wants to be in. Involuntary revocation of an “S” election will usually be a financial disaster.
Disability Insurance: Most disability insurance policies are based on earned income. Understated wages reduce disability coverage. If any of the shareholders become disabled, there may not be enough cash flow from the disability policy to pay the shareholder’s needs. This same issue applies to Social Security disability. This is a situation one of the authors has seen firsthand: The shareholder suffered kidney failure in his early thirties. Due to the dialysis treatments, he could no longer work. Because his Social Security disability benefit was based on his low earned income, he was reduced to poverty for the rest of his life.
Social Security: Let’s now fast forward to the shareholder’s golden years. If the wages paid were less than the Social Security maximum, the benefits are also less. Most shareholders spend all of the tax savings realized during their working years. Few people have the self-discipline to deposit all the tax savings into their retirement accounts, potentially leaving the shareholder with too little to live on throughout their retirement.
Besides the dollar and cents costs of these adjustments, the time and stress put on the shareholder(s) is not measurable, but very real. All of the time the shareholder(s) devotes to these issues distracts them from running their business. This translates into lost profits.
There are numerous negative consequences too under or overstating compensation that can affect tax liabilities, disability insurance, retirement benefits, and Social Security benefits. We need to strive to make sure our clients are paying themselves reasonable compensation.
Stay tuned for Part Two as the plot thickens with valuation issues, entity choice, and the potential impact on the tax preparer.