Dec 12, 2022
This is something your accountant or CPA may have spoken with you about… the notion of “reasonable compensation” in the eyes of the IRS or state. Reporting W-2 income to officers on behalf of an S-Corporation on the annual income tax return is a gray area, but if you get it wrong in the eyes of the IRS or state, it can cause a world of problems for you in the form of an audit.
The IRS requires S-Corporations to pay reasonable compensation to their officers, shareholders, and employees for the services those individuals provide to the company. This dissuades owners from essentially structuring their income in a way that allows them to avoid paying taxes. Remember, an officer is not subject to self-employment taxes on a deemed or actual distribution of S-Corporation income, and the corporation doesn’t pay employee withholding taxes on a distribution. Suppose an S-Corporation is not providing reasonable compensation to its officers. In that case, it could be open to an audit that could lead to a tax debt or criminal charges if deemed egregious enough. Neither of which is fun to deal with.
This is a question that stumps a lot of people when first asked because it is so subjective! To assign a definition to it, reasonable compensation is equivalent to the amount of income paid for similar services in similar industries under similar circumstances. To put a monetary figure to reasonable compensation, several factors are considered, such as geographical location, duties performed, and skill level of the person performing the tasks. Once these factors are analyzed, an officer will be able to confirm how their business should reasonably compensate them.
Excellent question! It is always important to have supporting documentation for all business activities. As for a specific document to support a determined reasonable compensation, a report can be compiled: a Reasonable Compensation Analysis Report. This report is an independent and unbiased report that determines reasonable compensation for an officer of an S-Corporation. Each report is based on the officer’s duties, tasks, and responsibilities with the S-Corporation and the officer’s proficiency level with each of those duties. Because this type of report is compiled using the same resources the IRS and states use to determine reasonable compensation in the case of an audit, it is 100% defendable should an audit occur. Think of this report as a way to be five steps ahead of the IRS or state when it comes to the question, “are you receiving reasonable compensation as an officer of the S-Corporation?”
Absolutely! The IRS has stated they intend to scrutinize reasonable compensation of officers in the coming years closely, and we are already starting to see an increase in the number of these audits performed. It is an area on a tax return that can be easily flagged by the IRS and the states, thus opening an S-Corporation to an audit. By obtaining a Reasonable Compensation Analysis Report for all applicable officers, you can reduce the risk of setting off triggers that begin an audit; these reports essentially provide an insurance policy. They can also provide protection for your tax return preparer against potential preparer penalties.
Once the specific factors for each officer are obtained, this information is compared to data secured from the Bureau of Labor Statistics, the U.S. Census Bureau, and State and County Department Wage and Income Reports from all 50 states to compile the report. The IRS and state tax departments utilize the same sources when determining reasonable compensation during an audit of S-Corporation taxpayers, so think of it as having access to the same playbook as the tax authorities.
It should be noted that during an audit or court proceeding, the following factors are considered when determining reasonable compensation:
As these reports base their data on the same sources the IRS, State and courts refer to, the majority of these factors will be covered with the results of the report an officer will have in their records.
As data changes often based on current economic situations, it is recommended that a new report is secured on an annual basis. Additionally, anytime there is a change to duties or responsibilities within an S-Corporation, it is suggested that an updated Reasonable Compensation Analysis Report be secured as you will ensure your W-2 income remains aligned with pay provided to others performing similar tasks and duties. Not only is it beneficial to update the report annually, but you can also obtain a report for past years in the case of an active or pending audit.
The Golden Lion Tax Solutions team is here and ready to assist you with providing your custom Reasonable Compensation Analysis Report. The process is quick and painless; we can produce accurate reports within two business days of you completing a questionnaire that requires only about 15 minutes of your time. Please get in touch with us immediately to begin relieving your stress about whether or not you are receiving reasonable compensation. And if you are learning of this after an audit of your S-Corporation has left you with a payroll tax assessment, contact us today to discuss our 941 tax debt solution options.
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