Avoid the Easy Way – S Corporation Owner Reasonable Compensation

Posted By: Larry Stone ICOR Blog & News,

Sometimes people like to take the easy way. Even tax professionals like to use conventional wisdom, rules of thumb and safe harbor methodologies to simplify, but these approaches do not pass the important test of the tax court judges.

A recent poll of 4,451 CPAs, EA’s and other tax professionals asked the following question:

Which of the following methods of determining reasonable compensation (for S Corporation owners) are recognized by the IRS?

  1. Industry Rule (set wages as a percentage of sales or revenue based on industry standard)
  2. 50/50 Rule (50% distribution – 50% wages)
  3. Safe Harbor Rule (Set wages at the social security maximum)
  4. All the above
  5. None of the above

More than 3/4s of the respondents selected A, B, C or D. That is not a passing grade. None of the above (E) is the correct response. Why did so many get this answer wrong? They are following the popular myths available over the internet and published by some magazines. Entrepreneur magazine (November 19, 2020) stated that determining your reasonable compensation should not be more that 50% of the total amount you take out. Forbes (October 15, 2020) stated that a good starting point for determining reasonable compensation is 40% of your profits.

There are many myths on the internet and published related to how much you pay yourself out there. The IRS requires that the owners of an S Corporation who performs services for that corporation pay reasonable compensation. But how do you determine what is reasonable?

In 2012, the Tax Court weighed in their idea of reasonable compensation in Watson v. Commissioner, 668 F. 3d 1088, where Watson was an accountant (go figure) and paid himself a salary of $24,000 even though the firm grossed $3 million in revenue. Yes. Watson was a CPA with advanced accounting degrees. The IRS asserted that the $24,000 wage was not sufficient to support his lifestyle. The IRS brought in a comparative analysis of what others would pay someone like Watson to perform similar work. The tale is that the Tax Court asked Watson – how did you determine your wages were reasonable? Watson had no response. The Tax Court concluded that if you could not explain your methodology to determine your wages then your wages were deemed unreasonable. The reclassified all his distributions taken during the year as wages resulting in additional taxes, interest, and penalties.

Many attorneys love the word “reasonable” because it provides a place where they can disagree. There is no single factor or rule which can be used to set reasonable compensation of the S Corporation owner wages. One may want to look at the factors recommended by the IRS, see https://www.irs.gov/pub/irs-news/fs-08-25.pdf as a starting point.

What is expected by the Tax Court is a reasonable compensation study. It should be in writing, and it should use comparable wage and salary information related to the work performed. The decision that your compensation is reasonable will be based on your specific facts and circumstances. These change every year so you should have reasonable compensation reviewed annually.

At Stone Wealth Strategies (formerly Stone CPA and Advisors), we assist our clients with a reasonable compensation study. We recommend that you have one, too.  If you think you may be missing something in your tax coaching and preparation, ask about our Discovery Session by emailing info@coloradotaxcoach.com.