We periodically remind our S Corp. clients of the importance of paying themselves a reasonable salary. We offer to perform a reasonable compensation analysis for them for a nominal cost, especially in light of the dollars at risk. There are those who respond that they have themselves determined that their salary is reasonable. When we hear these types of responses, we often think of the adage “What do you call an attorney who represents himself in court? A fool.” The same can often be said for these business owners who don’t understand how the IRS determines reasonable compensation.
For those of you who may not be familiar with the issue, the IRS discovered years ago that some S Corp. shareholders were not paying themselves any salary. That meant that while their corporations’ net profits were subject to income taxes, they were not paying any Medicare or FICA taxes. This was a very substantial tax savings compared to a sole proprietor or partner whose entire earnings are subject to these payroll taxes.
Accordingly, the IRS now says that shareholders who are employees in their S Corps must pay themselves a reasonable salary. Like so many very important tax issues, the IRS and the Internal Revenue Code do not define what is meant by “a reasonable salary”. Thus, when the IRS finds that there was not a reasonable salary paid, it not only assesses the unpaid payroll taxes, but also imposes penalties and interest for the failure to timely remit those payroll taxes to the IRS. If the IRS auditor finds that there was not a reasonable salary paid, the burden of proof is not upon the IRS to prove that the salary was not reasonable, but the burden of proof falls upon the taxpayer to prove that the salary was reasonable. In most cases, the taxpayer has no substantiation (which is why we offer a reasonable comp study) and the IRS usually always prevails.
What are some of the best practices for determining reasonable compensation for a shareholder-employee of an S Corp that we incorporate in our studies? First, we identify ALL of the services provided by the shareholder-employee. 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 for the other income producing employees or assets.” We next work with the shareholder-employee to break down the amount of time devoted for each of the services provided. “Time and effort devoted to the business” is one of the key factors the courts look. Now that we know what services are provided by the shareholder-employee and the amount of time devoted to each service, we determine the appropriate wage to be paid for these services. We then consider such factors as years of experience and the local where the services are being provided as wages differ by city, state, region, etc. Then all of this info is put into an Excel worksheet to determine the reasonable compensation for each service provided by multiplying time spent by the appropriate wage for each type of service provided.
One may think that the reasonable compensation analysis has now been completed, but that is not the case as the courts look at other factors. The secret to prevailing against the IRS is to understand the factors it and the courts use and to use those same factors to the taxpayer’s advantage. Other factors to consider include the distribution history of the company, compensation paid to non-shareholder employees, timing and manner of making bonuses to key personnel, compensation agreements, and any board of directors’ minutes regarding compensation. You then incorporate all of this analysis and memorialize it in the board minutes of the S Corp.
This analysis can usually be completed in 30 days or less and we usually recommend that it be done every 3 years.
If you want to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
