Reasonable compensation - S Corporations

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When the IRS announced they were going to focus specifically on S Corps, distributions, and reasonable comp, a lot of people sat up and took notice. Especially some functional changes such as not being able to pay for Medical Premiums as distribution (needs to run through the W2) and other cost categorization issues that are limited by the "2%" or "10%" shareholder status. There was a lot of (personal) cost shifting that did not withstand scrutiny. Yet, there still is some bad advice out there, mostly old school concepts.

The first thing I do is discuss with a client how much this can hurt if they want to play a game with the IRS: Penalty and interest along with late fees for payroll tax and payroll reports, when the IRS decides to recharacterize distributions as, "you attempted to avoid payroll."

The amount of work for due diligence from there really depends on how cooperative your taxpayer intends to be. They know what they do and what that would be worth in the marketplace. They should be able to project what it would cost to pay someone to replace all of that, as well. You can reference BLS and other labor databases. My State has good resources, a worker comp insurance agent can be helpful, and my local Job Service/Workforce Center, where they handle job fairs and unemployment management, is another great resource.

If your client is going to lean hard on you to provide all the info, you need to feel comfortable with carrying the load if they do get audited for payroll. I cautiously lead clients through this process to the end where they clearly made the final decisions (and document it), so that it never comes back at me. That includes identifying their workload by time spent and by tasks and by levels of responsibility. Another metric that works well is cost for risk of failure or errors. Sometimes it is value or price of tools, equipment and materials used in the course of the work, and if there is any specific licensing or certifications required, and if they need to be annually maintained or Continuing Ed. The more complexity, the more $ value, the easier it is to point the client into not undervaluing their work.

Don't tell me you operate a $3m robotic thingy that burns through $30,000 consumables, and you rent a crane to be onsite with a licensed operator for you to do your thing, you had to be trained 90 days at the vendor's shop to be certified to run that robot, but your salary would be $20,000 annually.

Another example:

A designer with a small showroom isn't a licensed architect, but does drafting and has plans signed by an engineer or subcontracts to architects. They charge relative to the scope of work, and if employed by a licensed firm, would hold a mid-level position in a design/build firm. So, reasonable comp is higher than draftsman, lower than senior architect, and might get some compensation through materials markup (sales associate). Based on the performance of their S Corp, you would set a reasonable salary that shows volume of work is taken into consideration, and being highly profitable might reflect some of the "sales associate" revenue portion of compensation, and then there would possibly be distributions.

Distributions are not as frequent as payroll, not relative to payroll or in lieu of payroll, not based on hours or work performed. I recommend something like a quarterly P&L analysis. Year end would be the same as a company bonus program, determined as part of a management decision (could be year end annual meeting and in the minutes). Also, bonuses in some industries are based on project completion, that is easily justifiable, but that is payroll and not distribution "bonus."

In other words, does it look right, does it make sense, will it withstand scrutiny? If hemming-and-hawing, then start again.

What IRS tells you is, 

"There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case."

 https://www.irs.gov/pub/irs-news/fs-08-25.pdf

What IRS doesn't tell you is that there are very few court cases, and most of those are where owner/employees took zero salary.  And despite the saber rattling about what they are going to do with an extra $88 billion from Congress, you have to remember that Congress has since taken away $87 billion.  Or something like that. 

It's logical to assume that the greater percentage of funds going to owner/employees are considered salary, the less likely an audit.  But of course, little about taxes and audits is logical, and nothing can be assumed. 

ADP has an interesting suggestion:

"The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions."

https://www.adp.com/resources/articles-and-insights/articles/s/s-corp-payroll.aspx#  

Of course that has nothing to do with looking at what non-owners earn in similar jobs in similar locations.  It is all about, "What can I get away with?"  So you need to figure out, that's really the basis of any discussion on this subject. 

And the court cases tell you only what happened when IRS and the taxpayers did not settle before trial, as happens in a high percentage of cases.  What kind of case doesn't settle? The most recent Tax Court case I found on "reasonable compensation (Blossom Day Care) does not even involve an S corporation.  The taxpayers were paying personal expenses and deducting them on their 1120.  IRS disallowed the deductions, but reclassified them as wages, so they could collect payroll taxes.  The case was decided in 2021, but the years involved were 2005 through 2008.  IRS might have enough auditors to begin "reasonable compensation" cases, but the Tax Court has been down a couple judges for years, and has better cases to decide than those that are heavy on "facts and circumstances."  And IRS knows this.  

See also the MacAlary case, decided in 2013 by Judge Guy, involving a real estate broker in Southern California in 2006.  IRS had an expert witness (an IRS employee) who said reasonable compensation was $101,000.  The taxpayer's preparer had reported zero wages on the 1120-S, and did not prepare any payroll tax returns or W-2 forms.  The judge looked at the report and said $80,000 was more like it.  The taxpayer had to pay failure-to-file penalties, which would have been avoided even if minimal amounts had been reported quarterly.  

"CCH, to my surprise, does not have a client letter on this subject."

A client has just started working as a bartender.  He asks, "how much of my cash tips should I report?"  Surprisingly, CCH doesn't have a client letter on that subject either. 

The answer, of course, is that "it's all income, so all of them should be reported."

But then, should you add? "Very few people do that, though.  IRS has guidelines to figure the minimum amount  they would find acceptable in an audit.  Let your conscience be your guide, but also keep that IRS method in mind."

So it's like the "reasonable compensation" discussion. Tell your clients that there are sources for finding what amount applies to the work they do in the business they own in the location they chose.  That is what IRS expects them to report as reasonable compensation.  But you can add, "very few people do that.  Audits are rare, and a certain discount from reality will probably be accepted.  Let your conscience be your guide, but definitely report something and file quarterly payroll returns to avoid penalties."

What's interesting is that for every court case where IRS claimed compensation was too low, there is another one, involving an 1120 rather than an 1120-S, where they claimed it was too high and really a disguised dividend.