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Archive for Paul Hamann

Step By Step Guide: How To Calculate Reasonable Compensation

How to calculate reasonable compensation

The old adage “Simple isn’t always easy” perfectly sums up the IRS and Court guidelines for determining Reasonable Compensation. At first blush the IRS and court guidelines seem simple enough – but once you start to follow the roadmap the IRS and Courts have laid out – simple quickly turns to challenging.

Following are five steps for calculating Reasonable Compensation for any closely-held business owner:

Step One: Decide which approach best fits your client’s situation. The IRS Job Aid on Reasonable Compensation discusses three approaches:

Cost Approach (a.k.a. Many Hats Approach): Considers all tasks a business owner provides, such as administration, accounting, marketing, purchasing etc., then breaks the time spent by the owner down in the various tests performed. Wage levels are assigned for each task based on the owner’s proficiency, then added back together to obtain a hypothetical replacement cost. Commonly used for small businesses where the owner is wearing multiple ‘hats.’
Market Approach (a.k.a. Industry Comparison Approach): Looks at compensation of employees and businesses of similar size and from the same industry. This approach then compares both the business and the position of the owner to that of its peers. Commonly used for medium businesses where the owner is predominantly or exclusively performing management duties.
Income Approach (a.k.a. Independent Investors Test): Determines whether a hypothetical investor would consider the level of compensation justified based on the financial performance of the company. Commonly used when the owner is considered an outlier and comparability data cannot be found.
Step Two: Gather the appropriate information on your client and their business: (sample Questionnaires below)
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Planning S Corp Distributions To Keep The IRS Off Your Back

Paul Hamann On S Corp reasonable compensation

“I’ll just take distributions, then pay myself reasonable compensation at the end of the year.” Quack, quack.

“Holding a meeting is a hassle. I’ll just write a check for my distribution when I do payroll.” Waddle, waddle.

Reasonable compensation is payment for the value of work performed by an S Corp shareholder/owner. Distributions are whatever the Board of Directors deems appropriate (votes on). These are two different events.

If you or your clients are tempted to put off paying reasonable compensation to the end of the year, or skip an actual meeting to vote on distributions, beware. The IRS believes that if it looks like a duck, walks like a duck and quacks like a duck – it is a duck. And some agents will assess payroll tax penalties and interest for late filing and late payment of the payroll taxes when compensation is not paid throughout the year. There is no reason to take this risk. Here’s what to do instead.
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What If An S Corp Owner Cannot Afford To Pay Reasonable Compensation?

S Corp and Reasonable Compensation - Paul Hamann

This is by far the number one question we receive, and the answer is both simple and complex. Why? Because the amount of Reasonable Compensation actually paid is tied to distributions, not profit or loss.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take Reasonable Compensation plus a distribution, just Reasonable Compensation, or neither. What the shareholder-employee can’t do take a distribution instead of Reasonable Compensation.

To help you better understand, let’s run through a few simple scenarios and then move onto some more advanced ones. Keep in mind the following:

Reasonable Compensation is defined by the IRS as: “The value that would ordinarily be paid for like services by like enterprises under like circumstances.” or the hypothetical “Replacement Cost” of the shareholder-employee.
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Did The IRS Really Lose? Lessons From The Davis Case

Paul Hamann -S Corp Compensation

The IRS usually wins when it challenges an S Corp.’s Reasonable Compensation in court. Over the years there have been in the neighborhood of 25 to 30 such cases. The IRS has come out on top in all except one: The Davis Case. What made Davis different? What valuable takeaways are there for you and your clients?

The case focused on two concepts that every S Corp. and business advisor should understand:

Officer in name only
Substantial services
DAVIS v. UNITED STATES (1994)

Background: Mile High Calcium was owned by Carol L. Davis and her husband Henry Adams. This case revolved around transfers in and out of Mile High Calcium from 1987 to 1989. The IRS re-characterized all transfers for the timeframe in question to Reasonable Compensation, resulting in assessed taxes, interest and penalties of $39,220. Carol L. Davis successfully sued the IRS for a partial refund based on the following two-pronged defense focusing on each of the two owners:
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1099 Or W-2 for Shareholder – Employees Of S Corps? Updated for 199A

PAUL HAMANN A

1099 or W-2? Answer: W-2

We hear your argument: Paying wages via 1099-MISC instead of W-2 has no tax effect!

Here is the law:

FS-2008-25 states: Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code.

Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.

Just to be certain we looked up the IRS definition of Employee and Independent Contractor, just to make sure there wasn’t some loophole or wiggle room to argue for independent contractor status.

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