How to Help Clients Determine Reasonable Compensationby
Starting back in 2005, the way that IRS examiners have approached noncompliance when it comes to reasonable compensation has changed significantly. This has posed a particular challenge for accountants who provide financial and tax advice to their small business clients.
“Reasonable” Compensation Requirement
In subsequent rulings regarding S corporations – the most common corporate entity in the United States today – the US Treasury Department determined that to the extent the owners of an S corporation performed services for their company, the company was required by law to pay that owner a reasonable salary as compensation for those services. In addition – and crucially – that reasonable salary is subject to self-employment tax.
The goal was and is to prevent S corporation owners from exploiting a payroll tax loophole by requiring them to pay themselves reasonable compensation for their services before taking distributions. As a result, the main focus of IRS examination of S corporations’ tax returns over the past decade or so has been on determining whether the reasonable compensation amount paid to the S corporation owner was “reasonable” based on the services provided. Note that the IRS is typically examining data in the three to five year range.
Court cases between 2010 and 2013, including one that went all the way to the Supreme Court, have supported the methodology of the IRS, as well as shed further light on the issues involved.
The takeaway from all these cases is that the amount of reasonable compensation taken must be reasonable for all the services the S corporation owner performs for the company and that reasonable compensation is triggered by distributions, not profit or loss.
Because there is no safe harbor for reasonable compensation, the best strategy is to research and document reasonable compensation every year. Then, you will have a defensible position if a reasonable compensation challenge comes your way.
How is “Reasonable” Determined?
The difficulty is that the Treasury and the IRS have failed to provide S corporation owners with adequate specific guidance on how exactly to determine the reasonableness of an owner’s salary. S corporation owners must pay themselves, but how much? This has left many small business owners – and their tax advisors – resorting to various rules of thumb instead of basing their figures on empirical data.
Researching and documenting now, versus guesstimating, will make it much harder for the IRS to challenge your client’s numbers. One result of the lack of empirical data in calculating reasonable compensation has been wide disparities in salaries reported on tax returns by S corporation owners, including those operating in similar industries and regions.
Naturally, these disparities stick out like a sore thumb to the IRS and Treasury. As recently as 2009, a US Government Accountability Office report stated that in just two previous years, S corporations had underreported their shareholder compensation by nearly $25 billion – with those with fewer than three shareholders accounting for the lion’s share of the underreporting.
It is important to note that in many of the cases taken to court by the IRS, the plaintiffs were not only the S corporation owners but also the CPA firms that advised them. The IRS has started assessing penalties for tax preparers regarding reasonable compensation.
How Courts Are Determining What is “Reasonable”
According to forensic accountant Richard Pasquantonio, writing in the April 2016 RCReports newsletter, one 2013 case in particular (Sean McAlary LTD Inc.) “highlights the factors that the court will weigh in making its reasonable salary determination.” Pasquantonio, CPA/CFF, CFE, CDFA, is an associate at Adam Shay CPA PLLC who focuses on forensic accounting, fraud prevention and detection, and tax controversy resolution. Those factors the court will weigh, according to Pasquantonio, include compensation of nonowner employees, past salary history, industry formulas, and the financial condition of the company.
However, Pasquantonio explains, even though “all these factors are considered, the court’s most heavily weighted consideration appears to be summarized as the replacement cost to the company of hiring an outside party to perform the business owners’ duties. The court considered three key factors in support of the replacement factor:
- Is there a methodology that can be duplicated?
- Is the methodology grounded in reliable empirical data?
- Is there a measure of the duties that the owner has performed and their proficiency at those duties?”
Stakes for CPAs and Financial Advisors
For CPAs and other tax and financial advisors, the stakes in helping your clients meet the challenge of increased IRS challenges to their reasonable compensation determinations are significant. Obviously, an S corporation owner who is challenged by the IRS and winds up paying back taxes, plus penalties and interest, is going to turn to their trusted advisor and ask why they weren’t better advised.
However, being equipped to deliver sound advice in determining reasonable compensation is not just critical for holding onto your clients and keeping them happy. Being proactive in delivering sound advice based on empirical data instead of guesstimates can also become a profit center for the tax and financial advisor – an added value delivered to clients for a fee.
Since 2010, small business owners have seen a significant uptick in reasonable compensation challenges, as the IRS has increasingly trained its tax examiners to examine payroll tax issues in particular – among them reasonable compensation. We find that small business owners almost never have good documentation to mount an effective defense of their numbers.
There are more than half a million S corporations in the United States today, and about 40,000 CPA firms providing them with tax and financial advice, so the risk of unhappy clients due to an IRS examination that determines the client paid too little is quite significant.
The IRS will typically set a high number, usually near the Social Security maximum, if it determined that the reported salary is not defensible. But if presented with empirical data in the form of a report, that amount can typically be negotiated downward by a significant amount.
If you’re guessing, there’s not only the danger that you may be underpaying, and thereby setting up your clients for an IRS challenge, but there’s also the danger that you may be overpaying when it comes to payroll tax. This is a real possibility, Pasquantonio explains, when using rule-of-thumb approaches like the 50/50 formula.
Offer Your Clients an Added Valuable Service
If your S corporation clients have not reviewed their approach to setting salary in the past two or three years, they could be facing significant exposure to an IRS examination. As a proactive tax and financial advisor, you can provide a valuable service to your clients – and charge for that valuable service – by adopting the best practice of having them complete a report annually.
While completing such a report is not a legal requirement, your client will thank you when they talk with a business owner who has just fallen afoul of an IRS examination and had to fork out significant dollars in back tax, penalty, and interest. In fact, your client will probably recommend you as a replacement for the CPA firm that just let them down.
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