By Paul S. Hamann & Jack Salewski, CPA, CGMA
COVID is affecting everything in 2020, and that includes Reasonable Compensation. Business owners may be putting in more hours, or less, taking on new online tasks, or giving themselves a pay cut along with their employees. As businesses adapt to the pandemic, Reasonable Compensation calculations must be adjusted as well. “Set it and forget it” doesn’t work anymore in 2020.
What adjustments are warranted? There are three primary adjustments you should consider discussing with your S Corp. owners before the end of the year and a few others you should be aware of.
- Time and Effort Devoted to the Business. Depending on each business’s particular situation, the amount of time they are dedicating to the business may have increased or decreased. For example, a business owner may be covering for furloughed employees. Or a restaurant owner may be offering take-out just three evenings a week versus the 60+ hour schedule they were keeping before COVID. The time and effort adjustment can be made in the updated Reasonable Compensation Report or included with other credible documentation being used. In addition, the increase or decrease should be noted on Form 1125-E.
- Duties and Responsibilities. When COVID hit, business owners scrambled to reorganize duties and responsibilities for themselves and their staff. Remote work, new PPE requirements, or changes to marketing and sales strategies are just a few changes businesses made. The owner’s duties and responsibilities almost certainly changed along the way. An updated Reasonable Compensation Report can easily be done to adjust for the revised business model. Tip: Pay close attention to the skill or proficiency level chosen; a lot of S Corp. owners are now taking on new tasks they had little or no experience with before COVID.
- Internal Consistency. If a business cut all (non-shareholder) employees’ wages by 15%, cutting the S Corp. owner’s wages by 15% would also be warranted. This adjustment will likely need to be made manually. It should be made on the Reasonable Compensation Reports Advisors Worksheet or included with the other credible documentation being used.
Some additional criteria and planning scenarios that you may also want to consider are Distributions, Make-Up Pay, Shareholder Loans, and Corporate Minutes.
Distributions: IRS guidelines are clear that Reasonable Compensation must be paid before distribution can be made. There may be planning opportunities depending on your client’s situation, where they may be able to take a substantial distribution because the adjusted Reasonable Compensation is significantly lower than it would have been without the COVID adjustment. For more on this topic click HERE.
Make-Up Pay: In our newsletters, we typically address compliance issues with S Corp.’s. However, C Corp.’s have very similar Reasonable Compensation requirements. When it comes to make-up pay, both S Corp.’s and C Corp.’s should document that there will be make-up pay in the future. For more on this issue and S Corp.’s see (Example 4) HERE.
Shareholder Loans: First and foremost, make sure any shareholder loans are properly documented and treated as loans, or they could be viewed by the IRS as additional paid-in capital. If the business is deferring any shareholder loan payments, again document the deferral and when the deferral payments will be made up in the future. If you don’t, even a properly documented loan may be viewed by the IRS as an additional basis. For more click HERE.
Corporate Minutes: The thread that runs through this article is documentation. And there is no better place to document and memorialize Reasonable Compensation and the issues that surround it than corporate minutes. You will find sample corporate minutes at the end of all S Corp. and C Corp. Reasonable Compensation Reports, or work with your corporate counsel for help if you do not know where to start. For more on using corporate minutes to your advantage click HERE.
A final thought from the authors: please do not apply adjustments to Reasonable Compensation figures that were pulled out of thin air or set using a “rule of thumb” (aka a WAG). Adjusting a Reasonable Compensation figure that has no credible foundation is a waste of your time, your client’s time and will only increase the inherent risk that comes with a Reasonable Compensation Challenge.