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Why there is no right answer for Reasonable Compensation – but there are wrong ones

By Paul S. Hamann

The wrong answer goes something like this:  I guessed; I split my distribution 50/50, or any other answer that involves a WAG.  In other words, any answer that does not have supporting information will probably have little creditability with the IRS.  So if there are wrong answers how come there aren’t right answers?  The easiest way to think about this puzzle is to stop thinking “I need a right answer” and start thinking “I need a credible answer.”

 Any Reasonable Compensation figure can be challenged by the IRS.  Surviving a challenge requires backup data to support your figure.  Think about all the receipts and other documentation you already maintain for your business in case 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.  As with any other wage determination, you should consider all the available information, and make a rational reasonable determination.

How should you advise your S Corp clients on the issue of reasonable compensation in 2014?  Start by telling them:

  • The IRS is now 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 shareholder-employees of an S Corp determine their reasonable compensation figure.

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.”

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