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Reasonable Compensation Then & Now

By Paul S. Hamann

It doesn’t seem that long ago that the best advice for determining reasonable compensation was a rule of thumb or safe harbor figure; boy, have things changed.  Beginning in 2005 the IRS launched a study of S Corp compliance.  Since launching this study the IRS has:

  •  Modified Audit Selection Criteria: The IRS has systematically improved the methods for selecting S Corps for audit, and has more than doubled the average recommended adjustments from $50k for TY 2003-2004 to $105k for TY 2007-2011.
  • Reaffirmed its Authority: From 2007-2012 the very public case of David Watson went through the tax courts, putting an exclamation point on the IRS’s authority to reclassify distributions as wages if they believe the wages paid were not reasonable for the services provided.
  • Provided Guidelines: In 2008, the IRS issued Fact Sheet 2008-25 which provided guidelines and criteria that S Corps and their advisors can use to help determine reasonable compensation; we no longer needed to guess at a reasonable compensation figure.

So what are you telling your clients?

According to an RCReports poll, only 12% of S Corp Owners research and document how they reached their reasonable compensation figure.  This means every S Corp owner who does not research and document their reasonable compensation figure is at risk of having distributions reclassified as wages if the IRS believes the wages paid were not reasonable for the services provided.

What defense does the other 88% have, if examined?  Not much.  If an S Corp Owner did not research and document their RC figure, the IRS will do its own calculation, and stick the S Corp Owner with a tax bill for the reclassification of the difference between the S Corp Owners guesstimate and the IRS’s number.

The prudent 12% who did research and document their reasonable compensation figure will fare much better, having a defensible position to the IRS’s inquiry.  And if they adopted the research and documentation into their corporate minutes, their reasonable compensation figure will be all but untouchable.

How should you advise your S Corp clients on the issue of reasonable compensation in 2013?  Start by telling them:

  • The landscape has changed and the IRS is looking much more closely at S Corps and reasonable compensation.
  • The IRS has stepped up its enforcement of S Corps:  Audits are up 33% over the last 2 years and are expected to continue increasing.
  • The cost of an IRS reclassification is high – total cost is typically more than double the original tax that would have been due.
  • There are easy-to-use solutions you can provide to your clients that help a shareholder-employee of an S Corp determine their reasonable compensation figure.

How do you convince your clients to heed your advice?

  • Start by sending them an issue letter on reasonable compensation.  RCReports provides an issue letter template that our subscribers can download and customize.
  • Talk with them about the importance of being in compliance.  In an RCReports poll, the majority of CPA’s (90+%) said the best way to persuade their clients to research and document their reasonable compensation figure is to advise and educate them on the high cost and the risks of an IRS audit.
  • Add the requirement and cost of a Reasonable Compensation Report from RCReports to your annual engagement letter, and build the cost into your 1120S fee.
  • Notify them you cannot start their return until the reasonable compensation research and documentation has been provided to you; protect yourself from IRS preparer penalties.

Planning season (Oct. 16th through Jan 15th) is the best time to counsel your clients on reasonable compensation.  Order your clients a Reasonable Compensation report, and begin protecting and advising them today. 

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