By Paul S. Hamann & Jack Salewski, CPA, CGMA
Is credible data really that important? Yes. In one recent case, data convinced an IRS Examiner to abandon an unreasonable position, saving the taxpayer thousands of dollars. In the process, the CPA, whose data-less compensation guess attracted the audit in the first place, saw his reputation tarnished. But the reputation of the taxpayer’s data-driven CPA rescuer is looking even brighter.
We have noticed a sharp uptick in Reasonable Compensation challenges over the last 12 months. This particular case took place in the Northwest. The winner in this challenge is a long-time RCReports subscriber and we thank him for sharing details with us, so you can be prepared should one of your clients’ Reasonable Compensation be challenged. For confidentiality, we will present the case study without disclosing any sensitive information.
Our subscriber, we will refer to him as “CPA Smith,” started using RCReports in 2013. He requires all his S Corp owners to have a Reasonable Compensation Report as a proactive measure against an IRS challenge. He is now considered an expert on the subject. Because of this status, CPA Smith is the go-to CPA in his area for S Corps in trouble. Enter an S Corp in trouble, which we will refer to as “Insurance Corp.”
- Insurance Corp is an insurance agency with one shareholder and a few employees.
- Revenue of $400,000
- Profit distribution of $165,000
- Reasonable Compensation $10,000
Insurance Corp was audited by the IRS. Targeting the low compensation figure, the Auditor recharacterized all profit distribution, $165,000, as compensation. The CPA who had prepared Insurance Corp’s taxes recommended accepting the adjustment. Rather than fork over a gigantic chunk of change in taxes, interest, and penalties, Insurance Corp decided to retain an expert, CPA Smith.
CPA Smith is convinced the low Officer Compensation drew the audit in the first place, so he asked Insurance Corp where the $10,000 Reasonable Compensation figure came from: “Our CPA at the time put a finger in the wind,” was the answer. Insurance Corp had no credible backup for the $10,000 figure.
CPA Smith performed a Reasonable Compensation analysis using RCReports and determined Officer Compensation should have been $42,000. (If even this figure seems low, keep in mind the shareholder did not work full time for the S Corp.)
CPA Smith presented his fresh, data-driven compensation report to the Auditor. The Auditor signaled his willingness to compromise and lower his adjustment a little bit, a typical response in this scenario. BUT this is where this case gets interesting!
CPA Smith held his ground on the $42,000. Confident in his own expertise and the Reasonable Compensation Report produced by RCReports, he told the Auditor he would not go higher and was ready to proceed to Appeals and Tax Court if necessary. The Auditor backed down and accepted the $42,000 figure. That’s what a credible independent report can do in the hands of an expert.
In the end Insurance Corp had only $32,000 of distributions recharacterized as wages, instead of the $165,000 the original CPA recommended accepting, a mammoth saving in tax, penalty, and interest. How much? Approximately $39,000 for 2018 and $41,000 for 2019. Plus, in future years, Insurance Corp’s Reasonable Compensation figure will reflect something closer to $42,000 instead of $175,000, huge ongoing savings!
I’s are being dotted and T’s crossed to close out this audit, but for the owner of Insurance Corp, the matter is not closed. He feels betrayed by his first CPA, both because he set the original $10,000 compensation figure putting him at risk in the first place, and because he recommended accepting the Auditors adjustment without a fight. Insurance Corp. is currently contemplating a malpractice suit against the first CPA.
CPA Smith’s reputation is growing in his area, bringing him others with compensation challenges. He is currently working with another new S Corp client, “Tech Corp”. This case is in progress, but CPA Smith is confident he can resolve the issue fairly with the help of RCReports – stay tuned.