The U.S Treasury has urged the IRS to increase S-Corp audits on reasonable compensation due to compliance studies (see IR-2005-76) showing a large amount of underreporting. The underreporting is typically done to minimize employment taxes. S-Corps can be great tax saving entities with the flexibility to minimize FICA taxes/self-employment tax by having the ability to categorize distributions as either compensation (through payroll) or dividend distributions (not subject to payroll/self-employment tax). Since this structure can create abuse by owners by paying themselves either extremely low wages or even no wages at all, the IRS requires a “reasonable compensation” be drawn by the business owner each year. In addition, the qualified business income (QBI) deduction of 20% is also overstated when an owner takes no or too small of a proper salary.

Treasury department auditors have found that IRS procedures regarding reasonable compensation are inadequate and in most cases revenue officers auditing returns do not even investigate this area. This has pushed an interest in further auditing compensation set by business owners.

How do you compute reasonable compensation? IRS Section 162-7(b)(3) defines reasonable compensation as, “The value that would ordinarily be paid for like services by like enterprises under like circumstances”. Compensation is typically set up on a case-by-case basis and can change every year as businesses’ earnings fluctuate and distributions pulled by the business fluctuates (since reasonable compensation cannot exceed distributions taken in a year). It’s a topic you will want to have regularly reviewed by your tax practitioner.

Since the issue is regularly litigated there is a lot of information that can be gathered regarding issues the courts are typically looking for. During a reasonable compensation audit, IRS agents are typically looking at some of the following:

• Amounts paid by similar sized business for the same type of work.
• Salary policies for all employees.
• Whether compensation is predetermined or determined retroactively.
• Qualifications, educational background, and work experience.
• General and local economic conditions.
• Different duties of work and time allocated to each duty (think business owners who wear various hats including bookkeeping, admin work and their normal trade work. A lawyer without an admin person, who is devoting 30% of their time to admin work would impact their reasonable comp.).
• Dividend History.
• Compensation agreements.
• Formulas being used to determine compensation.
• Bonus payment history to key people.

Notable Court Cases regarding Reasonable Comp.:

• David E. Watson, P.C. V. United States (8th cir. 2012)
• Sean McAlary Ltd, Inc. v. Commissioner
• Glass Blocks Unlimited . Commissioner (2013
• Joy v. Commissioner (2000)
• Joseph M. Grey Accountants P.C v. Commissioner (2002)

There are three main methods for determining reasonable compensation including:

Cost approach: Also known as the many hats approach, this typically works well with small business owners.

The Market Approach: Also known as the industry comparison approach: Generally works well with small business owners who’s main day to day tasks includes mainly managerial duties.

The Income Approach: Also known as the independent investors test, generally works well in unique situations. This test emphasizes how much a reasonable investor would expect to pay to cover a key person’s wages.

With this issue being a point of interest for IRS auditors, it’s important to run a compliance check on your business and work with your tax professional to make sure your business would pass an audit in this area. Our firm provides comprehensive reports to calculate reasonable compensation to ensure compliance and provide detailed workpapers in the event of an audit.

Contact us today for a reasonable compensation consultation.