Tax law states that S Corporation shareholders providing services to the business must receive reasonable compensation for the services provided. The IRS places the burden of proof on the taxpayer to support and justify compensation paid to shareholders. If compensation is determined to be unreasonable, the IRS can reclassify income (distributions) with assessments of penalties and interest.
How is reasonable compensation determined by the IRS? While it depends on facts and circumstances, the good news is we have guidance from the IRS and professionals can be hired to assist in determination of reasonable compensation. There is no definition of reasonable compensation in the tax code, however regulations state that reasonable compensation is an amount paid for like services by enterprises under like circumstances. To navigate the process, for both field agents and taxpayers, insight is provided based on Tax Courts cases and IRS tools. Tools include the Job Aid for IRS Valuation Professionals, Internal Revenue Code, tax return statistics, calculation methodologies, and industry sources. This collection of data provides us with a comprehensive list of factors that when applied correctly provide the basis and documentation for proper reasonable compensation.
First let’s review the background of reasonable compensation for S Corporation Shareholders. Next, we can explore the most common factors used in determination, then lastly discuss documentation.
Shareholders are regarded as separate persons from their S Corporation, therefore when providing a service for the business they are treated as being an employee. In addition to the shareholder(s), family members must also be paid reasonable compensation for services rendered. Family members do not need to own shares in the S Corporation. Family members include spouses, ancestors, and lineal descendants.
The IRS and Tax Courts have stated that distributions made to a shareholder that provides services to the S Corporation can be recharacterized as wages subject to payroll taxes. If successful, the IRS will then assess penalty and interest for failing to withhold and remit the appropriate taxes. Many S Corporation shareholders that violate reasonable compensation are found to be under compensated, attempting to keep payroll taxes at a minimum. Tax avoidance, structuring transactions to reap the largest tax benefit, is perfectly legal. However, tax evasion, an attempt to reduce tax liability by deceit or concealment, is a crime. By and large, most IRS determinations of inadequate shareholder compensation are simply based on ignorance of the determination factors and lack of a specific plan with documentation.
There are many factors that can be considered with determining reasonable compensation. The more complex the business, the greater in size, likely the greater number of factors to consider. Here are the most common factors and those that span across both tax court and the IRS.
- Shareholder’s role in Corporation: Position held, hours worked, and duties performed.
- How compensation compares to other employees with similar positions within and outside the company.
- Shareholder’s qualifications, background, experience and knowledge of the business.
- Size and complexity of the company.
- Compensation in comparison to shareholder distributions.
Based on guidance, one might conclude that documentation of the process for determining reasonable compensation is just as, or more, important as the methodology for arriving at the correct answer. Documentation of the process will show the taxpayer put forth reasonable effort to make sure their compensation was adequate based upon their business’s specific circumstances.
- If the corporation has a payroll policy for all employees, there should be a policy to address shareholder compensation. As policy or rates change for all employees, there should be changes reflected in shareholder’s compensation.
- Corporate minutes can be powerful evidence when defending reasonable compensation. Corporate minutes establish intent by documenting at the beginning of the year how much shareholder compensation is planned and what methodology was used in determination.
- The IRS has three methods to calculate reasonable compensation: Market Approach, Income Approach, and Cost Approach. The Market Approach references how much would be paid for the same position, work and hours being paid by a similar company for a non-shareholder employee. The Income Approach is based on an independent investor “test”, and if they would accept their return on investment based on the Company financial performance combined with the shareholder’s compensation. The Cost Approach breaks the shareholder’s roles and responsibilities into categories, time spent in each category, then compares to the market rate for the same positions. Each of these three methods requires some amount of research, industry data and naturally creates your supporting documentation.
While the task of determining reasonable compensation might seem daunting, taxpayers have been provided an understanding of the importance of reasonable compensation and framework to guide themselves through a process to determination. Further, after an understanding is gained, various factors can be applied to assist a taxpayer in their calculations. As with any defense against an IRS inquiry, documentation showing reasonable effort is beneficial to support your conclusion of reasonable compensation.
There are also professionals that can assist by providing a Reasonable Compensation Report based on one or more of the three approaches used by the IRS. These reports draw from such databases as the Bureau of Labor Statistics and the US Census Bureau. The reports are very affordable and provide some assurance if reasonable compensation comes into question. For business owners “getting the house in order” for a potential exit, having accurate and defendable shareholder compensation helps present accurate financial position to potential buyers and their valuation experts.
The content shared on this page is intended for informational purposes, reference and guidance to the reader, and is not intended to be a substitute for the reader seeking professional advice based on specific factual situations. Information in this post does not constitute professional accounting, tax, financial, investment or legal advice.
