Advising S corporation clients on reasonable compensation

Editor: Arthur Auerbach, CPA, CGMA

S corporations are a favored entity structure for their combination of limited liability and passthrough taxation, which prevents double taxation. Shareholders of an S corporation receive compensation and distributions based on their roles within the company. Shareholder-employees, for instance, are required to pay themselves reasonable compensation via W-2 wages before taking any distributions. This compensation is subject to employment taxes, including for Social Security (6.2%) and Medicare (1.45%), with the employee and employer portions combined totaling 15.3% (as Federal Insurance Contributions Act (FICA) tax). If a shareholder-employee is not paid reasonable compensation, the IRS may recharacterize distributions made to the employee as compensation.

Myths surrounding reasonable compensation

One common misconception about reasonable compensation is that S corporations can use a 50/50 split, dividing profits equally between salary and distributions. However, this approach often contradicts IRS guidelines, which emphasize that compensation should reflect the shareholder’s duties and responsibilities. Another myth involves setting compensation at the Social Security annual maximum taxable earnings ($168,600 for 2024). But this assumes that that amount aligns with fair pay practices across all roles within the company, which is not always the case. Additionally, using arbitrary fixed amounts, without considering industry standards or individual circumstances, can attract IRS scrutiny.

To avoid potential issues, tax professionals and business owners should analyze the IRS guidelines and standard industry pay rates, as well as an S corporation’s gross receipts and total assets, to ensure compensation is set at a reasonable level.

Recognized approaches

To determine reasonable compensation, it is essential to use a recognized approach to avoid vulnerabilities in the face of an IRS challenge. Regs. Sec. 1.162-7(b)(3) defines reasonable compensation as the value that would ordinarily be paid for services by like enterprises under like circumstances. It requires a fact-based approach using any of three primary methodologies.

First, the cost approach, also known as the “many hats approach,” is suited for small businesses where owners undertake multiple roles. Real estate agents, social media influencers, and gig workers are covered under this approach. It breaks down the owner’s duties into distinct components (e.g., administration, marketing, etc.) and assigns comparable wages using salary surveys, summing these to determine total compensation.

Second, the market approach compares the owner’s compensation against the compensation paid for similar positions held by nonowners within the industry.

Third, the income approach, or “independent-investors test,” applies when comparability data is lacking or the situation is unique. It assesses whether a hypothetical investor in an S corporation would find the return on investment satisfactory, considering the owner’s compensation, contingent on the fair market value of the S corporation.

The auditors are coming …

The IRS, using a variety of strategies, has intensified its enforcement efforts, particularly targeting complex passthrough entities. Using artificial intelligence and advanced technology, the IRS aims to enhance its detection capabilities for tax-compliance issues and emerging threats, thereby improving case selection. Audits of related areas may alert the IRS to reasonable-compensation issues. Particularly important are payroll tax audits, which have increased significantly. Also especially important are audits focusing on the determination of reasonable compensation for S corporation owners who receive wages via Form W-2, Wage and Tax Statement. Moreover, audits of employee retention credit claims may lead to additional audits for S corporation owners, particularly concerning the appropriateness of their reasonable compensation. Furthermore, IRS audits of Form 941, Employer’s Quarterly Federal Tax Return, to assess whether independent contractors should be classified as employees, add to the compliance challenges. The qualified business income deduction also ties closely to reasonable compensation and poses new risks of tax penalties and interest if challenged successfully by the IRS.

What S corporation owners should know

S corporations are required to compensate shareholder-employees with reasonable wages for their services before making distributions. The wages paid are deducted from the S corporation’s income.

Factors determining reasonable compensation

Several factors determine what constitutes reasonable compensation, including the duties performed by the employee; the volume and complexity of business handled; the level of responsibility, time commitment, and individual achievements; and the company’s overall compensation policies. Additionally, historical salary data of the shareholder and comparable wages in similar businesses play significant roles in determining the appropriateness of compensation levels. Adhering to these factors ensures that S corporations comply with IRS regulations and mitigate the risk of audits related to reasonable compensation. An especially significant factor in distinguishing compensation from other payments is the intent with which it is made.

Demonstrating compensatory intent: Regs. Sec. 1.162-7(a) establishes that deductible compensation must directly correspond to services provided. To substantiate compensatory intent, meticulous documentation is essential, including board meeting minutes, detailed records of duties and hours worked, issuance of Forms W-2, payment of employment taxes (FICA), filing of payroll tax returns, and inclusion in financial statements.

Court decisions provide further clarity on deductibility issues. For instance, in Paula Construction Co., 58 T.C. 1055 (1972), payments initially recorded as distributions were not reclassified as compensation due to insufficient evidence of compensatory intent at the time of disbursement. More recently, Clary Hood, Inc., T.C. Memo. 2022-15, aff ’d in part, 69 F.4th 168 (4th Cir. 2023), outlines criteria for deducting as compensation guaranty fees paid to employee-shareholders, emphasizing factors including whether the fees were reasonable in amount given the financial risks; whether it was customary to pay guaranty fees to shareholders; whether the shareholder-employee demanded compensation for the guaranty; whether the company had sufficient profits to pay a dividend but failed to do so; and whether the purported guaranty fees were proportional to stock ownership.

Lack of compensatory intent may lead to reclassification of the following transactions as dividends, distributions, or additional wages, impacting taxes and income:

• Catch-up payments for prior under-compensation;
• Loans to shareholders, unless properly documented and at arm’s length;
• Personal guarantees by shareholders;
• Under-market-value leases from shareholders; and
• Intercompany payments.

How to deal with a noncompliant new S corporation client

When facing a new S corporation client who did not take reasonable compensation in the previous year, practitioners must ensure compliance. While new advisers are not liable for past noncompliance, they must conduct a thorough analysis and implement corrective measures promptly.

Prior-year underpayment of compensation

If distributions were taken in prior years in which reasonable compensation was not paid, reasonable compensation must be paid for those years. Keeping track of compensation shortfalls is essential for future compliance.

If the payroll tax deadline has not passed, actions to take to remedy prior-year compensation underpayment include performing a compensation analysis for the prior year, potentially issuing a lump-sum W-2 payment to cover the missed compensation, and establishing a regular payroll to ensure ongoing compliance. If the payroll tax deadline has passed, actions to take include performing a compensation analysis for the prior year and possibly paying the owner a lump sum via a Form 1099-NEC, Nonemployee Compensation, for the previous year’s shortfalls.

Understanding compliance risks

Lump-sum W-2 payments or Form 1099 payments, however, may raise red flags with the IRS or state tax authority. Services rendered throughout the year must be paid regularly. Reasonable-compensation analysis and adherence to W-2 wage requirements are crucial to avoid penalties. For clients owning interests in multiple S corporations, conduct annual reasonable-compensation analysis for every S corporation of which the client is a shareholder-employee. Tax practitioners should ensure well-documented, justifiable compensation to avoid triggering additional audits.

Mitigating preparer penalty risks

Tax preparers should adhere to certain processes to avoid preparer penalty risks on reasonable compensation. Educating clients on the concept and importance of reasonable compensation ensures they understand compliance requirements. Assessing reasonable compensation involves verifying that the compensation aligns with factors such as the client’s experience, responsibilities, and industry standards. Using evaluation tools such as preparer penalty checklists aids in a thorough assessment.

Taking a proactive approach, preparers should ask relevant questions and request comprehensive documentation to substantiate compensation decisions. Staying informed about IRS expectations and updates through reliable sources is necessary to adhere to professional standards. Documenting advisory efforts and maintaining best practices further enhances compliance and supports the tax preparer and clients during IRS examinations.

Reasonable compensation as an area of practice development

Including advisory services on reasonable compensation in your practice will help S corporation clients with their compliance and financial success. These could cover strategic planning; incorporating reasonable compensation into entity planning; retirement strategies; and advising on compliance to ensure value retention during mergers, acquisitions, and exit planning.

For accounting and valuation, reasonable compensation’s role is essential for accurate business valuations and in divorce proceedings, where financial matters are scrutinized. Further, evaluating reasonable compensation unearths overall financial and tax planning opportunities, as wages affect contributions to retirement plans and the value of health and retirement benefits.

Contributors

Niyati Hemani, CPA, is founder of Hemani Financial Solutions LLC in Spokane, Wash., and a Chartered Accountant (India). Arthur Auerbach, CPA, CGMA, is an independent tax consultant in Atlanta. Hemani is a member, and Auerbach is vice chair, of the AICPA Tax Practice and Procedures Committee. For more information about this column, contact thetaxadviser@aicpa.org.