You are probably aware that taxpayers who own a C Corporation and Subchapter S Corporation who provide services in that corporation are required to take a “reasonable salary.” But what does that mean, exactly?
The Treasury Regulations define ‘reasonable compensation’ as “the value that would ordinarily be paid for like services by like enterprises under like circumstances,” and goes on to state that “Reasonableness is determined based on all the facts and circumstances.”[1]
The instructions for S Corporation tax returns state: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
This issue is a common one, particularly for Subchapter S Corporations, where the lower the “salary” taken by the owner, the more income comes out as dividends not subject to the self-employment tax. If a corporate owner does not take a reasonable salary the IRS may come in and create one for them, charging the missing self-employment taxes, penalties and interest accordingly. Hence, most tax professionals understand that they are supposed to recommend their client take a reasonable salary for their corporation.
What if the client refuses? It is not uncommon for business owners to push back on the salary issue, either because they don’t want to pay for a reasonable compensation report, or they simply don’t want to increase their salary and tax burden.
This will leave the tax professional in a conundrum of wanting to help the client, but also concerned about their own exposure if the IRS shows up and determines the taxpayer was not taking a reasonable salary.
The tax professional effectively has three choices when the client refuses to have a reasonable compensation report done:
- End the relationship with the client,
- Proceed with the salary claimed by the client, or
- Have the client sign a waiver that they understand the reasonable compensation issue and will hold the tax professional harmless.
End the Relationship or Go Forward?
I think we can address the first two options together. If the client refused to take any salary, or one that was so minimal that it was obviously too low, then I would end the client relationship. You’re better off without them.
If, however, the client was taking a number that could be in the ballpark, I would probably carry on and just note the file that I advised the client to get a report to back-up the number they claimed.
What would I not do?
Have the Client Sign a Waiver
Absolutely positively do not do this! Period!
I know you probably think it will prove you tried to get the client to do the right thing and prevent you from being blamed, but it actually does the exact opposite. Let me tell you about a CPA called Bob I was friends with here in Connecticut.
Bob had over 500 clients, butt he cause of the issue was twenty of his fifty corporate clients, virtually all Subchapter S corporations. These twenty S Corps took either no salary or very little salary. Bob did not do the company books or their payroll, so would receive this information after year end. He would complete the return but send letters to these clients each year that they need to take a reasonable salary and he would not guarantee what they did would stand up to an IRS exam.
Bob believed the letters would insulate him from being blamed by his clients if the IRS showed up and challenged the corporate return and salary. And show up the IRS did. After auditing the twenty S corporations I question the IRS penalized Bob himself under IRC § 6694 for both negligence and reckless disregard of the rules, arguing that the letters he sent to the clients each year proved he knew the salary was not legitimate and yet he filed the tax return anyway. The penalties across two years added up to $120,000.
Ultimately we challenged the penalties and managed to have them reduced to just the negligence penalty ($20,000) at which point Bob just wanted the case over. He also spent $20,000 in legal fees fighting the case.
The Lesson
If you are faced with a client that refuses to have a reasonable compensation analysis done properly, you can either proceed with their number (if it looks reasonable) or, if they claim no salary or very little, fire them. Remember the old saying – you make more money on the clients you DON’T take, meaning avoiding bad clients will save you time, money and agita in the long run.
Also please do not try and insulate yourself with waivers or letters like Bob did, as it will amost certainly come back to haunt you.
[1] Treasury Reg Section 1.162-7(b)(3)
