COVID Distribution Strategy for S Corps – Avoid a 15% Reasonable Compensation Penalty

Avoid a 15% Reasonable Compensation Penalty

COVID has taught us a lot about protecting ourselves, and not just about wearing a mask. We’ve learned a lesson on how to use distributions to protect a company’s assets during any prolonged crisis.

Distributions are the expected reward for a well-run company. Plus, distributions protect funds from being at risk if the company gets involved in litigation.  But the third reason for distributions you may have never considered is what CPA David Kolts dubs the 15% Reasonable Compensation Penalty. (Penalty here refers to consequence or disadvantage, not punishment.)

The concept is best explained with an example. Your client has a great year in 2019. The owner decides to leave excess cash in the business instead of taking a distribution. COVID shows up in 2020. Per IRS guidelines, Reasonable Compensation must be paid before a distribution can be made. If a prolonged crisis, such as COVID, drains the coffers, the only money left to be paid to the owner is what was carried over from 2019. So, what could have been distributed in 2019 becomes reasonable compensation in 2020.

What difference does it make? Payroll taxes. Payroll taxes are assessed on Reasonable Compensation, but not on distributions. While it’s too late to prevent this tax consequence for COVID 2020, the same scenario could be caused by a personal illness, accident, natural disaster, or anything that causes extended business disruption.

But a company can’t starve itself with distributions. A business still needs operating funds and money to invest in future growth. Not to mention that in the above COVID-drained-coffers scenario, the business with no cushion could just go belly-up. So what’s the answer? Take excess funds out of the business in good years and put some of those excess funds in a personal investment vehicle so the money remains available for the owner to lend back to the business in bad years.

There are other considerations:

  • Are there outside requirements to keep funds in the corporation? If the company has a loan, most banks will demand enough cash in the bank to cover 90- or 120-days’ worth of expenses. Bonding companies have working capital requirements such as a current ratio of 150% current assets to current liabilities. These types of requirements are critical to maintaining.
  • Other tax reasons: One example is when a client has suspended losses due to a basis limitation from prior years and the current year is profitable. Profits increase basis, distributions decrease basis. If a distribution is made, some or all the suspended losses may need to remain suspended. If no distribution is made those suspended losses can be used to offset the current year’s profits, thereby saving current year taxes.

Once all these factors are considered, an informed decision can be made to distribute or not distribute funds. Then document, document, document! All distributions need to be documented in the corporate minutes. Loans back to the business also need to be documented in writing, thoroughly.  Any documentation that an outside bank would insist upon, so should the owner/lender. Your client should review with their legal counsel to make sure everything is done to ensure the corporate veil cannot be pierced.

COVID. It’s not just about masks.

What Is a Pass-Through Entity?

Entity Planning April 17, 2024

A Guide to Salary Benchmarking

Best Practices March 20, 2024

Start exploring RCReports today.

        Submit a Ticket

        Scroll to Top