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 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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Haik Chilingaryan, C- Corps, S-Corps, Tax Lawyer

Prior to tax reform, the C-corporation tax rates ranged from 15 to 35 percent. Under the new law, there is a 21% flat rate. Also under the new law, there is this new deduction known as the Qualified Business Income deduction that is available for Pass-Through Businesses.

Synopsis

The Tax Cuts and Jobs Act of 2017, otherwise known as the GOP tax reform bill, largely went into effect on January 1, 2018. If utilized properly, the new law can be significantly beneficial for business owners. To understand how the new laws can be beneficial for business owners, it’s important to be familiar with the two types of businesses that can have an impact on the taxation of a business entity.

Taxation Of A Business Entity

One way is for the entity to be structured as a C-corporation, in which case the income generated from the business may be taxed twice. For example, the corporation gets taxed at the corporate level upon earning a profit, then after the corporation makes a distribution to the shareholders, the shareholders also pay taxes on their individual tax returns. This concept is known as double-taxation. Under the new law, all the C-corporations will pay a 21% tax on their corporate profits.

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