Do You Own An S Corporation?
S Corporation owners typically are required to pay themselves a "reasonable" salary. At year-end, remaining profits can be distributed to the shareholders free of employment (Social Security and Medicare) taxes! The challenge is determining what salary is "reasonable."
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 might not have any basis in reality.
The proactive strategy is the most successful, but does require you and your clients to immediately address the question, "What is my Reasonable Compensation Figure?" The following steps will help prepare you should an IRS challenge land on your doorstep.
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.
The IRS guidelines state:
"In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed..."
Research what the going hourly rates are for the list of services in your community. Document your findings and sources of information and file them with the final Reasonable Compensation figure. Adopt the findings into the corporate minutes. This simple but often overlooked step gives the Reasonable Compensation figure an added layer of defensibility.
Congratulations! You and your clients were proactive. Go pull that file you created a few years earlier with the research and documentation backing up your client's Reasonable Compensation figure.
Grab the corporate minutes and meeting notes. This will probably be one of the first things the examiner will ask for.
Lay out this information next to the corporate minutes where the research, documentation and final Reasonable Compensation figure was adopted by the S Corp.
At this point your examiner should check the issue off his or her lead sheet, and move on to other issues. After all, you have done what the IRS wanted and paid Reasonable Compensation for the services provided to the S Corp. In addition the Reasonable Compensation figure was adopted into the corporate minutes. You have made it next to impossible for the examiner to successfully challenge the Reasonable Compensation figure.
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:
Acceptance -- 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.
Compromise -- Concede the high ground. No matter what Reasonable Compensation figure you present to the examiner, it will be suspect. The examiner is aware that the figure you are presenting was most likely built to defend a Reasonable Compensation figure that was pulled out of thin air, or counter the figure they are proposing.
Create a list of all the services the S Corp Owner provides for his or her company for the year(s) in question. These are the same steps as the Proactive strategy, but now your client has to try and remember what they were doing in the year(s) in question.
Research what the going rates for the list of services were, for the year(s) in question, in your community. Document your findings and sources of information.
Compromise. Usually the Reasonable Compensation figure you came up with in 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.
Credit: Paul S. Hamann & Jack Salewski, CPA, CGMA
Contact us today and allow us to advise you on a Reasonable Compensation amount that will best fit your business and put you in a strong defensible position! Furthermore, we will walk you through the steps necessary to prevent an audit in the first place so that you won't have to deal with the headache of "surviving" this challenge!