Anatomy of an IRS Reasonable Compensation Challenge

By Jack Salewski, CPA, CGMA & Michael E. Breslin CPA, MST, JD

What does an IRS reasonable compensation challenge look like from A-Z? Following is an analysis of a recent reasonable compensation challenge for a real estate agent in the Northeast handled by tax attorney Mike Breslin:

An S Corp owner has a fantastic year. More zeros than he’s ever seen. Then comes “The Letter” from the IRS.

That’s what happened to tax attorney Mike Breslin’s client. A real estate agent had a banner year, primarily because of one huge sale, more than doubling his usual income. But, like every other year in his career, he claimed no reasonable compensation on his S Corp tax return.

Here’s what happens before and after an S Corp owner receives what RCReports’ Jack Salewski calls the “It’s your lucky day” letter.

The IRS churns tax returns through its computers, using analytics to flag anomalies for audit. The analytics are secret, but CPAs and tax attorneys discern that the program looks for sudden changes in income, discrepancies from others in the same industry and same geographic area, surges in mileage or meals or thank you gifts. On the other hand, IRS analytics seem to ignore consistency. Mike Breslin’s client had been consistently reporting about the same amount in distributions, with zero reasonable compensation, for about a decade, without drawing any attention to his S Corp. He’d never even heard of reasonable compensation. Then one fantastic year inflated the size of his distribution. Red flag.

After being flagged by analytics, the realtor’s tax return was reviewed by the IRS. Why no reasonable compensation? Finding no easy explanation, the agent sent out the audit letter. This initial letter includes an explanation of the taxpayer’s rights, including the right to be represented by an attorney. The taxpayer has two weeks to call and set up an appointment with an auditor. The letter lists the documents and accounting data the auditor wants to see: corporate minutes, prior tax returns, and the like. If reasonable compensation seems low, the IRS may ask for backup documentation. Since the realtor reported zero compensation, there was no point in this case. But the realtor took the right to representation seriously, which is why he retained Breslin, managing partner for The FulServ Group in New York City.

Salewski advises S Corp owners who receive an audit letter to contact their CPA first. The CPA can recommend a tax attorney, if necessary. Breslin’s client didn’t have a CPA, he’d been using a tax preparer service, what Breslin calls a “chop shop.” Which explains why the realtor had never heard of reasonable compensation.

After scheduling the audit appointment, the taxpayer gets a few weeks to prepare. Gathering documents can take hours or days, followed by a two- to four-hour meeting with the CPA or attorney, then more document and data gathering.

In the realtor’s case, because he’d reported zero reasonable compensation, attorney Breslin knew existing documents would not protect his client from huge taxes and penalties. The IRS would start negotiations arguing that the realtor’s entire $180,000 in distributions should be recharacterized as salary. But the realtor, like most in his field, wears many hats and does various tasks. He empties his trash, takes photographs, writes website postings, drives around placing signs, schedules appointments, keeps the books. Breslin knew his client’s one-time good fortune was a windfall, not salary. But he needed a methodology to calculate an accurate salary. Working through RCReports, he and his client came up with $57,000. They were ready for the auditor.

The audit meeting went smoothly. IRS auditors typically treat taxpayers with respect. They arrive with a checklist and go through it methodically, making sure not to miss any issues. The audit meeting can take one or two hours. If more documents are needed, a follow-up meeting may be scheduled. In the realtor’s case, attorney Breslin predicted correctly. The auditor expected to recharacterize all $180,000 in distributions as salary. Breslin showed him the RCReports analysis. Although the auditor couldn’t be talked down to $57,000, he came down to $75,000 as the reasonable compensation figure (but did accept $57,000 figure for the other year under investigation). According to Breslin, it was a big help that his client hadn’t been dishonest. He had just not known. But if he had known, and been proactive, the $57,000 salary figure would probably never have been challenged.

To avoid all this, Jack Salewski advises accountants to begin every conversation with a new client by asking, “How much do you want to pay yourself?” Without professional guidance, “everybody does a poor job of calculating reasonable compensation.” Even when they take the time to figure it out, they often want to just “keep it the same for all eternity.” That’s a mistake. Compensation should be revisited every year. Because things change.

It’s still relatively unlikely for an S Corp to face a reasonable compensation challenge. Breslin and Salewski expect that to change. The IRS recently admitted that it finds it more efficient to target small taxpayers than richer ones. Likewise, it’s easier to audit small S corporations than big, publicly-traded ones. Also, both Breslin and Salewski have heard reports of the IRS hiring more auditors for reasonable compensation challenges.



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