Reasonable comp: Demoting a CEO makes sense

A key tax planning strategy for small business owners who have S Corporation entities is to help them reduce self-employment tax obligations by paying themselves as an employee of their business. If you employ this strategy for your clients, then you are likely aware that you must also calculate their reasonable compensation. The question is—as it should be—if the client uses the “CEO” title in their business, is this the role for which you should calculate their reasonable compensation?

In the best interest of your client, the answer most often to calculating reasonable compensation for them as a CEO should be “no.” See below for four solid reasons why, but first, a here’s a reasonable compensation refresher so you can understand the logic of the argument for demoting your client when it comes to how much their salary should reasonably be reported to be.

Reasonable compensation is supposed to equate to the true salary of someone who is performing the specific functions of a role in an organization. It can only be accurate and defensible to the IRS, should a reasonable comp audit be ordered, if it is based on what your client would be paid for the work they do in their business.

Most business owners wear many hats and not all of them are at the CEO level. Therefore, if you aren’t basing your client’s compensation on real, verified data about the true market value of the services they provide to their own business, you may be increasing their audit risk and, potentially, increasing their tax bill more than necessary.

Four reasons to avoid the CEO classification

1. Not having accurate reasonable compensation can leave your client vulnerable to wage reclassification and additional payments. If your client takes distributions at the CEO-level and the distributions are deemed to be too low by the IRS, you risk them having all of their distributions reclassified. This could mean hefty penalties, interest, and back taxes. The best way to protect your client and yourself is to run a reasonable compensation analysis each year, and keep the report on file and easily accessible should the IRS come knocking.
2. Inaccurate calculation of reasonable compensation at too high of a level may skew the value of a clients’ business. By ensuring officer salaries are indeed reasonable, you will have true clarity on the actual profitability of a company—and therefore its market value. This can prevent overpayment or underpayment for your client’s business.
3. Changes in  family, health, or other personal situations may impact your client’s true reasonable compensation. Imagine if your client’s distributions are based on the inflated calculation of a CEO role and they experience a divorce. If a high salary is used, and alimony or child support is awarded, that may mean they have to pay more based on their earnings.
4. A clients’ future retirement income is also affected by the accuracy of reasonable compensation calculations. The level of compensation claimed and ultimately paid via payroll taxes will impact your clients’ Social Security payouts down the road. If the wages are unrealistically high and the wages are at some point reclassified, this can cause a discrepancy between expected retirement income and actual income. Alternatively, paying too much into Social Security can shortchanges a business owner’s cash flow in the short term if the CEO-level contributions are not realistic.

Are you ready to demote your client?

Having an open discussion on your clients’ reasonable compensation reality, based on their actual role in the company they own, supports your role as a true business advisor in your clients’ eyes.

In addition, educating your clients using the four-point list can help you fairly and accurately leverage reasonable comp analysis as a tax savings strategy related to payroll taxes for your clients and a revenue stream. You can package the reporting as an advisory service or an add on at tax planning time in your firm.

Most importantly, it’s a critical step in protecting your client and their business from the financial and audit risks related to overestimating compensation for S Corp officers instead of having defensible reasonable comp reports that will stand up under IRS scrutiny.