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Case Study: Profitability V. Distribution and Reasonable Compensation

 

By Paul S. Hamann

One of the most frequent questions we receive on the issue of Reasonable Compensation (RC) for shareholder-employees (SE) of S Corp’s revolves around the profitability of the S Corp.  Unfortunately, RC has very little to do with the Profit or Loss of an S Corp, and everything to do with the S Corp’s Distributions.

So let’s try and clear up any confusion between the Profitability of an S Corp and a Distribution to an S Corp SE as it relates to RC.  Profitability and Distributions are not the same; they are separate and distinct events.  Reasonable Compensation is not tied to Profit or Loss – it’s tied to Distributions.  The IRS guidelines for RC state: The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.  It does not mention profit or loss at all but instead talks about ‘amounts received’ by the SE.  Therefore it does not matter whether or not the company is making or losing money; what matters is whether or not the SE is taking money (or other items of value) out of the S Corp.  Let’s take a look at a couple examples so we can better understand the issue:

Example 1:  Scott Stone is 100% owner of Stone Concrete, an S Corp.  In 2012 Stone Concrete made a net profit of $112,000 before considering Scott’s salary*.  Scott’s RC figure for the services he provided to his S Corp was calculated to be $74,685.  Scott would like to take out as much cash from Stone Concrete as he can.  After consulting with his CPA Scott elects to take $90,000 out of Stone Concrete.  Scott will receive wages* of $74,685 and a distribution of $15,315.

Example 2:  Scott Stone is 100% owner of Stone Concrete, an S Corp.  In 2012 Stone Concrete made a net profit of $23,000 before considering Scott’s salary.  Scott’s RC figure for the services he provided to his S Corp was calculated to be $74,685.  Scott would like to take out as much cash from Stone Concrete as he can.  After consulting with his CPA Scott elects to take $30,000 out of Stone Concrete.  Scott will receive wages of $30,000 and a distribution of $0.

Example 3:  Scott Stone is 100% owner of Stone Concrete, an S Corp.  In 2012 Stone Concrete had a net loss of $42,000 before considering Scott’s salary.  Scott’s RC figure for the services he provided to his S Corp was calculated to be $74,685.  Stone Concrete borrowed money from its line of credit to cover expenses and pay Scott a salary of $48,000.  Scott’s Reasonable Compensation will be $48,000 with no distribution.

There are a lot of ‘what ifs’ when it comes to the issue of RC for an SE of an S Corp.  We will be periodically exploring these ‘what ifs’ in our monthly newsletters.  If you have a ‘what if’ you would like us to explore, or if you have experience with one and would like us to share it with our readers please contact us.

*Salary, Wages and Reasonable Compensation are used interchangeably in this article. 

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