Stop Throwing Money Away: How a Reasonable Compensation Report Can Save You Thousands

throwing money away because you didn't get a reasonable compensation report

S Corp owners who work in their business are required by the IRS to pay themselves a reasonable salary, or reasonable compensation, via W-2. The costs for non-compliance can be steep, but so can the missed tax savings if you are overpaying reasonable compensation. The best way to get the most tax advantages while staying in IRS compliance is to run a reasonable compensation analysis every year and use that to set your salary. The cost associated with a reasonable comp report is minimal compared to the costs of over or under paying your wages.

Costs of S Corp Reasonable Compensation Non-Compliance

If you are audited by the IRS and you have taken distributions out of your S Corp, the IRS can initiate a reasonable compensation challenge. During a challenge, the auditor will examine the amount of the W-2 wages that you paid yourself to determine whether this amount is ‘reasonable’. If you were found to have underpaid your salary, and therefore overpaid your distributions, the costs can be huge.

Typically, the costs for non-compliance include back taxes, penalties, and interest, and may also include fees paid to a CPA and/or lawyer that represents you in the audit. While these amounts can vary by situation, we typically see it amount to about 30% of the wages that were not paid, plus your representation fees.

As an example, if the IRS says your reasonable compensation should have been $60,000 and you paid yourself $50,000, you will likely be looking at around $3,000 to settle up with the IRS, plus any fees you rack up for audit support from your CPA and/or lawyer. On top of that, audits typically don’t just look at one year, they look at 2-3 years, so you can keep multiplying those costs.

If you find yourself in this situation, the best thing you can do is purchase a reasonable compensation report to provide to the IRS. Providing a fact-based figure before they come up with a number on their own can go a long way in helping your case.

Costs of Overpaying Reasonable Compensation

The tax advantages of an S Corp come when you can pay yourself reasonable compensation as W-2 wages and distributions. W-2 wages are subject to payroll taxes, where distributions are not, thus saving you money. If you are overpaying your salary, you are missing out on potentially large tax savings.

One mistake that a lot of S Corp owners make is thinking that all the money they make must be considered W-2 wages. Even for service-based businesses, this is not true. The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”

There are two ways you can look at this: replacement cost and fair market value. The replacement cost is if you were to hire someone else to perform all the duties you currently perform (this may need to be more than one person) – what would you pay them? To think about the fair market value, think if you were going to find a job at another company doing the exact same tasks you do today, what salary would you expect to make?

In both examples, it is important to remember that you should account for all the duties you perform for your business. Do you clean the office? Order supplies? Do the bookkeeping? Sales? Marketing? And on and on.

Tapping into the RCReports database of wages, you get the best data possible for each job duty that you perform for your business, providing you with the most accurate and defensible reasonable salary figure, plus documentation to back up your number.

Next Steps to Calculate Your Reasonable Compensation

As you can see, setting your reasonable salary as an S Corp owner is a delicate balance between tax compliance and tax strategy. Understanding your reasonable comp can save you thousands and it all starts with one simple report.

 

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