So far in 2023, we’ve asked over 8,000 accounting and tax professionals to identify the methods recognized by the IRS to accurately determine reasonable compensation. Over 73% of these professionals got it wrong. This really isn’t surprising, however, as there are several myths floating around regarding “proper” ways to calculate a reasonable compensation figure—some of these myths have even found their way into articles on Forbes and similar publications.
You’ve probably heard of some, if not all, of these including the:
- 50/50 (or 60/40) rule: split distributions and salary 50/50 or 60/40
- industry rule: setting wages as a percentage of sales or revenue
- safe harbor rule: setting wages at the social security maximum
If you are using any of the above ‘rules’ to set reasonable compensation you need to stop now. None of these methods are recognized by the IRS and could result in inaccurate calculations that cost you, and your clients, thousands.
To help you get on track with reasonable compensation, let’s first look at how the IRS defines it:
The value that would ordinarily be paid for like services by like enterprises under like circumstances.
What does this mean? If the business owner were to step away from their role, what is appropriate, and fair in the market, to pay another individual to fill the role and perform the same duties.
Some factors considered by the courts in determining reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
The key to establishing accurate reasonable compensation is determining what duties the shareholder-employee performs for the business, finding unbiased, reliable data that shows the fair market pay for those duties, and compiling all of the information into a report. Or you can use a tool like RCReports to do this for you.
So, what happens when you get reasonable compensation wrong? The consequences can be dire as shared in our annual Horror Stories webinar where three industry experts shared real-life examples from clients that underwent a reasonable compensation challenge.
Social Insecurity
Tom Gorczynski, EA, USTCP, of Gorczynski & Associates, LLC and Co-Owner of Compass Tax Educators, tells us a story about a taxpayer that got bad advice and set reasonable compensation at $24,000 annually for over 20 years. This taxpayer was a successful full-time, real estate broker, so it’s not reasonable for compensation to be set at that low of an amount. However, the taxpayer was uneducated on the topic of reasonable compensation and was happy to be saving money on payroll taxes. The taxpayer’s S-Corporation was selected for examination, and he hired Tom to represent him.
When Tom began reviewing this taxpayer’s situation, he uncovered the unreasonable compensation they were paying themselves as the only employee of their S-Corporation and reached out to their tax advisor to learn more about how his $24,000/year salary was determined. His accountant said, ‘I always do 15% of gross receipts’ and ‘the IRS never bothered his clients about it’. This is not an acceptable way to determine reasonable compensation. Additionally, just because your clients have never been audited it’s not a defense to the advice given.
In this case, the taxpayer ended up dodging a bullet. The S-Corporation examination was closed, and the revenue agent never addressed reasonable compensation. However, Tom advised him to check his Social Security benefit estimate. He was shocked he had a small benefit accrued and was in his mid-50s. Unfortunately, there is no way for him to make up for previous years. Aside from the risk of penalties in the event of an IRS audit, not taking appropriate reasonable compensation can throttle a taxpayer’s retirement benefit.
Haunted by No Compensation
As many 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 Dawn Sabo, CPA, Owner at Sabo Tax & Accounting, when she represented a client who was a realtor after he faced a reasonable compensation audit with the IRS. He reached out to her after his audit so he could get on track with payroll.
The client was an S-Corporation 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. The audit kicked off on his personal return and his bank statements and tax documents were reviewed. 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. As a result of a personal return audit, the client has to deal with:
- The IRS recharacterizing shareholder distributions to officer compensation. For 2017 $105,000 of distributions were recharacterized out of $215,000.
- For 2018 $200,000 of distribution’s recharacterized out of $395,000 and for 2019 $295,000 of distributions recharacterized out of $525,000.
- Interest and penalties were more than the taxes owed.
The client was not the only one suffering in this situation. The prior CPA was also charged with a preparer penalty.
Death by Preparer Penalty
An IRS audit on reasonable compensation isn’t always a horror story for just the taxpayer. It can also be a nightmare for the tax preparer. This was the case for the client of Eric Green, Partner of Green & Sklarz, LLC and Founder of the Tax Rep Network, represented in this scary story.
Eric gets a call from Bob, a CPA. One of Bob’s S-Corporation clients was audited and then all 25 of his clients were reviewed. The auditor questioned why there was no salary on 20 of them. Bob sent copies to the auditor of the letters he issued to his clients explaining they must take reasonable compensation, or the IRS can recharacterize their distributions.
It is worth noting, Bob did not provide bookkeeping, payroll or tax consultation to any of the clients. He is a CPA that only prepared their tax returns.
Bob was charged the 6694(a) (negligence) and 6694(b) (reckless disregard) penalties at $5,000 each which amounted to $100,000 in penalty fees. On top of that, Bob also accrued a preparer penalty of 15% ($15,000) and $20,000 in legal fees. Through litigation, Bob was able to settle with the DOJ to resolve the case and only be responsible for paying the preparer penalty and legal fees, which was more than he profited from his clients. It could have been significantly worse and he would have been responsible for $125,000.
The lesson here is very simple. You can’t get your clients to waive accounting advice to take reasonable compensation. As a CPA, you are responsible for ensuring your clients are paying their taxes appropriately. Otherwise, the IRS may go after you.
About RCReports
RCReports is the #1 reasonable compensation analysis solution. Thousands of accountants and business valuators use RCReports because it is the fastest, most credible way to determine reasonable compensation for tax compliance, tax strategy and business valuations. If you work with S-Corporations or other closely-held businesses, you can’t afford not to use RCReports.
Learn more about RCReports here or book a 30-minute demo to see it in action.
