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S-Corp Reasonable Compensation Audits

Feb 13, 2023

Reasonable compensation for S-Corporation officers can always be the tax return line item to open a business to an audit. It is one of the first things reviewed by the IRS when a tax return has been filed to determine if an audit is necessary. Now, IRS audits are something no one wants to deal with, especially if you want to ensure your business operates correctly within all required laws. So, what exactly is reasonable compensation? The IRS defines reasonable compensation as “the value that would ordinarily be paid for the like services by the like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.” Essentially, reasonable compensation is an officer’s compensation determined by market data of similar industries and the standard tasks routinely performed.

Why is it essential to ensure each S-Corporation officer receives reasonable compensation, and why is the IRS so concerned with this matter? Well, there are several reasons why the IRS monitors reasonable compensation. We all know the main concern will be payroll or income tax related. Historically, a consistent theme has been exposed through Tax Court cases where businesses deliberately falsified compensation to avoid paying taxes. A fine line must be tip-toed between taking a tax position that is smart with taking advantage of current tax codes and allowances and one that crosses over into the tax evasion realm. However, there are several instances where businesses are simply uneducated about how their compensation policies go against tax laws.

The following are a few examples of what the IRS would say is not reasonable compensation:

  • Family business when a relative, like a child, receives a salary more than the reasonable worth.
  • Closely held business when an employee is also a shareholder receiving dividends within their salary.
  • S-Corporation business issuing a low salary to an owner or officer to avoid payroll taxes or lessen the payroll taxes.
  • Business loan issued to an employee that is, in fact, disguised compensation.

If you are a business owner, especially if your business is classified as an S-Corporation, ensuring reasonable compensation is issued and correctly reported is crucial as it is included in the business expense section the IRS will be scrutinizing as the return is processed. If the IRS finds after reviewing your tax return that there are issues with the business expenses, the business may come under audit. During such an audit, you as an officer will have to provide supporting information on how you came to determine officer compensation. Suppose it is not reasonable based on the IRS criteria. In that case, you could face additional payroll tax assessments, penalties, interest, and notification to the state advising of the error in the reported payroll. Owing money to the IRS is scary and can cost a business quite a bit, especially since the IRS interest rate is astronomical.

How can you avoid a potential audit and ensure that compensation issued to officers is reasonable? It is always wise to consult your CPA to ensure the business finances are accurate and appropriate compensation is given. Another option to ensure reasonable compensation is issued to business officers is obtaining a Reasonable Compensation Report. What exactly is a Reasonable Compensation Report? This report compiles information tailored to an individual to determine an estimated annual salary amount. These reports will evaluate the role of the individual within the business, tasks performed, proficiency levels, and time dedicated to each task. The information is then compared to market data compiled by Federal and State agencies to determine a reasonable salary for the individual for whom the report is compiled.

When it comes to preventing IRS audits and running a successful business without issues, it is always important to be educated on the proper ways a business must operate. Another critical factor is to have adequate records. A Reasonable Compensation Report should be included in your records AND updated annually. If your business is flagged for an audit, by having this report included in your Corporate Minutes on an annual basis, you will prove due diligence has been taken concerning quantifying reasonable compensation for the officers.

How can you obtain a Reasonable Compensation Report? Our Golden Lion Tax Solutions team can compile these reports for S-Corporation Officers based on each officer’s tasks and duties. One of the most significant benefits of the reports we compile is that they are guaranteed to hold up under scrutiny by the IRS, state, or tax court. Because the information is based on market data the IRS and states also reference, you can rest assured they will be accurate and a great resource to assist your business in determining reasonable compensation.

So, if you need a report, we are here to help. The process is quick and seamless, and as mentioned above, it is recommended that the reports are updated annually. Once you are in our system, the annual updates can be completed quickly, providing you with the peace of mind of knowing you have a document that is accurate and will hold up against an audit as long as the report is followed. So don’t hesitate any longer; reach out to the Golden Lion Tax Solutions Team today to obtain a Reasonable Compensation Report to help you determine your or an officer’s proper compensation.


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Disclaimer: There are requirements that must be satisfied in order to qualify for some of the tax solutions we discuss on our website. Not all of our services will be suitable for every client. Golden Lion Tax Solutions is here to help you find the most appropriate solution to fit your situation.