We thought it was a myth that a tax preparer would be assessed a penalty when their clients did not pay themselves Reasonable Compensation for the services they provided their S Corp. Then a CPA from California sought us out to run Reasonable Compensation Reports for all his S Corp clients after he was hit with a $5,000 preparer penalty. Surely the facts, in this case, must have been very egregious, we thought, but we were wrong. This CPA had actually been working with his client for years to bring his compensation in line. They were actually getting very close when the IRS challenged his client’s compensation figure and whacked him with the huge penalty.
The CPA told us that when he started working for this client, the client was reporting an extremely low compensation amount. The practitioner got the client to start increasing his salary. Every year the compensation was raised with the intent to get it to a reasonable amount over a few years. Fast forward four or five years. The IRS challenged the compensation figure. Because the taxpayer was so close to a reasonable amount, the adjustment was small. But for his role, the agent was fined $5,000. He appealed the penalty and after a time-consuming and drawn out process was able to get the penalty removed. However, battling the IRS was “a living hell.” Moreover, he felt his reputation was damaged and worried that his other S Corp clients would now be on the IRS’s radar.
Because the majority of S Corp owners do not understand Reasonable Compensation, educating them falls to their Tax Advisor. The IRS requires tax preparers to be proactive in asking for the right information, even if it means the preparer will need to spend more time with the client during the preparation process. Asking the appropriate questions and providing appropriate documentation should keep the Tax Preparer out of harm’s way. The following points are by Larry Jacobson, CPA/JD from an article in the AICPA Tax Preparers Beware.
- …the IRS does expect preparers to have appropriate checklists for different types of clients. The IRS appropriately expects preparers to elicit information from taxpayers that would be reasonably necessary to prepare a tax return.
- …the IRS does not expect the preparer to merely accept the information given to her by the client. Rather, the IRS anticipates the preparer will review the information given by the client, compare that information to a checklist or some other written procedure and ask the client for additional information if necessary for the preparer to complete a professional tax return.
- …the IRS does require the preparer to be proactive in terms of asking for the right information necessary to prepare tax returns, even if it means the preparer will need to spend more time with the client during the preparation process.
- …penalties can and will be imposed on preparers who fail to make reasonable inquiries of their clients during the preparation process.
The best practice for meeting these standards is to require your S Corp clients to provide documentation backing up their Reasonable Compensation figure. However, we live in the real world, and sometimes your clients may not take your advice. In this case, the Best Practice would be to document your attempt/request to have them research and document their Reasonable Compensation figure and keep it with the return.
RCReports can help with both Best Practices. Reasonable Compensation Reports are quick and easy to prepare for your clients and have an excellent revenue stream. Free tools such as our downloadable issue letter, engagement letter, and printable Reasonable Compensation questionnaire are available to all account holders at no charge and provide tax advisors with some cover when provided to clients that don’t take their advice.