“Reasonable comp” audits are coming.
By Eric Green
Tax Rep Network
“The IRS never audits reasonable comp, so don’t worry about it.”
Have you ever heard this phrase? Well, when it comes to IRS priorities and increasing enforcement, S corporations and their owners will find themselves in the crosshairs of the IRS.
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In 2020, the U.S. Treasury Inspector General for Tax Administration (TIGTA) reported more than 10 million non-filers, many of them high-income earners. Then, in 2021, a TIGTA Report told the IRS to begin cracking down on S corporation owners who take little to no compensation to avoid employment taxes effectively.
It’s obvious why S corporation owners want to take as little of the income as wages as possible. But when does this cross the line and become an abuse by the taxpayer?
For years, tax professionals, including the author, have had to try and navigate this minefield, either selecting a number based on the wages of the other employees, allowing the taxpayer to pick their own, or trying to get the client to pay for an actual study. Thankfully, software with databases now makes this a snap.
When it comes to S corporations, understanding and appropriately determining reasonable compensation for shareholder-employees is crucial. The IRS has specific guidelines in place to ensure compliance with tax regulations. Given the IRS’s new focus on reasonable compensation for S corporation shareholders, it’s worth reviewing this often misunderstood topic.
What is “Reasonable Compensation”?
According to the IRS, “reasonable compensation” refers to the value that would ordinarily be paid for like services by like enterprises under like circumstances. In other words, it is the compensation that an individual would receive for similar services in a comparable business setting.
To satisfy IRS requirements, compensation must be both reasonable and for services rendered.
Tools for Compliance: Audit and Education
The IRS has two primary tools to ensure compliance regarding reasonable compensation for S corporations: audit or examination, education and information dissemination.
In the education and information category, the IRS began sending notices to new S corporations after 2005. These notices aimed to inform S corporation owners about their obligations regarding compensation to shareholder-employees.
The notice emphasized that when a shareholder-employee provides services to the S corporation, reasonable compensation must be paid, and it is subject to employment taxes. Additionally, as outlined in Revenue Ruling 74-44, the IRS has the authority to recharacterize distributions as wages if they were paid instead of reasonable compensation. This ruling empowers the IRS to ensure the proper classification of payments and prevent tax avoidance.
Employee Classification: 1099 vs. W-2
S corporation owners must pay themselves through W-2 forms, not 1099 forms. Revenue Ruling 74-44 makes this clear by considering an officer of a corporation as an employee. The IRS expects S corporations to act like corporations, and accordingly, compensation should follow the established norms. Regardless of whether one is a shareholder-employee or a non-shareholder-employee, payment should be made through a W-2 form.
Reclassification of Distributions as Wages
The IRS can reclassify S corporation distribution payments as wage payments subject to employment taxes. For federal employment tax purposes, the term “wages” encompasses all remuneration for employment. The form of payment is immaterial; what matters is whether the payment was actually received as compensation for employment.
Consequently, a shareholder who performs substantial services for the S corporation, regardless of the form of remuneration, is considered an employee subject to federal employment taxes. The S corporation itself is also liable for its share of employment taxes on those wages.
Criteria for Determining Reasonable Compensation
The IRS provides clear and concise guidelines for establishing reasonable compensation for S corporation owners. The key lies in determining what the shareholder-employee contributes to the S corporation’s operations. The following factors should be considered:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Comparable businesses’ payment for similar services (replacement cost or fair market value)
- Use of a formula to determine reasonable compensation
- Payments to non-shareholder employees
- Compensation agreements
- Timing of paying bonuses to key personnel
- Dividend history
It is important to note that the courts may consider one or all of these factors, depending on the specific circumstances of each case. It should be evident that this analysis is quite involved, takes significant time and can be quite expensive.
Application of the Reasonable Compensation Amount
Suppose an attorney’s reasonable compensation is determined to be $100,000 per year. The first $100,000 that attorney takes in distributions from his S corporation must be W-2 wages. So, if that attorney’s practice made $200,000 in 2022, and took $200,000 of distributions, $100,000 would be wages; the next $100,000 would be distributions as dividends not subject to the self-employment tax.
If that same attorney’s practice in 2023 only makes $80,000 and still takes out of the corporation $100,000, they would have to pick up the entire $100,000 as wages.
As many of you may know, wages are separate and distinct from income. The reasonable compensation number is one that is required to be based upon documentation and analysis, not a compensation agreement that either lacks an arm’s-length negotiation or is based on gross receipts and net sales.
