Reasonable Compensation Analysis
In late December of 2017, the most significant piece of tax legislation since the Tax Reform Act of 1986 was signed into law (Brady, 2017). Dubbed the "Tax Cuts and Jobs Act of 2017" (TCJA), the legislation not only made minor reductions to most individual tax brackets and major reductions for corporate tax brackets, but it also complicated much of the existing laws, particularly around closely held corporations or S Corps. One element which was modified for S Corps, in particular, was the impact of reasonable compensation on the S Corp owner's personal tax return.
Reasonable compensation has been an issue for S-Corp offi cers virtually since their inception. The challenge comes from the often dual role held by owners of S-Corps as both a corporate officer and anemployee. The IRS code makes it clear that an officer of an S-Corp is considered an employee of that corporation, primarily for purposes of Federal Employment Taxes. As an employee, an officer needs to be compensated for their work and should be paid a wage. Some try to avoid this by regarding S-Corp owner's compensation as distributions rather than wages. However, this will often draw IRS scrutiny and may result in an audit. In 1974 the IRS issued a ruling stating that if an officer or shareholder fails to take a salary, or if that salary is considered unreasonable, an auditor should shift that officer's distributions to account for reasonable compensation. This will make the compensation subject to traditional taxes on wages, such as Social Security tax, Medicare, Federal Unemployment
Tax, and the state tax in which the S-Corp resides. Having been enforced in one manner for more than 40 years has led many businesses and shareholders to have a set perspective on how to calculate reasonable compensation. The introduction of the TCJA, however, has caused confusion and difficulty in figuring reasonable compensation. Likewise, the IRS has a renewed focus on reasonable compensation figures due to the importance of accurately calculating such a number. Why has this occurred? One specific deduction holds the answer: Section 199A. Also known as the Qualified Business Income (QBI) deduction, the Section 199A deduction has caused massive confusion on the part of businesses and accountants alike. Troublingly, the 199A deduction operates with a type of circular logic that the IRS, businesses, and accountants find confusing. At its core, the 199A deduction relies on the S-Corp's profit and the taxable income of the taxpayer as reported on their 1040 (including the W-2 income,
also known as reasonable compensation). Any change to the S-Corp's income or reasonable compensation paid will, in turn, cause changes to the taxpayer's 1040. Those changes on the 1040 will impact the 199A deduction, which will impact the optimum entity type for the taxpayer for that specific tax year. This complicated and circular calculation heavily relies on an accurate and defensible reasonable compensation figure.
What is Reasonable Compensation?
Since the issue first arose in 1917, determining reasonable compensation has been an ongoing dispute. What is considered reasonable compensation for a position in one state may differ in another, or from city to city or person to person.
Likewise, industries vary in their compensation for employees who may have similar titles. Add to this ongoing fluctuation in markets, changes in inflation and deflation, and a multitude of other issues, and it is understandable how this issue has haunted the IRS and tax filers for more than a century. The IRS defines reasonable compensation as "the value that would ordinarily be paid for like services by like enterprises under like circumstances". This definition does not necessarily clarify how to calculate an accurate reasonable compensation figure. Additionally, many business owners conflate how profitable an S-Corp is with how much their reasonable compensation should be, often over- or under-paying themselves.
Four fundamental facts help to outline how profit and reasonable compensation differ: Reasonable compensation is based on the value of service provided, not profit or distributions. Wages (i.e.,reasonable compensation) should be paid BEFORE distributions are made. A shareholder-employee can take wages without taking a distribution, but not vice versa. A shareholder-employee who does not want to take any reasonable compensation can refuse ALL compensation and play "catch up" in a later year. Profitability and distributions are fundamentally two separate and distinct elements. Reasonable compensation is tied to distributions, not profit or loss. IRS guidelines for reasonable compensation state that "the amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly". Whether the company is making or losing money is irrelevant. The sole issue is whether the owner of the S-Corp is taking money out of the S-Corp.
How to Derive Reasonable Compensation?
There are three basic methods employed to determine reasonable compensation for the owner of a closely-held business (S-Corporation).
There isn't a single right or wrong methodology. Instead, we should examine the factors for each business owner (e.g., owner's job duties, business's size).
Cost Approach - The cost approach (also known as the "many hats" approach) generally works best for small businesses wherein the owner is responsible for many different tasks. Their role can't be classified by one single title. Someone who owns and operates a small bakery, for example, is responsible for baking, ordering supplies, customer service, accounting, and cleaning, among many other roles. The cost approach breaks down the time spent by the owner performing each task and assigns them wage levels. This approach relies heavily on comparability data. In other words, what are other workers paid with similar job duties, similar experience, and within a similar geographical area?
The cost approach calculates a reasonable compensation value through four basic steps:
Step One: List all of the services the business owner provides to their company, making sure to include even those that aren't income-producing.
Step Two: Estimate the amount of time devoted to the business and subdivide that time based on an approximation of the time spent on each task listed in Step One. A key factor when defending a reasonable compensation figure is time and effort devoted to the business.
Step Three: Having listed all the services the owner provides to the business and how much time was spent on each service, gather reliable wage data to match the services listed. Wage data should match both the service provided and the proficiency level of the business owner. Comparable wage data should be drawn from the location of the business where the services are performed, as wage data can vary drastically between cities, counties, and states.
Step Four: Calculate the time spent on each service by the wage data. The total of these annual figures will be
combined to find the owner's reasonable compensation figure. The final figure is what the IRS and Courts call the business owner's "replacement cost" or "fair market value."
Market Approach - The market approach (also known as the industry comparison approach) determines reasonable compensation by answering the question: How much compensation would be paid for the same position, held by a non-owner in an arms-length relationship at a similar company? This approach seeks to determine the owner's compensation by analyzing the compensation of employees in businesses of similar size and from the same industry, as well as in comparable locations. The market approach focuses strongly on the owner's business type and the specific position held by the owner: typically CEO or General Manager.
This approach then compares both the business type and the position of the owner to that of its peers to conclude what reasonable compensation should be. The market approach works best when the owner's time is devoted to only one occupation (usually in upper management) and can be easily compared to peers working in the same industry with similarly sized companies and comparable geographic areas. Due to these factors, the market approach is the preferred methodology when working with larger small companies and medium-sized closely held businesses where the owner is responsible solely for running the company (titles such as general manager or chief executive).
Income Approach - The income approach (also known as the independent investor test) seeks to determine whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.
To determine reasonable compensation using the income approach there are three key pieces of information:
Once these three values have been determined they are put into an Income Approach Calculator and the reasonable compensation is calculated.
- Fair market value (FMV) of the business at the beginning of the year.
- Increase in FMV by the end of the year before owner compensation.
- Target return of the independent investor.
Of the three methods discussed, the income approach is the only method that does not rely on comparability data but instead draws a conclusion for what reasonable compensation should be based on the financial performance of the business. This approach generally works best for outliers. Outliers are business owners whose achievements are so great that they deserve compensation above that of their peers (sometimes referred to as a superior/key employee), or perform a unique occupation, skill or duty where no comparability data exists. In these cases, the income approach would be an appropriate choice.
Pascarella Accounting Group specializes in providing reasonable compensation analysis for small and medium closely-held business owners. We encourage S-Corp clients to engage in reasonable compensation analysis on a yearly basis applying a systematic approach for deriving their reasonable compensation figure. Most importantly, we help business owners reduce their risk by providing defensible, accurate, and objective reasonable compensation figures by utilizing credible and independent data that meet IRS criteria and are supported by court rulings and industry standard salary intelligence.
So, if you are unsure about the compensation paid to you or if you want to know the risks associated with a low-wage compensation, contact us today and start closing the gaps between your business and an IRS audit.