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Tag Archive for Reasonable Compensation

Clarifying The Contours of “Reasonable Compensation”

Clarifying The Contours of “Reasonable Compensation”

The law has always favored the term “reasonable.”  For example, the law affords protection against a negligence lawsuit if a person can demonstrate he or she acted as a reasonable person would have under similar circumstances.  Moreover, federal tax law provides that a taxpayer may generally avoid federal tax penalties if the taxpayer had “reasonable cause” for a failure to comply with the Internal Revenue Code (the “Code”).

But, what is “reasonable”?  For those who prefer bright-line rules, you will not like the answer.  What is reasonable is often in the eye of the beholder, i.e., the decision maker.  Stated differently, what is reasonable is difficult to ascertain in many cases because what is reasonable to one person may not necessarily be reasonable to another.

Given these ambiguities, it is no surprise that taxpayers and the IRS have historically quibbled over a corporation’s “reasonable allowance” for salary and other compensation.  Because of the nature of subchapter C of the Code (applicable to C corporations), there is almost always a natural incentive to reduce the dual level of taxes at the corporate and individual level through paying higher compensation.[1]  However, in many instances, corporations also legitimately want to pay their employees, particularly hard-to-replace executives, competitive salaries and bonuses for hard work.  This Insight discusses the reasonableness requirement for deduction of compensation under Section 162(a)(1) of the Code.

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Reasonable Compensation: The New Elephant In The Room

Paul Hamann - Reasonable Compensation For Shareholders of S Corps

In late December of 2017, the most significant piece of tax legislation since the Tax Reform Act of 1986 was signed into law. Dubbed the Tax Cuts And Jobs Act(TCJA) of 2017, 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(IRS 2018b). One element which was modified for S Corps, in particular was the impact of reasonable compensation on the S Corps owner’s personal tax return. This White Paper examines why the IRS is now focusing on an accurate reasonable compensation figure, and how reasonable compensation can be derived properly.

You are invited to attend a complimentary webinar on Reasonable Compensation and receive CPE credits. Leading expert on S Corps and Reasonable Compensation will share with you how to get this done accurately and easily and ensure you protect your clients on audit of their compensation.

Register For Tuesday, May 12th Complimentary Webinar On Reasonable Compensation

Register For Tuesday, June 2, 2020 For Complimentary Webinar On Reasonable Compensation

Profit V. Distribution And Its Effect On Reasonable Compensation

Profit V. Distribution And Its Effect On Reasonable Compensation - Paul Hamann

How does profitability factor into a Reasonable Compensation calculation? This is one of the most frequent questions we receive. The short answer is: “Very little.”

That being said profit now plays a role on the shareholders 1040 with the passage of the TCJA. How section 199A and the QBI affects your clients 1040 will vary significantly, because, as has been pointed out many times since the passage of the TCJA, section 199A is incredibly complex and the IRS has released guidance on the issue.

To help you better understand why profit has very little to do with a Reasonable Compensation calculation we’ll run through a few simple scenarios and then move onto some more advanced ones. To begin, keep the following four facts in mind:

1.Reasonable Compensation is based on the value of services provided, not profit or distributions.
2.Wages (Reasonable Compensation) should be paid BEFORE distributions are made.
3.A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.
4.A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation, and play ‘catch up’ in a later year.
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Internal Revenue Service Lays Out Steps To Keep Reasonable Compensation Out Of Court

IRS Lays Out Steps To Keep Reasonable Compensation Out Of Court

In a memorandum to its examiners and appeals agents, the IRS lays out steps to keep Reasonable Compensation challenges out of Tax Court. Great, you say, nobody wants to go to court!

Not so fast. The option of filing a petition in Tax Court provides taxpayers with time and leverage. By following the steps in this memo, IRS examiners can prevent taxpayers who cannot reach a resolution on Reasonable Compensation from filing a petition in Tax Court. This means:

Tax must be paid now. When filing a petition with the Tax Court, taxpayer can avoid paying the tax until the matter is finally resolved.
Leverage Lost. Filing or even the threat of filing a petition with the Tax Court can give taxpayers and their advocates’ leverage to get the appeals agent to settle the dispute favorably.

Since 2005, when the IRS began studying the issue of compliance and Reasonable Compensation, the agency has been regularly and consistently improving enforcement and compliance strategies. This relatively unknown memo, prepared by Janine Cook, Deputy Associate Chief Counsel (Exempt Organizations/Employment Tax/Government Entities) to Barbara Wulf, Program Manager (Specialty Exam Policy & Quality, ET policy), is another example of their continued efforts to do just that.
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Reasonable Compensation And Single Shareholder S Corporation

Reasonable Compensation And Single Shareholder S Corporation

“If there is only one shareholder and no other employees, should all distributions be taken out as Reasonable Compensation?”

This is a common question we receive at RCReports and like with most of the questions we receive, the answer is: “Maybe.”

If the business is so unique or the services of the shareholder are so unique, that no one could be hired to replace the owner and there are no other assets in the corporation, then everything taken out of the business should be treated as wages (Reasonable Compensation) and nothing should be considered a distribution.

If the corporation has tangible assets, such as equipment or inventory, the owner deserves a return on that investment. Likewise, if the business has employees or uses contractors, the owner deserves a return on that investment as well.

If the corporation has intangible assets, such as goodwill, a license to operate or a favorable lease, the shareholder should be getting a return on these assets. These assets may or may not have a tax basis. An example of this would be internally developed goodwill.
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Reasonable Compensation And Normalization

Reasonable Compensation And Normalization

Defining reasonable compensation is a fairly simple task. According to Black’s Law Dictionary, it is, “compensation which is consistent with the normal reward for any employee for the work performed or duties that are involved.” However, that definition is not as simple as it may appear. A key word jumps out to any business valuator or reasonable compensation expert – normal. What is a normal reward? What is normal to one may not be normal to another. The compensation for any job title can vary by industry, location, and experience. Normal is a relative term, making it all the more challenging to determine reasonable compensation.

In this post, we will discuss the dangers of not normalizing reasonable compensation when valuing a business, the three approaches to reasonable compensation, and the challenges of using antiquated techniques in determining reasonable compensation.

Why Normalize?

As a valuator, you need to normalize reasonable compensation to complete your engagement successfully. Owners, and in particular owners of closely held businesses, will often adjust their salary to maximize their business’s profitability or minimize tax burdens. The challenge when performing a valuation on these businesses is determining what normal compensation is for the owner, not the salary they are choosing to pay themselves.

Take one of our recently published Case Studies. Matthew Cassedy, a veteran business appraiser, was brought in by the wife in a divorce. Both the husband and wife were lawyers, but the husband was the single-owner of a medium-sized law firm. The valuation he produced used the market approach, resulting in his salary being extremely high, leaving the business (a shared asset in the divorce) with no enterprise goodwill. Mr. Cassedy was brought in and was able to produce a far more reasonable normalized figure for the husband’s compensation.
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Reasonable Compensation: The X Factor In The QBI

Reasonable Compensation: The X Factor In The QBI

If you’ve sat down with pencil and paper or an Excel spreadsheet and attempted to map out what Section 199A deduction for Qualified Business Income (QBI) means to your pass-through business clients, then you’ve likely encountered circular logic, or with Excel – the circular reference error. And if you’ve been paying attention, even a little bit, to the conversations regarding Section 199A, then you have heard (over and over again) that this section of the Tax Cut and Jobs Act (TCJA) is arguably one of the most, if not the most challenging provision.

Since the TCJA passed we have been fielding countless calls and emails from advisors wondering what affect Reasonable Compensation will have on entity selection and the Section 199A deduction. And without doubt (and with good reason) advisors are frustrated with the way Section 199A was crafted, and hungry for Congress and the IRS to clarify the provision.

We are fortunate to have built a vast network of thought leaders across many spectrums – including top educators, former IRS examiners & appeals agent’s, valuation experts and niche practitioners specializing in closely-held businesses. The conversations we’ve had so far are, for the most part, inconclusive. To share much of what we have discussed would be irresponsible because most of what is being discussed right now are speculation. Speculation on what Congress’s intent was, what regulations the IRS will put into place, and what changes will be made this year.

There are, however, three points that just about everyone we have talked with agrees upon.
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Small Business Owner Ego and Reasonable Compensation For S-Corps

Paul Hamann - S Corp and Reasonable Compensation

There are times when every small business owner’s ego can be an asset, although when it comes to Reasonable Compensation and S Corps, having a big ego could cost your client thousands of additional dollars in payroll taxes and QBI deductions.

Let’s look at an example: Meet Joan and her over-inflated alter ego Joanna.

When Joanna completes a Reasonable Compensation survey, she does so with an immensely inflated ego. She doesn’t bother to read the job descriptions and selects tasks based solely on title; there is no task Joanna –doesn’t consider herself awesome at completing; so she rates her skill level as high for each selected task on the survey.

When Joan fills out her Reasonable Compensation survey, she takes her accountant’s advice and sets her ego aside. She reads through the job descriptions and chooses tasks that best fit what she really does for her business. She is honest with herself, and acknowledges she can’t possibly be impeccable at every task and so rates her skill levels appropriately.
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Can Form 1125-E Protect You From Accuracy Penalties?

Paul Hamann On Form 1125 - E

Can Form 1125-E protect your clients from accuracy penalties? The answer to this question, oddly enough, does not lie within the instructions for form 1125-E, but instead within the IRS job aid on Reasonable Compensation (Pg. 22) – and the answer is YES, well, maybe, as in, Yes, if you have done other things appropriately.

If you really don’t want clients coming into your office waving “interest and penalties” letters and pointing the finger of blame at you, recognize that it’s not enough to follow the instructions for Form 1125-E, although that’s a good start. You must also meet the IRS’s disclosure standard. If you don’t, the IRS Reasonable Compensation Job Aid suggests the examiner apply accuracy related penalties under Section 6662.

A few simple steps will protect your client from accuracy penalties.

File form 1125-E for ALL your corporate clients. You MUST file it for corporations with revenue above $500,000, but you can (and should) file it for all your corporations.
Meet the IRS disclosure standard for reporting officer compensation, which means:
The taxpayer completes the forms and attachments in a clear manner and in accordance with the instructions.
The dollar amounts must be verifiable.
The taxpayer must be able to demonstrate the origin of the amount claimed.
The taxpayer must be able to show that he entered the amount in good faith.
Well, step 2a. should be a no-brainer for any tax preparer. However, steps 2b., 2c. and 2d. clearly indicate that the taxpayer must have verifiable documentation to back up the amount of officer compensation entered. Without this documentation your client is at risk of accuracy related penalties. And when your client is assessed penalties, the finger-pointing often escalates to threats of malpractice claims.
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What If An S Corp Owner Can’t Afford To Pay Reasonable Compensation?

Reasonable Compensation S Corp

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.

Reasonable Compensation is based on the value of services provided (Hypothetical Replacement Cost), not profit, distributions or the amount the company can afford to pay.
Wages (Reasonable Compensation) should be paid BEFORE distributions are made.
A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.
A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation (distribution), and play ‘catch up’ in a later year.
Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business. While Reasonable Compensation has nothing to do with profit and loss, it does relate to Distributions. Why? Because the IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S Corp owner is taking money (e.g. a distribution or other items of value) out of the S Corp.
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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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