If It’s Not Documented, It’s Not Done Right
Having a Reasonable Compensation figure that is “reasonable” isn’t enough anymore. With the IRS turning up the heat on Reasonable Compensation compliance [See IRS TECH TARGETS S CORP OFFICER DOCUMENTED COMPENSATION], having that figure backed up by a credible source and documented is now vital in order to safeguard an IRS obstacle.
The First to the Table With a Fact-Based Figure Wins
If you are playing a game of chicken with the IRS, the very best method to get the IRS to flinch first is to be the very first to the table with a fact-based figure supported by a trustworthy source and documented.
Just how essential are research and documentation? An IRS challenge earlier this year highlights how credible research study and documentation are vital. Even if the S Corp owner’s wage is indeed “reasonable,” the examiner might still challenge that figure if it is not well-researched and documented.
Consider the following case research study:
“Nancy” owns, and works for “Nancy’s Nail Salon,” an S Corp. Nancy leases booths to other nail technicians and pays them by means of 1099, a typical plan in her industry [keep this in mind; it is very important later]
In 2019 Nancy and her [previous] tax consultant set her Reasonable Compensation at $40,500. Nancy was really more focused on running her own business each day then dotting the i’s and crossing the t’s of tax compliance. Plus, she and her accountant had practically no concern about being chosen for a Reasonable Compensation challenge. They hadn’t documented their research or reasoning behind the figure.
Fast Forward to January 2022. Nancy’s Nails was chosen for audit by the IRS’s Specialty Examination Employment Tax Program, which concentrates on companies paying workers through 1099 instead of W-2. The audit started as you would anticipate, investigating whether or not the 1099 contractors need to have been paid as employees through a W-2.
Bingo! Nancy’s Nails did everything right!
She cruised through this part of the audit.
The IRS was just starting. Within the IRS’s Specialty Examination Employment Tax Program is a Specialty Workstream focused entirely on S Corp officers’ compensation. So, in addition to examining the 1099 concern, examiners took a look at her Reasonable Compensation. The examiner requested the source of the $40,500 figure [i.e. Is it Documented], and Nancy had none.
Without any documents, the examiner was obliged [added to all examiners’ lists in 2018] to examine what she thought Nancy’s Reasonable Compensation should be and came up with $67,000, a difference of $26,500. Nancy was looking at taxes, penalties, and interest in the area of $10,000 [general rule: 2.5 times the initial tax owed of $4,055]
Along the way, Nancy changed her “feels great” accountant. Her new accounting professional, we’ll call him J.R., had (fortunate for her) just completed a course on Reasonable Compensation through RCReports.
J.R. ran a Reasonable Compensation report for Nancy that determined Nancy’s compensation to be $41,833. J.R. provided a documented, fact-packed report to the examiner in defense of Nancy’s $40,500 figure.
The Fight Begins
The IRS examiner stuck to her guns and would not budge from her $67,000 figure. J.R. understood what to do. He turned the tables on the inspector. How exactly did she develop her figure? What data set did she use? What assumptions were made? The examiner had J.R.’s detailed report, and he requested the same from her, which he got.
Turns out the examiner had actually used the Cost Approach to figure out Nancy’s Reasonable Compensation, just as J.R. had– a good start. The examiner’s data set closely matched RCReports data– another great indication.
The $26,500 difference boiled down to just how much time Nancy spent carrying out various tasks within her company, an important element of the Cost Approach.
The Documented Side Wins
The examiner had actually guessed how Nancy invested her time. It just felt right to divide it down the middle– 50/50 in between operations and nail tech jobs.
J.R. had not relied on uncertainty or feelings. He had data. He might show that Nancy spent 22% of her time on operations and 78% dealing with her customers’ nails. Realities matter. J.R. successfully argued the realities, and in the end, Nancy received a no-change letter.
A feeling, honest intentions, and even being right weren’t enough for Nancy. She required realities. Although she made it through the difficulty, she paid a steep cost in time and money. J.R.’s services were worth it but cost Nancy a pretty penny. Had her very first accounting professional documented her figure with realities from a reputable source, she might have avoided paying extra charges, not to mention prevented months of tension and distraction from her company.
If you are a member of an S-Corp or an LLC taxed as an S-Corp, and you have questions about a documented Reasonable Compensation Study, click on the link here.
October 2022
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