Reasonable Compensation For S Corps: Dont F*** It Up!

Howdy folks! I am a Certified Public Accountant, certified in NY & NJ and today I'm going to briefly discuss something that I believe to be important as we progress into 2020: Reasonable Compensation for S Corp shareholders. In 2019 and 2020, there will be more scrutiny towards reasonable compensation calculations and S corporations in general. With the passing of the TCJA the IRS and several authorities, including Michael Gregory (former employee of the IRS and CVA expert) have confirmed that beginning in 2019 there will be an increase in the number of S Corporation Reasonable Compensation Audits. I will be encompassing some IRS guidance and throwing some illustrations into play to help you understand how serious this topic is. If you have any further questions after reading, feel free to email us at info@darianaccounting.com.

What is an S Corporation?

What is an S Corporation? An S Corporation is not an entity in and of itself but is a tax status that offers several benefits including pass-through taxation, protection of assets, and potentially favorable tax consequences.

You may be asking yourself: Shouldn't everyone just elect for S corporation status for their businesses? The answer is No, not everyone. You would need to consider the State laws that kick into effect, LLC requirements and the cash flow and status of the organization to see if it would be preferable. The addition of the QBID in 2018 makes this a little less black-and-white than you would think and any CPA that can say this with certainty hasn't viewed every lens that we would examine at Darian Accounting. Send us an email today or speak with a CPA or tax professional if you are having trouble with this or want comprehensive professional guidance. This could be a substantial decision that can having lasting effects if done incorrectly so be sure to do things correctly.

LLC vs. S Corporation

S Corporations, in the simplest terms, are preferred because they are not required to pay Self Employment tax. We will look at a simple illustration (ignore SUTA and FUTA for now) to depict some of the tax ramifications of an LLC vs. an S corporation.

Let’s say John Doe started a carpet installation business and is the President and has only one employee, Jane Dough his executive assistance. In Year 1, after expenses and salary paid to Jane Dough he had a net profit of $100,000, of which he paid himself a $60,000 salary in the form of a distribution.

Net Profit after expenses: $100,000

With an LLC, he would have to pay self-employment tax on the entire net profit, or approximately $15,300 (15.3% for employee & employer portion) in self-employment tax regardless of distributions and salary. LLC's are disregarded entities. They simplify things but you can see why from a tax strategy standpoint, CPA's may advise against them in the long-term, or if you are or booking healthy profits.

With an S Corporation, he would only have to pay self-employment tax on his salary of $60,000 for a total of $9,180, unless of course this salary is deemed unreasonable.

In this illustration, by having an S Corporation instead of an LLC John Doe would save $6,180 in taxes in Year 1! Not bad at all! Hmmm but then the inquisitive reader may say, if he lowered his salary even FURTHER, then he would pay even less! Which is exactly what the IRS was thinking when they released guidance and requirements stating that the salary for S Corporation shareholders must be reasonable in the circumstance.

What does Reasonable Compensation mean?

Reasonable compensation to tax and accounting professionals has been defined as either: 1) fair market value, or 2) replacement cost.

What would somebody have to pay to “replace” the employee in question. If we look at a Partner in a multi-million dollar law firm with a JD, MBA, and 20 years of legal experience it would be unreasonable to say a $24,000 salary is the 'replacement cost' to replace this employee if he brings in $500,000 in revenue and is highly efficient and knowledgeable. What is the going rate for someone in this position—this is what replacement cost refers to (what would be the cost of replacing someone of these qualifications), while fair market value would be what theoretical salary would be paid for in a comparable role, in a comparable industry, with comparable qualifications, and comparable duties (you look at the market salary). FMV and Replacement Cost are similar but they can be different as I'm sure you can imagine (more complicated when intangible assets come into play and depending on economic dynamics of supply and demand). The cost of replacing someone can be more than their fair market value. I digress. This calculation becomes complicated as there are many factors including industry, education, experience and efficiency at function that complicate this. There is no set formula for calculating reasonable salary but there are a myriad of factors to consider to help cover yourself from IRS scrutiny. I have included a few factors that may help you from IRS scrutiny. The more tangible support you have to warrant your calculation, the better your chance of prevailing. There are no guarantees but these are some things the Service has looked at in the past, as every circumstance is different.

1) Training and experience

2) Duties and responsibilities

3) Time and effort devoted to business

4) Dividend history

5) Payment to non-shareholder employees

6) Timing and manner of paying bonuses to key people

7) What comparable businesses pay for similar services

8) Compensation agreements

9) The use of a formula to determine compensation

For more information see IRS Publication 2008-25—Wage Compensation for S Corporation Officers.

What’s the idea here?

If we look at the example above with a Partner in a law firm with a $24,000 salary and 20 years of experience, let us say he pays himself distributions of $100,000 in Year 1. This means that he only pays self-employment tax on $24,000 and the $100,000 is completely exempt from self-employment tax. He would save $15,300 if this salary was reasonable. However, this is almost irrefutably going to be deemed unreasonable, as he takes a distribution for 4x his salary, and in all likelihood the Service would step in and reclassify the distributions as salary.

The IRS, in many court cases, has stepped in and said: if it looks like a salary, smells like a salary, and has the form of a salary, then we’re going to tax it as a salary. There have been 30 court cases against the IRS and of these 30 court cases, only one has prevailed against the IRS (in the case of United States v. Davis). In the example above the Service would likely step in and reclassify the distribution as salary and assess a $15,300 tax with interest and penalties which would translate to a balance of approximately $35,000. As a general rule of thumb, just to understand how real the assessed penalties and interest can be, multiply the original tax assessed from reclassification by a 2.5x multiplier: $20,000 in tax reclassification would look like $50,000 i.e. Remember they can only assess reclassification on what was actually distributed to the shareholder. If there is one thing you should learn from this article it is that they can not put an assessment if there was no distribution paid to the shareholder.

What you can do?

Option #1: Maintain documentation and support for salary calculation. If the IRS comes knocking, and you have evidence and support to justify your calculation with a salary, industry information (IBISWorld or the Bureau of Labor and Statistics are my personal go to for industry information) and ideally, a formula for your calculation, it may work to your benefit. I cannot stress enough that nearly everyone who has stepped to the IRS in a reasonable compensation suit HAS LOST, so do not let it get to that stage, because it will end badly.

Option #2: RC Reports. RC Reports (Reasonable Compensation Reports) is a for-profit organization with industry experts and CPAs who stand behind their work. This is one of the best options you can do to protect yourself and your business. You pay a quarterly or annual subscription fee and they furnish you a report with a calculation that considers many factors that the IRS also considers. If you have an RC Report, the IRS will not question the validity of your reasonable compensation calculation.

Option #3: Speak with a CPA today to find out how to optimize your salary. You want to pay yourself a reasonable salary so that you don't overpay in taxes but you don't want to underpay yourself to trigger an audit. In any case, you should consult with an accounting professional to CYA. We here at Darian Accounting will put in the necessary diligence, research and support to protect your S corporation and keep you in compliance.

Thank you for reading! I hope you learned something of value!