Help! My New Client Didn’t Take Reasonable Compensation Last Year

By Paul S. Hamann & Jack Salewski, CPA, CGMA

This is a question we get a lot at the beginning of the year: “I just took on a new S Corp client and they didn’t take any Reasonable Compensation last year. What do I do?!”

First things first: Reasonable Compensation only applies if the owner takes a distribution. If the owner did not take any distributions last year, they are still in compliance. This situation is rare as most S Corp owners can’t go a whole year without taking salary or distributions from the business. If this does happen, the shortfall in owners’ compensation needs to be tracked so it can be made up in future years. If it comes up it is a great area for you to offer advisory services.

Be aware there are lookback periods that are associated with Reasonable Compensation. If the S Corp owner takes distributions for a two-year period, for example, they will need to pay themselves Reasonable Compensation for those two years. For more on this scenario take a look at example 4 in this blog post.

Ok, on to a more common scenario: The S Corp owner did take distributions out of the business but took zero or low reasonable compensation.

First, know that you as their new advisor are not liable for what happened prior to your involvement. However, now that they are your client, you do have a professional responsibility to ensure they are acting in compliance with IRS regulations.

If you take on this new client BEFORE the payroll tax deadline, you can:

  • Run a reasonable compensation analysis for the client for the prior year.
  • Pay the client via W-2 in one lump sum for that amount before the payroll tax deadline.
  • Run a reasonable compensation analysis for the client for the current year.
  • Ensure they are set-up on regular payroll for the current year and that they take reasonable compensation before distributions per the law.

Will the one lump sum raise a red flag with their State or the IRS? Maybe. But if you can show that the taxpayer is paying the correct amount of taxes, you’ll be far better off with the examiner.

If you take on this new client AFTER the payroll tax deadline, you can:

  • Run a reasonable compensation analysis for the client for the prior year.
  • Pay the client this amount via 1099 so they can pick it up on their individual tax return. Note that this technically is not in compliance as you MUST pay reasonable compensation via W-2. There are some important nuances associated with this strategy, such as not taking a 199A deduction on the owner’s Schedule C; please review W-2 or 1099 for Shareholder-Employees of S Corps? to make sure you understand the issue thoroughly.
  • Run a reasonable compensation analysis for the client for the current year.
  • Ensure they are set up on regular payroll for the current year and that they take reasonable compensation before distributions per the law.

Will the payment via 1099 be challenged by the State or the IRS? Maybe. And they technically can impose penalties on your client. However, in our experience, most examiners will see that the taxpayer has paid the same amount of self-employment taxes as the payroll taxes would have been if paid on a W-2 and is now trying to be compliant and should be reasonable.

As you take on new clients this year, make sure that all of your S Corps have a current reasonable compensation analysis on file and that they are taking the appropriate amount as wages via W-2. If not, you could be opening up your client, and yourself, to steep penalties should the IRS come knocking.



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