What You Need to Win an IRS Reasonable Compensation Challenge

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

This is a true story. Names & identifying details have been changed to protect the innocent.

Nancy had a feeling that $40,500 was a good Reasonable Compensation figure for her as owner of Nancy’s Nail Salon. She didn’t have any facts or data to back it up, but she wasn’t trying to get away with anything either. Her accountant thought it felt right, too. Who would check, anyway? Nancy just wanted to get back to the salon and keep making money. Her accountant jotted down $40,500 and reported that to the IRS.

Turns out Nancy’s feeling was correct.

But being correct didn’t save her from months of stress when the IRS came after her. Being correct didn’t save her from expensive accountant fees. And for months she was distracted from the business she loved.

What went down in Florida with Nancy’s Nail Salon is an example of the danger of the “set it and forget it” philosophy of Reasonable Compensation. Maybe you do a little (free) online research. Maybe the figure you choose just feels reasonable. You don’t document how you came up with this number or have any real data to back it up. A few years later, along comes an IRS challenge. How do you defend yourself?

Here is what went down in Florida:

“Nancy” owns, and works for “Nancy’s Nail Salon,” an S Corp. Nancy rents out booths to other nail technicians and pays them via 1099, a common arrangement in her industry [keep this in mind; it is important later].

In 2019 Nancy and her tax advisor set her reasonable compensation at $40,500. Nancy was more focused on running her own business then dotting the i’s and crossing the t’s of tax compliance. Plus, she and her accountant had almost no concern about being selected for a Reasonable Compensation challenge. They didn’t document their reasoning behind the figure.

Fast Forward to January 2022. Nancy’s Nails was selected for audit by the IRS’s Specialty Examination Employment Tax Program, which focuses on employers paying employees via 1099 instead of W-2. The audit began as you would expect, investigating whether or not the 1099 contractors should have been paid as employees via a W-2. Bingo! Nancy’s Nails did everything right! She sailed through this part of the audit.

The IRS was just getting started. Within the IRS’s Specialty Examination Employment Tax Program is a Specialty Workstream focused solely on S Corp. officers’ compensation. So, in addition to investigating the 1099 issue, examiners looked at her reasonable compensation. The examiner calculated Nancy’s reasonable compensation at $67,000, a difference of $26,500. Nancy was looking at taxes, penalty, and interest in the neighborhood of $10,000 [rule of thumb: 2.5 times the original tax owed of $4,055].

Along the way, Nancy replaced her “feels good” accountant. Her new accountant, we’ll call him J.R., had (lucky for her) just completed a course on Reasonable Compensation through RCReports. J.R. ran a compensation report for Nancy that determined Nancy’s compensation to be $41,833. J.R. presented a fact-packed report to the examiner in defense of Nancy’s $40,500 figure.

The IRS examiner stuck to her guns and would not budge from her $67,000 figure. J.R. knew what to do. He turned the tables on the examiner. How exactly did she come up with her figure? What data set did she use? What assumptions were made? The examiner had J.R.’s detailed report, and he requested the same from her, which he got.

Turns out the examiner had used the Cost Approach to determine Nancy’s reasonable compensation, just as J.R. had – a good start. The examiner’s data set closely matched RCReports data –another good sign.

The $26,500 difference boiled down to how much time Nancy spent performing different tasks within her company, an important component of the Cost Approach. The examiner had guessed how Nancy spent her time. It just felt right to split it down the middle – 50/50 between operations and nail tech tasks.

J.R. hadn’t relied on guess work or feelings. He had data. He could show that Nancy spent 22% of her time on operations and 78% working on her customers’ nails. Facts matter. J.R. successfully argued the facts and in the end, Nancy received a no change letter.

A feeling, honest intentions, even being right, weren’t enough for Nancy. She needed facts. Even though she survived the challenge, she paid a steep cost in time and money. J.R.’s services were worth it, but cost Nancy a pretty penny. Had her first accountant documented her figure with facts from a credible source, she could have avoided paying extra fees, not to mention avoided months of stress and distraction from her business.



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