- October 1, 2019
- Posted by: Paul Hamann
- Category: Blog

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

This is by far the number one question we receive, and the answer is both simple and complex. Why? Because the amount of Reasonable Compensation actually paid is tied to distributions, not profit or loss.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take Reasonable Compensation *plus* a distribution, *just* Reasonable Compensation, or *neither*. What the shareholder-employee *can’t* do is take a distribution *instead* of Reasonable Compensation.

To help you better understand, let’s run through a few simple scenarios and then move on to some more advanced ones. Keep in mind the following:

- Reasonable Compensation is defined by the IRS as: “The value that would ordinarily be paid for like services by like enterprises under like circumstances.” or the hypothetical “Replacement Cost” of the shareholder-employee.
- Reasonable Compensation is based on the value of services provided (Hypothetical Replacement Cost), not profit, distributions, or the amount the company can afford to pay.
- Wages (Reasonable Compensation) should be paid BEFORE distributions are made.
- A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.
- A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation (distribution), and play ‘catch up in a later year.

Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business. While Reasonable Compensation has nothing to do with profit and loss, it does relate to Distributions. Why? Because the IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amounts 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 shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S Corp owner is taking money (e.g. distribution or other items of value) out of the S Corp.

Let’s take a look at a few examples so we can better understand the issue:

**Example 1:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2016 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA, Scott elects to take $175,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $78,950 and a distribution of $96,050.

Analysis: This is the simplest example of how Reasonable Compensation and Distributions relate to one another. Scott chooses the total amount he will take ($175,000); pays himself Reasonable Compensation for the services he provides his S Corp ($78,950), and makes a distribution to himself for the remainder ($96,050).

But what happens if the distribution amount is lower than the Reasonable Compensation figure?

**Example 2:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2016 Stone Concrete had a net profit of $43,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA, Scott elects to take $50,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $50,000 and a distribution of $0.

Analysis: IRS guidelines clearly state: S Corps must pay Reasonable Compensation to a shareholder-employee before non-wage distributions may be made. Until Scott’s total ** wage** distribution (AKA Reasonable Compensation) of $79,950 is met, he should not receive a

**distribution. In this example Scott’s total distribution falls below the level of his Reasonable Compensation figure; therefore, he will not receive a non-wage distribution.**

*non-wage*What happens if Scott elects to take zero distribution from his S Corp?

**Example 3:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2016 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. After consulting with his CPA, Scott elects to take NO distribution from Stone Concrete. Scott will receive Reasonable Compensation of $0 and a distribution of $0.

Analysis: Stone Concrete is Scott’s company and he alone gets to decide how much of distribution will be made (if any). **The IRS does not require S Corps to make distributions.** Keep in mind the IRS’s guidelines: *The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly**.* Because Scott received no distribution, he is not required to pay himself Reasonable Compensation, either.

The last example becomes more complex because Reasonable Compensation issues can span multiple years, known as a look back period, a scenario we will explore next along with how basis and loans affect Reasonable Compensation.

**Example 4:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2016 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott elected to take NO distribution from Stone Concrete for 2016. Therefore, Scott can choose to also take zero Reasonable Compensation.

In 2017 Stone Concrete has net profits of $220,000 before considering Scott’s salary. Let’s assume Scott’s Reasonable Compensation figure remains the same as 2016. After consulting with his CPA Scott elects to take $400,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $157,900 and a post wages distribution of $242,100.

Analysis: For a multi-year scenario we fall back to the IRS guidelines: S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made. Because the distribution Scott is making in 2017 is the product of earnings from 2016 and 2017, Scott must pay himself Reasonable Compensation for 2016 and 2017 ($78,950 + $78,950 = $157,900).

A multi-year scenario like Scott’s always generates three interesting questions: What, How & Why:

**What**about the tax implication in 2016 of the S Corps net profit of $187,000? Won’t Scott have a large tax burden on his personal taxes? Yes, he will. Ultimately it is Scott’s decision how much of a distribution he takes from his S Corp, the IRS cannot force him to take a distribution. We hope Scott has a plan to deal with the tax burden in 2016.**How**many years can a look-back period include? We don’t have a definitive answer. We suggest a minimum of three years, but we have no guidance on this from the IRS or the Courts. Three years assume the IRS will not examine a longer time frame without extenuating circumstances.**Why**would Scott do this? Maybe he wants to invest in equipment or hire a marketing person. But for this article, let’s assume he sees a tax advantage in this strategy.- If Scott took a distribution in 2016 of $180,000, he would have paid himself Reasonable Compensation of $78,950 and paid payroll taxes of $12,079 ($78,950 * 15.3%). Then in 2017 he took a distribution of $220,000 and paid himself Reasonable Compensation of $78,950 and paid payroll taxes of $12,079 ($78,950 * 15.3%). Total payroll taxes for 2016 and 2017 of
**$24,158**. - If Scott took a distribution in 2017 of $400,000, he would have paid himself Reasonable Compensation of $157,900 and paid payroll taxes of
**$20,352**($127,200 * 15.3% + $30,700 * 2.9%).**Total tax savings of $3,806.**

- If Scott took a distribution in 2016 of $180,000, he would have paid himself Reasonable Compensation of $78,950 and paid payroll taxes of $12,079 ($78,950 * 15.3%). Then in 2017 he took a distribution of $220,000 and paid himself Reasonable Compensation of $78,950 and paid payroll taxes of $12,079 ($78,950 * 15.3%). Total payroll taxes for 2016 and 2017 of

Lastly, as a cautionary tale, let’s explore how an S Corp can lose money and still be required to pay Reasonable Compensation.

**Example 5:** Scott Stone is 100% owner of Stone Concrete, an S Corp.

- In 2012 Stone Concrete was struggling through the recession and Scott personally
*transferred*$60,000 to Stone Concrete to keep it afloat. Stone Concrete had a net loss of $22,000 in 2012. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was $74,120. Scott took no distribution and no Reasonable Compensation. - In 2013 Stone Concrete had a net profit of $17,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was $75,650. Scott elected to take no salary in 2013. Instead, Scott
*transferred*$30,000 (of the original $60,000 from 2012) back to himself from Stone Concrete.

Analysis:

Scenario 1: If Scott **properly** classified and treated his $60,000 *transfer* to Stone Concrete as a ** loan** according to IRS and court guidelines, then he can repay $30,000 of the loan to himself without having to pay Reasonable Compensation first. Stone Concrete’s net profit remained unchanged at $17,000.

Scenario 2: If Scott **did not **properly classify and treat his $60,000 *transfer* to Stone Concrete as a loan according to IRS and court guidelines, then the loan was, in fact, additional paid-in capital (basis), and the repayment of $30,000 was actually a distribution (return of basis) not a loan repayment. Because Reasonable Compensation needs to be paid before any distributions can be taken, Scott must reclassify his distribution as wages.

When reclassifying the $30,000 of loan repayment as wages Stone Concrete will incur employment taxes of $2,295 for the $30,000 *salary* paid to Scott. Stone Concrete will therefore be pushed into the red, changing the $17,000 net profit into a **-$15,295** loss ($17,000 – $30,000 – $2,295).

This Scenario assumes Scott’s CPA caught the issue and treated it properly. If, however, this reclassification was due to an IRS Reasonable Compensation challenge, Stone Concrete’s losses would have been significantly higher after interest and penalties are assessed. For more on this see Glass Blocks Unlimited V. IRS.

Anything that compensates the S Corp owner can be re-characterized as wages, including personal expenses paid by the S Corp or loans to the S Corp owner. At the end of the day, distribution of any kind triggers the requirement to pay Reasonable Compensation for services provided. The best practice is to know what the value of those services is and pay that amount in Reasonable Compensation before taking a *post-wages* distribution of any kind.

One final thought: Profit now plays a role on the shareholders 1040 with the passage of the TCJA. How section 199A and the QBID affects your clients 1040 will vary significantly, because, as has been pointed out many times since the passage of the TCJA, section 199A is incredibly complex.

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