How do you know if Compensation is Unreasonable?

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.

So, stop looking for the “right answer” and start documenting “a credible answer.”

Any Reasonable Compensation figure can be challenged by the IRS.  Surviving a challenge requires backup data.  Think about all the receipts and documentation a business already maintains in the event of an IRS examination.  Reasonable Compensation is no different.

The IRS and tax courts have made it clear that S Corp shareholders-employees should both research and document how their Reasonable Compensation figure was reached.  The 1125E disclosure standard states:

  • The dollar amounts must be verifiable.
  • The taxpayer must be able to demonstrate the origin of the amount claimed.

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 expects 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.

We will leave you a final thought from a recent court ruling.  It is some of the best advice we have heard on the issue of Reasonable Compensation: “Determining an employee’s reasonable compensation is dependent upon a number of factors and is far from an exact science.” As with any other wage determination, you should consider all the available information, and make a rational reasonable determination.



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