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Your Best Strategy for Surviving an IRS Reasonable Compensation Challenge

By Paul S. Hamann

There are two ways to survive an IRS Reasonable Compensation challenge.  The first is a proactive strategy, getting all your clients ducks in a row ahead of time so you are prepared if the Reasonable Compensation figure is challenged.   The second is a desperate last-minute struggle to defend a Reasonable Compensation figure that may not have any basis in reality.

The Proactive Strategy: Is the most successful, but does require you and your clients to address the question “What is my Reasonable Compensation Figure” now.  Follow the steps below and you will be well prepared should an IRS challenge land on your doorstep. 

  1. Create a list of all the services the S Corp Owner provides for his or her company.  The courts have taken into consideration ALL the services provided by the S Corp Owner, not just their primary function or industry.
  2. Research what the going rates are for your list of services in your community.  Document your findings and sources of information and file them with your final Reasonable Compensation figure.
  3. Adopt your finding into your corporate minutes.  This simple but often overlooked step gives your Reasonable Compensation figure an added layer of defensibility.

The Last Minute Struggle:  If the S Corp owner did not research and document his or her Reasonable Compensation figure in the year being challenged you have two options.

  1. Accept what the IRS examiner is proposing, pay your tax, penalties, and interest (usually in the neighborhood of twice the original tax that would have been owed), lick your wounds and move on.
  2. Create a list of all the services the S Corp Owner provides for their company in the year being challenged.  Research what the going rates are for your list of services for the year in question.  This requires the same effort as the proactive strategy; except you no longer have the high ground.
  3. Compromise.  Usually, the Reasonable Compensation figure you came up within the last step falls somewhere between the figure originally submitted to the IRS and the figure the IRS examiner is proposing.  Now the challenge.  At this point, the best negotiator normally prevails and a compromise is struck.

My advice to you and your clients: Don’t procrastinate and pray.  If you don’t want to take the time and effort to determine your Reasonable Compensation, let us do it.  We live and breathe all things Reasonable Compensation.  In about 20 minutes we walk any S Corp owner through an online interview and produce a professional, defensible Reasonable Compensation Report.

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