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

 “I’ll just take distributions, then pay myself reasonable compensation at the end of the year.” Quack, quack.

“Holding a meeting is a hassle. I’ll just write a check for my distribution when I do payroll.” Waddle, waddle.

Reasonable compensation is payment for the value of work performed by an S Corp shareholder/owner.  Distributions are whatever the Board of Directors deems appropriate (votes on).  These are two different events.

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

So how do you know if your S Corp client’s Compensation is Unreasonable? The most efficient way is to stress test it (download stress test here). Outside of stress testing compensation, the next best strategy is to compile credible documentation to back up the Reasonable Compensation figure being used.

There is no absolute right answer when it comes to Reasonable Compensation – but there are many wrong ones! Such as: I guessed; I split my distribution 50/50; or any other answer that involves a WAG.  In other words, any answer that does not rely on supporting information is a wrong answer, because it will have little credibility with the IRS.

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

The old adage “Simple isn’t always easy” perfectly sums up the IRS and Court guidelines for determining Reasonable Compensation.  At first blush the IRS and court guidelines seem simple enough – but once you start to follow the roadmap the IRS and Courts have laid out – simple quickly turns to challenging. 

Following are five steps for calculating Reasonable Compensation for any closely-held business owner:

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

Without an accurate Reasonable Compensation figure, tax planning is just a guess.

1. Educate. Send an issue letter so your clients are thinking about Reasonable Compensation before you meet.

  • Most S Corp owners, once they understand the issue, will follow your advice as their Trusted Advisor. For those who don’t, sharing the issue letter will document your attempt to do so.
  • Download Issue letter HERE

2. Stress Test. Is your client’s Compensation figure Reasonable?

  • If it fails the stress test, it likely won’t survive a Reasonable Compensation challenge.
  • Download Stress Test HERE

3. Research. 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.

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

This is by far the number one question we receive, and the answer is both simple and complex. Why? Because the amount of Reasonable Compensation actually paid is tied to distributions, not profit or loss.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take Reasonable Compensation plus a distribution, just Reasonable Compensation, or neither. What the shareholder-employee can’t do take a distribution instead of Reasonable Compensation.

To help you better understand, let’s run through a few simple scenarios and then move onto some more advanced ones. Keep in mind the following:

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

We have asked over 20,000 accounting professionals “What is your biggest concern or aggravation when advising your clients on Reasonable Compensation?” The number one response by far: Educating my clients 59%. Followed by Finding Reliable Comparability Data 26% and Accuracy 15%.

The RCR Resource Library includes Tools designed to help you educate your clients, including:

Armed with these tools, practitioners can efficiently educate their clients and simultaneously reduce risk of preparer penalties plus build an additional revenue source.

We recently updated our most effective issue letter, based on feedback from a long-time RCReports user:

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:

For additional information or to speak with our team
contact us directly on +1 (720)-279-8800 or Get Started now