Reasonable Compensation Workpaper Summary

The process for determining a reasonable compensation amount for IRS purposes is not easy.  It is the age old issue in tax of fairness vs. simplicity.  A simple system could result in better compliance however, it might be an unfair tax burden on some.  On the flipside, a complicated system might be fair tax wise but could result in poor compliance because of a lack of understanding and financial resources.

The IRS provides general guidelines which are a starting point.  Court cases on the subject have resulted in more information around which variables are important and how we should weigh them.  Despite this however, there are still several factors which make the process difficult for practioners such as…

  • Many different approaches that can conflict such as Investor Model, Ratio Analysis, etc.
  • Findings from C-Corps court cases that have been miss applied to S-Corps cases.
  • Cases that have focused in on less important variables such as compensation of the highest paid non-shareholder employee causing confusion.

 

The employee of an S-Corporation who is also a shareholder provides a unique problem for tax purposes.  The shareholder-employee wears two hats which are obviously that of an employee requiring a salary for work and that of an investor, requiring a return on investment.   Both forms of compensation have different sets of tax issues.  The largest area of uncertainty is around the general concept of company performance and how that effects salary.  If a company does well, is that the result of the employee role and therefore payable as bonus compensation or is it the normal return on an investment and therefore payable as distributions to the investor?  The correct answer is usually somewhere in between.

We use a “funnel” type of approach to zero in on what we believe is a fair amount for reasonable compensation.  We start by setting the outer limits which are plainly rooted in case law.  We then go step by step moving from certainty in tax law to discretionary areas until we come up with our conclusion on the amount.

We rely on the latest data and when guidance is missing, we will make a conservative reasonable assumption based on accounting and tax rules that are common in related areas.  Our goal is to provide a strong set of defendable workpapers in an efficient manner.

Free Entity Selector Template

If you advise on corporate structure (e.g. S-Corp vs. Sole Prop, etc), you may like this template.   It is a good starting point to help decide which entity is right for your clients.  It may not include all considerations, such as the impact of state fees, cost of processing payroll, etc. but overall its one of the best that I have seen.  Please use at your own risk.

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Business Structure Selector

Business Structure Selector

Guess & Get ($68 value):

Guess: What silly thing do the characters do at the end of our 2 min video (click here).

Get: If right, you’ll receive a free reasonable compensation opinion.  A great way to try out our service for the first time.  Email: davenagy@reasonablecompensation.com with answer by 6/15/2014.

Hint:  a. Juggle tax returns   b. Dance   c. Food fight

Video

 

How to Prepare for an Audit on Compensation

An IRS audit on owner compensation can be a costly and scary event.  Aside from the added costs of additional professional fees and many hours of your time, it can easily spill over into other areas of the tax return.  What could be a relatively small audit often turns into a full scale audit when the business owner is not prepared.  The best way for a corporate to protect itself if the IRS attacks their compensation is through documentation.  All corporations should document in the corporate minutes its wage policy and other factors that support the amount of wages that are being paid to the employee-shareholder(s).  If the corporation has solid documentation in place, it will usually result in an efficient, less expensive audit.  The documentation should address the amount of compensation paid for the amount of time and tasks that the employee-shareholder provides to the business as well as compensation for the size and financial performance of the company.  To learn more, please feel free to contact our CPA firm.

Do you need help with an IRS audit related to your reasonable compensation? Fill out the form below to get started now.

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