As many of us in the tax and accounting profession know, there’s rarely much good that can come out of the IRS flagging a business owner’s personal tax return for an audit. The faded memories of unreported income and, if the individual is an s-corp owner, their missing or incorrect reasonable compensation calculations is enough to scare even the most seasoned CPA, enrolled agent, or other type of tax preparer. Or at least it should!
This was the case for me when I represented a client who was a realtor after he faced a reasonable compensation audit with the IRS. He reached out to me after his audit so he could get on track with payroll.
My former payroll company had prepared all the quarterly 941 forms for three years and the Form 940 for three years of the audit because his CPA advised that he was not going to do payroll.
I never represented him as his CPA. He is now using a different CPA and I have since sold my payroll company, but the new owners still serve him and he has not had an audit since.
Setting the scene of the unreported “reasonable comp” crime
However, there was a real scare for this client before we were able to repair some pretty deep issues in his tax situation. So here’s the facts about the scene of this s-corp reasonable comp “horror show”, so you can avoid your clients falling victim to a similar situation.
The client was an s-corp shareholder audited for personal tax returns for cost-of-living reasons. He was married filing jointly with two children living in Idaho. His adjusted gross income claimed was less than $25,000. As such, he qualified for the Earned Income Credit.
Now for the scary part…the auditor claimed that a family of four couldn’t live in Sun Valley, Idaho in a $950k home on $30k.
Out of the shadows comes the IRS with a personal return audit
The audit kicks off on his personal return and his bank statements and tax documents are reviewed. This is when it gets scary, because the bank statements revealed large sums of money transferred to a joint personal bank account and the auditor asks for bank statements from the account the funds were being transferred from.
The account the funds were being transferred from was a business account for the shareholder for a real estate business, where the client was the only employee and a shareholder owner. The Shareholder owner generated 100% of gross receipts for the business.
No payroll was ever processed by the S Corp and according to the shareholder, his former CPA never had the discussion about officer compensation and/or reasonable compensation. Soooo…here’s where things really start getting painful. As a result of a personal return audit, the client has to deal with:
- The IRS re-characterizing shareholder distributions to officer compensation. For 2017 $105,000 of distributions were re-characterized out of $215,000.
- For 2018 $200,000 of distribution’s re-characterized out of $395,000 and for 2019 $295,000 of distributions re-characterized out of $525,000.
- Interest and penalties were more than the taxes owed.
The client was put on a three-year payment plan to repay taxes/interest/penalties and three years of 941 and 940 were required by the IRS to be submitted within a 30 day period.
The client was not the only one suffering in this situation. The prior CPA was also charged with a preparer penalty.
RCReports: A simple solution for preventing reasonable compensation carnage
Halting the possibility of horror for our clients stemming from a reasonable compensation audit is our mission as trusted advisors to our clients. And we need to protect ourselves from these scary situations, too, or risk our own livelihoods. Fortunately, RCReports makes this easy with a tool that takes all of the guesswork and complex, time-consuming calculations out of reasonable compensation analysis so you can provide your s-corp clients with defensible calculations that will help them avoid being part of their own IRS audit horror story.