Reasonable Compensation and the Modern Accounting Practice

Reasonable compensation and the modern accounting practice

As we approach the planning season, and you take stock of your practice, begin thinking about the clients who are fun to work with, have unique needs or complex situations, and you almost always find yourself thinking about small and medium businesses (SMB) and their owners.  A demanding bunch for the most part, as they should be.  They have engaged you to look out for their best interests, to point out tax and business strategies that will continue to help their business prosper; you are, after all, their trusted advisor.

One of the hard and fast rules of working with SMB’s is that you will regularly advise them on the topic of Reasonable Compensation.  The subject comes up from darn near the first conversation when they are forming the business and choosing their entity, to the last day when the business is sold or passed down to the next generation waiting in the wings.

Recently we completed a series of articles detailing the three methods of determining reasonable compensation and (more importantly) which method to use and when.  This month we take a look at the three areas of any practice (that works with SMB’s) where Reasonable Compensation is important to consider: Planning, Compliance, and Normalization.

Planning:  I begin with planning because it is the cornerstone of every successful practice; fail to plan – plan to fail.

  1. Business Life Cycle
    1. Entity Planning – Reasonable Compensation is a key component of entity planning, both when the company is initially formed and each year for your Schedule C, Partnerships and LLC.s. Some practitioners feel it is their duty to examine all their Schedule C, Partnerships and LLC.s after tax season ends.  Their reasoning: If we’re not looking out for them who is?
    2. M&A – as part of the life cycle of an SMB, opportunities to acquire, and be acquired come along. When this happens, your clients’ Reasonable Compensation will play a key role in the negotiations.
    3. Exit Planning – The time to get a business ready for sale or transition to the next generation is years ahead of the sale, and dialing in the owners’ Reasonable Compensation early is essential to building as much value as possible before the business hits the selling block.
  2. Retirement; SEP; 401k; Defined Benefit; ESOP – As business owners look toward more complex retirement planning and ownership strategies, the trusted advisor will need a defensible Reasonable Compensation figure for their client. Not only to help establish and maintain a complex plan but to defend it from a challenge.  A retirement plan (defined benefit, SEP, 401k) or ESOP plan that falls out of compliance because the compensation of the owner was determined to be unreasonable comes with significant and potentially devastating penalties.
  3. Tax – yep there are a few rarely used tax planning strategies for S & C Corps. Bring these to the appropriate client(s) and they will sing your praises all over town.  We will detail these in a future article, not enough room this month, but stay tuned

Compliance: Keeping you and your clients in compliance with state and federal tax regulations is one of the trusted advisors primary responsibilities as their tax preparer – to prepare a complete and accurate return.

  1. S Corp – Owners generally want to keep Reasonable Compensation as low as possible to avoid payroll taxes. Although we agree this is a good tax savings strategy, it will fall apart if you and the business owner can’t substantiate the Reasonable Compensation figure used.  Tax penalties and interest are in the neighborhood of 50-100% of the original tax that would have been owed.  As the preparer, you may be on the hook too.  The IRS has been handing out $5,000 penalties to preparers that signed a return that had unreasonable low compensation figures.
  2. C Corp – Same issue as S Corps, except the owners, generally want a Reasonable Compensation figure as high as possible to avoid double taxation.
  3. Family – Owners who put their family on the payroll must be able to justify the compensation paid to family members for the services provided. An attempt to shift the tax burden from the owner to his/her children (for example) is a well know tax scheme quickly identified by even the greenest IRS examiner.

Normalization: Normalizing owner’s compensation is part of the curriculum for Forensic Accountants and Valuators.

  1. Valuation – Frequently one of the bigger (if not biggest) adjustments a valuation expert will make when normalizing the subject businesses books is to Reasonable Compensation. This is significant because every dollar Reasonable Compensation is adjusted has an x-factor result to the final valuation of the business.
  2. Divorce – When marriage is being un-done by attorneys and an SMB is part of the mix, Reasonable Compensation is frequently established as a basis to calculate alimony, maintenance, child support, and property settlements.
  3. Shareholder Disputes – In a closely-held business when passive shareholders question the reasonableness of compensation paid to shareholders working for the company, a shareholder dispute arises, and Reasonable Compensation must be determined for those officers and employees.

Your SMB clients are some of the most rewarding folks you’ll work with and frequently become their friend as well as their trusted advisor.  One last piece of advice for you to share with your clients about their Reasonable Compensation figure:

Reasonable Compensation can sometimes be an emotional subject for business owners because they don’t understand it.  Gently remind them that it is the “hypothetical” replacement cost of an owner of a business. It is not their net worth as a human being, nor does it include enterprise goodwill, net worth, business profits, etc.

Planning season is here, the best time of the year to consult with clients about Reasonable Compensation.  As Albert Einstein said: “Intellectuals solve problems, Geniuses prevent them”

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