Debunking 3 common myths about reasonable comp

Extension season and year-end tax planning often mean more client touchpoints and opportunities to proactively address potential long-term tax issues and maintain favorable tax positions. However, one topic routinely does not register on the radar when it comes to these conversations for tax professionals and their business clients: reasonable compensation.

S Corporation owners need to understand reasonable compensation and act on it now, especially since the IRS is targeting business owner compensation with increased scrutiny.

Failure to accurately review, recalculate, and report the reasonable compensation of your clients on their tax returns can lead to significant payroll tax and income tax audit risks, not to mention putting a client’s future financial security at risk if their Social Security contributions are inadequate. Unfortunately, reasonable compensation is woefully misunderstood and underrepresented during most tax planning conversations. This is partly because so many myths surround the proper calculation and reporting of reasonable compensation.

To help you get your clients up to speed, the following list debunks four of the common myths around reasonable compensation. With this list, you can have clearer, more confident conversations about it.

1. Myth: The 50/50 Rule is the best way to calculate reasonable compensation. For some reason, there are many practitioners who believe S Corporation owners should split their income 50/50 between salary and distributions. This is not the case at all. This rule is overly simplistic and does not align with IRS guidelines. Instead, tax practitioners should be aware of the tax law that S Corporation shareholder-employees must pay themselves a reasonable salary or reasonable compensation before any distributions are taken. It’s the law. To ensure the salary paid is reasonable, you should complete a reasonable compensation analysis each year using one of the three IRS-approved approaches: Cost, Market, and Income.
2. Myth: Market and industry norms are the best benchmarks for reasonable compensation calculations. There is a misconception that compensation should align with what others in the industry are paying for a similar position as your client holds at their company. This thinking is too generalized to be accurate on an individual client basis. While industry norms can be a guideline, they do not replace a thorough, individualized analysis.
3. Myth: Reporting low compensation amounts to minimize taxes is a smart move. If your client believes that paying a low salary reduces tax liability, it is your fiduciary duty to steer them away from taking this action. The point of calculating reasonable compensation accurately, using IRS-defensible reports, is to avoid the trigger for IRS audits that can lead to significant penalties by making data-driven decisions.

There are best practices for reasonable compensation compliance, so use them!

As noted above, there are three IRS-recognized methods for calculating reasonable compensation: the Cost, Market, and Income approaches. These are considered comprehensive analysis methods to determine accurate compensation. It’s essential to maintain detailed documentation to support your compensation decisions and reduce the chances of non-compliance, including penalties and audits.

Editor’s note: Paul Hamann is the founder of RCReports, software designed to accurately calculate defendable compensation reports tailored to individual business needs.