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Navigating reasonable comp for niche clients

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The gig economy is still in high gear, a fact that will likely be front and center by many clients’ tax returns this filing season, and filing seasons for years to come. One of the telltale signs, of course, is when your client is working multiple jobs, and often working many more hours than the typical 9-to-5, W-2 job, sending you at least one 1099.

This type of gig worker client tends to be aggressive in expanding their businesses and developing multiple streams of revenue. As such, they need to be sure to not only pay appropriate income taxes, but also pay adequate payroll taxes. 

As their income grows, they may benefit from changing their entity type to an S Corp and paying themselves on payroll, which requires a careful analysis of reasonable compensation to avoid an audit and fines. But for you as a tax practitioner, missing their reasonable compensation amount could come back to your client because of related IRS issues. This could damage your reputation and long-term viability. No one wants that.

When it comes to reporting the compensation a self-employed individual receives from their business in some of the most popular emerging niche businesses, such as social media influencers, realtors, and gig workers, the conversation is completely different. It is one that too few business owners are having among themselves or with their accountants or financial advisors. This represents a critical opportunity—and an obligation for your firm.

Reasonable compensation 101: Accurate calculation can reduce your professional liability and client tax obligations 

Let’s take a look at some definitions of reasonable compensation and how they apply when your client has a niche-based business. Once your client understands the critical importance of calculating it correctly, they will see why it can be challenging to determine the exact pay, especially for businesses where the owners do multiple activities related to operations.

Three of the fundamental definitions of reasonable compensation include the following:

  1. IRS Code: Section 162-7(b)(3): Reasonable compensation is the value that would ordinarily be paid for services by like enterprises under like circumstances. 
  2. Valuation: The hypothetical replacement cost of an owner or key manager of a business.
  3. As a question: How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship at a similar company?

Now we need to simplify the basics. If your client just read these definitions, they would probably seem confused. To simplify:

  1. Replacement cost: If your client had to go out into their community and hire someone to replace them, and perform all the services and tasks they perform, what would your client have to pay them?
  2. Fair market value: If your client were to close their business, and go across town and work for a competitor performing the same services and tasks for your client’s competitor that your client currently performs, what would the competitor pay your client at fair market value for those same services?

The amount your client claims for reasonable compensation is reported on your client’s tax return in the form of payroll and self-employed taxes. This can be a source of debate for business owners and their accountants. And if your client is audited, your client can bet that the IRS will also be involved.

If you are trying to drive your client’s reasonable compensation up or down to avoid taxes, they need to fully understand those implications on their tax and Social Security, disability eligibility, and more.

It is critical to understand that reasonable compensation is so much more than just a method for determining compensation for business owners. In fact, it affects everything from payroll taxes and tax planning strategies to entity selection, Social Security Insurance, disability income, and more.

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