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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.

If you really don’t want clients coming into your office waving “interest and penalties” letters and pointing the finger of blame at you, recognize that it’s not enough to follow the instructions for Form 1125-E, although that’s a good start. You must also meet the IRS’s disclosure standard. If you don’t, the IRS Reasonable Compensation Job Aid suggests the examiner apply accuracy related penalties under Section 6662.

A few simple steps will protect your client from accuracy penalties.

  1. File form 1125-E for ALL your corporate clients. You MUST file it for corporations with revenue above $500,000, but you can (and should) file it for all your corporations.
  2. Meet the IRS disclosure standard for reporting officer compensation, which means:
    1. The taxpayer completes the forms and attachments in a clear manner and in accordance with the instructions.
    2. The dollar amounts must be verifiable.
    3. The taxpayer must be able to demonstrate the origin of the amount claimed.
    4. The taxpayer must be able to show that he entered the amount in good faith.

Well, step 2a. should be a no-brainer for any tax preparer. However, steps 2b., 2c. and 2d. clearly indicate that the taxpayer must have verifiable documentation to back up the amount of officer compensation entered. Without this documentation your client is at risk of accuracy related penalties. And when your client is assessed penalties, the finger-pointing often escalates to threats of malpractice claims.

The issue of Reasonable Compensation became much more complicated with the passage of the TCJA. In the past, S Corps typically skinnied down the owner compensation to save on payroll taxes and C Corps fattened it up to avoid double taxation. Now, the TCJA has provided opportunities for both S & C corps to do just the opposite to save on their overall tax liability (see Reasonable Compensation: The X Factor in the QBI).

Now and in the future the IRS will be looking to see if an owner’s compensation is either too high or too low and was it to the benefit of the taxpayer’s overall tax liability. Additionally, the Service will be expecting to see backup documentation.

It is now standard procedure for every corporate audit to look at Officer Compensation. There are rumors that the IRS has trained and graduated 2,500 agents specifically to target Reasonable Compensation. We’ve confirmed from former IRS executives (Will There Be A Rise In IRS Audits of S Corporations?) that the IRS is gearing up to enforce officer compensation. Don’t minimize the risk an IRS challenge could have on your firm (Are You at Risk for Preparer Penalties?) and your clients.

Bonus: There is one additional benefit to filing form 1125-E. If a shareholder is an officer in name only, entering 0% in column c (percent of time devoted to the business) will help protect the officer from an IRS Reasonable Compensation challenge. (Read more about Officer in Name Only in the August Newsletter: Did the IRS Really Lose the Davis Case?) This is not an all or nothing benefit. It will also help if the officer works part time, 30% or 12 hours a week.

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