There are times when every small business owner’s ego can be an asset, although when it comes to Reasonable Compensation and S Corps, having a big ego could cost your client thousands of additional dollars in payroll taxes and QBI deductions.
Let’s look at an example: Meet and her over-inflated alter ego.
When Joanna completes a Reasonable Compensation survey, she does so with an immensely inflated ego. She doesn’t bother to read the job descriptions and selects tasks based solely on title; there is no task Joanna doesn’t consider herself awesome at completing; so she rates her skill level as high for each selected task on the survey.
When Joan fills out her Reasonable Compensation survey, she takes her accountant’s advice and sets her ego aside. She reads through the job descriptions and chooses tasks that best fit what she really does for her business. She is honest with herself and acknowledges she can’t possibly be impeccable at every task and so rates her skill levels appropriately.
Shocker: in this example, Joanna’s inflated ego caused her to overstate her Reasonable Compensation by approximately $50,000, costing her roughly $7,500 more in payroll taxes plus the loss of QBI deduction if she qualifies.
The biggest game-changer between these two figures happens when Joan selects General Manager* instead of Chief Executive Officer** and chooses appropriate proficiency ratings in her categories. As you can see by looking at the definition of General Manager, it is a much better fit for Joan’s small business than the CEO title, and while Joan acknowledges she is not the best at every task she does, she rates herself realistically in her selected categories. Her Reasonable Compensation figure is an accurate reflection of the work she performs for her small business.
As one very wise CPA was overheard telling a colleague: “Every accountant I’ve ever met thinks they’re the world’s greatest accountant. Wouldn’t that actually make them all average?” Something to ponder…
When advising your clients on the topic of Reasonable Compensation, keep in mind some sage advice from the US Tax Court: “Determining an employee’s Reasonable Compensation is dependent upon a number of factors and is far from an exact science.” (McAlary v. IRS)
The secret to a defensible Reasonable Compensation figure is to be proactive and provide research and documentation to back up the figure. Because of the circular logic built into section 199A, being unreasonably low or unreasonably high could negatively impact your client’s 199A deduction, so there is no simple rule of thumb or safe harbor that advisors can use to determine Reasonable Compensation (and there never was – don’t get us started…)
Most experts agree that ball-parking, estimating, or otherwise guessing at a Reasonable Compensation figure for an S Corp. owner is both irresponsible and reckless. Researching and documenting Reasonable Compensation each and every year is the best way to put the IRS on the defense, should they challenge your clients’ figure.
As your client’s trusted advisor, feel free to share this cautionary tale with them.
*Chief Executive Determine and formulate policies and provide overall direction of companies or private and public sector organizations within guidelines set up by a board of directors or similar governing body. Plan, direct, or coordinate operational activities at the highest level of management with the help of subordinate executives and staff managers. May include extensive travel.
**General and Operations Manager Plan, direct, or coordinate the operations of public or private sector organizations. Duties and responsibilities include formulating policies, managing daily operations, and planning the use of materials and human resources, but are too diverse and general in nature to be classified in any one functional area of management or administration, such as personnel, purchasing, or administrative services.