“If there is only one shareholder and no other employees, should all distributions be taken out as Reasonable Compensation?”
This is a common question we receive at RCReports and like with most of the questions we receive, the answer is: “Maybe.”
If the business is so unique or the services of the shareholder are so unique, that no one could be hired to replace the owner and there are no other assets in the corporation, then everything taken out of the business should be treated as wages (Reasonable Compensation) and nothing should be considered a distribution.
If the corporation has tangible assets, such as equipment or inventory, the owner deserves a return on that investment. Likewise, if the business has employees or uses contractors, the owner deserves a return on that investment as well.
If the corporation has intangible assets, such as goodwill, a license to operate or a favorable lease, the shareholder should be getting a return on these assets. These assets may or may not have a tax basis. An example of this would be internally developed goodwill.
When assessing the rate of return on intangible assets that do not have a tax basis, the fair market value of the intangibles needs to be taken into consideration.
Let’s look at an example. Accounting practices are normally valued as a multiplier of one year’s billings. If a practice was grossing $250,000 and the local multiplier is 1.5 times one year’s billings, that would put the value of goodwill at $375,000. If we assume a rate of return of 15%, then $56,250 could be justified as a return on goodwill.
What should be done with this information? It can be used as a reality check. Reasonable Compensation is based on the value of services provided by the shareholder to the corporation. Any additional cash available to be withdrawn from the business can be taken out in the form of a distribution of earnings and profits. Reasonable Compensation must be paid before distributions are made. The return on investments accumulated since inception should be equal to or greater than the accumulated distributions since inception. If the accumulated distribution exceeds the accumulated return on investments, all assumptions need to be reviewed and adjusted. It may be necessary to adjust the Reasonable Compensation, the value of the assets or the return on investments.
When a single shareholder employee of an S Corp that only provides services is asked: “Do you believe that there is no replacement for yourself within your business?” Frequently the business owner will answer yes. On rare occasion this may be true, but more than likely they answered yes incorrectly for one of two reasons.
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First, they don’t fully understand the question. When we discuss replacing a business owner within their company in relation to Reasonable Compensation, we are re talking about the hypothetical replacement cost of the owner. When a small business owner contemplates finding another individual to perform all the same services they are performing, quite often they believe it’s impossible and will therefore answer “Yes” to this question when in reality all the services they are performing for their company can be done by others, the services are not so unique that no one else could possibly perform them.
Second is ego. Small business owners are usually exceedingly dedicated to their business and believe that nobody could fill their shoes. Again, when we are discussing replacing the business owner within their company in relation to Reasonable Compensation, we are talking about the hypothetical replacement of the owner. Therefore, we are not taking into consideration devotion to the company, sleepless nights, and other intangibles that small business owners bring to the table.
Helping your client accurately answer the question above “No” and understanding the nuances of single shareholder S Corp.’s, can help you advise your clients accurately on the topic of Reasonable Compensation and take advantage of the payroll tax savings S Corp’s enjoy when taking a distribution over wages.