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.
4. Get Up-to-Date. Put Section 199A & the QBI on the meeting agenda.
- This will likely be the most popular and important topic you cover with your clients this year. The only way to advise them accurately is to have a Reasonable Compensation figure based in fact.
5. Document. Add research to corporate minutes
- This simple step will add an additional layer of defensibility to your client’s Reasonable Compensation figure. Reasonable Compensation Reports for S & C Corps includes sample minutes.
6. Remind. Add Reasonable Compensation to your engagement letters
- Notify and document the issue of Reasonable Compensation with your clients by adding an additional paragraph to your engagement letter.
- Download Engagement Letter HERE
7. Verify. Report ‘in name only’ S Corp officers devoting no time to business.
- The IRS assumes all corporate officers are performing services for the S Corp and should be paid Reasonable Compensation. If your client is a corporate officer in name only and not performing any services for the S Corp, there is an exception in the IRS code for officers who perform only minor services. [Treas. Reg. § 31.3121(d)-(1)(b)] If you are filing Form 1125-E, make sure time devoted to the business is 0% and make a notation in the corporate minutes.
8. Authenticate loans. S Corp can repay valid shareholder loans
- Clients who would like to transfer money out of their S Corp as loan repayment should have that loan properly documented and treated as an arm’s length agreement. The IRS requires S Corps to pay Reasonable Compensation before taking a distribution, but an S Corp can re-pay loans before paying Reasonable Compensation to its shareholder-employees as long as the IRS deems the loan as valid.
9. Delay distribution. Not taking a distribution may avoid employment taxes in some cases.
- S Corp officers are not required to take Reasonable Compensation if they are not taking a distribution. If an S Corp owner can delay taking distributions for one or more years, when they do take a distribution (depending on the amount) they may be able to avoid some employment taxes. This happens when the Reasonable Compensation figure for multiple years exceeds the Social Security maximum. Be aware that when a multiple-year distribution is taken, the Reasonable Compensation should match the distribution’s time frame.
10. Update. Is your clients’ current occupation accurately reflected on 1040 and industry in SIC/NAICS codes?
- In most tax software this field auto-populates from the prior years’ return. Make sure it is up-to-date and best matches the services your client performs. If a client performs multiple job duties (as most small business owners do) consider using ‘Various’.
- The IRS uses ratios specific to industries to try and find S Corp owners who are paying unreasonably low compensation. Make sure your client’s SIC/NAICS code is accurate and hasn’t changed.
For the Trusted Advisor in you, the list above will get conversation rolling with your S Corps and will open the door for offering additional products and services.