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By Paul S. Hamann & Jack Salewski, CPA, CGMA

The IRS usually wins when it challenges an S Corp.’s Reasonable Compensation in court. Over the years there have been in the neighborhood of 25 to 30 such cases. The IRS has come out on top in all except one: The Davis Case. What made Davis different? What valuable takeaways are there for you and your clients?

The case focused on two concepts that every S Corp. and business advisor should understand:

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Can Form 1125-E protect your clients from accuracy penalties? The answer to this question, oddly enough, does not lie within the instructions for form 1125-E, but instead within the IRS job aid on Reasonable Compensation (Pg. 22) - and the answer is YES, well, maybe, as in, Yes, if you have done other things appropriately.

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Defining reasonable compensation is a fairly simple task. According to Black's Law Dictionary, it is, "compensation which is consistent with the normal reward for any employee for the work performed or duties that are involved." However, that definition is not as simple as it may appear. A key word jumps out to any business valuator or reasonable compensation expert – normal. What is a normal reward? What is normal to one may not be normal to another. The compensation for any job title can vary by industry, location, and experience. Normal is a relative term, making it all the more challenging to determine reasonable compensation.

By Paul S. Hamann & Jack Salewski, CPA, CGMA

In a recent memorandum to its examiners and appeals agents, the IRS lays out steps to keep Reasonable Compensation challenges out of Tax Court.  Great, you say, nobody wants to go to court!

Not so fast. The option of filing a petition in Tax Court provides taxpayers with time and leverage. By following the steps in this memo, IRS examiners can prevent taxpayers who cannot reach a resolution on Reasonable Compensation from filing a petition in Tax Court.  This means:

  1. Tax must be paid now. When filing a petition with the Tax Court, taxpayer can avoid paying the tax until the matter is finally resolved.
  2. Leverage Lost. Filing or even the threat of filing a petition with the Tax Court can give taxpayers and their advocates’ leverage to get the appeals agent to settle the dispute favorably. 

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Ask yourself a few simple questions:

  • Have I educated all my S Corp clients about Reasonable Compensation?
  • Is each client's Reasonable Compensation figure, on its face, reasonable based on the client's training, experience, responsibilities and time devoted to the company?

If you answered ‘yes’ to both questions you are probably not at risk for a Preparer Penalty. There are a few more questions you should consider before you know if you are out of the woods. To help evaluate your risk and avoid preparer penalties, please use our complimentary Preparer Penalty Check List and Stress Test.

If you answered ‘no,’ you may be at risk for a Preparer Penalty. We have interviewed preparers who have been assessed $5,000 penalties, and here’s what their experience can teach you:

By Paul S. Hamann & Jack Salewski, CPA, CGMA

In the past, the IRS generally challenged Reasonable Compensation for being too low (for S Corps). That will not be the case in the future, with the passage of the TCJA, making it critical to properly dial in your client’s reasonable compensation figure. Surviving a challenge requires credible backup data to defend your figure.

1099 or W-2 for Shareholder-Employees of S Corps? Updated for 199A

By Paul S. Hamann & Jack Salewski, CPA, CGMA

1099 or W-2? That’s the number one question Jack receives here at RCReports.

Answer: W-2

We hear your argument: Paying wages via 1099-MISC instead of W-2 has no tax effect!

Here’s Jack’s reply: It’s the law.

How to Stress Test a Reasonable Compensation Figure

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Stress testing a reasonable compensation figure is simple. The courts have listed the factors they consider when determining whether a reasonable compensation figure is indeed reasonable. We can use those factors to “stress test” any reasonable compensation figure..

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Without an accurate Reasonable Compensation figure the rest of tax planning is just a guess.

  1. Provide an accurate independent Reasonable Compensation Report to each shareholder-employee
  • Research and documentation is now a “must have” with the passage of the TCJA

What Approach Should I Use to Determine Reasonable Compensation

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Although there are general guidelines to help you pick the best approach to determine reasonable compensation, there are no hard and fast rules. For the overwhelming majority of your clients, one of two common approaches that rely on comparability data should do the trick. For the occasional client that just doesn’t seem to fit any molds, there is an approach for them, too.

Profit v. Distribution and its effect on Reasonable Compensation

By Paul S. Hamann & Jack Salewski, CPA, CGMA

How does profitability factor into a Reasonable Compensation calculation?  This is one of the most frequent questions we receive.  The short answer is: “Very little.”

That being said profit now plays a role on the shareholders 1040 with the passage of the TCJA.  How section 199A and the QBI affects your clients 1040 will vary significantly, because, as has been pointed out many times since the passage of the TCJA, section 199A is incredibly complex and the IRS has just released guidance on the issue.  Stayed tuned for more on the QBI in upcoming articles.

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