What does it really mean? And why you should care!
If you’re in business, you’ve probably noticed the term “Reasonable Compensation” has been in tax news more than ever in recent months. It’s not a new term, but it is receiving new attention by the IRS.
Who should care?
Anyone associated with a Subchapter S Corporation. You might call yourself an owner or a shareholder or even a partner. (I’m going to use ‘owner’ because it is short.)
The “owners” of a Sub-S are expected to be on salary. The salary is expected to be reasonable. (Get it? Salary is compensation for work performed within the corporation, and that salary is expected to be reasonable.)
Why wouldn’t it be reasonable?
Salary means taxes – both for the employee (who happens to be the owner) and the employer (who also happens to be the owner). For many Sub-S owners, this just feels wrong. Many Sub-S owners strive to keep the salary low so as to avoid paying both halves of those employment taxes. On the other hand, the IRS and the states want the employment taxes! They need all those contributions to their funds to keep up with their obligations.
Is this new?
No! There is nothing new about the conflicting desires of the Sub-S owner and the government, especially in the realm of compensation.
Is anything new?
Yes! The government has greatly increased penalties for owners who do NOT pay themselves reasonable compensation, and has even added penalties for CPAs whose clients do not pay themselves reasonable compensation. Furthermore, the IRS is actively pursuing the topic, even to the point of prosecution. This is very new.
So, what does “reasonable” mean?
There is no specific guideline. Owners are expected to have rationally contemplated the issue and to be able to provide a basis for their determination. Note: “I gave it a lot of thought and decided $30K was reasonable,” isn’t going to be enough. Some say putting 70% of net income into owner salary should suffice, but that isn’t working, either. Why 70%? Why not 71%? And who wants to pay both halves of the employment tax on net income of $300,000?
Is there any solution?
Personally, I think yes. Software which weighs multiple factors, including a detailed job description and time allocations among the tasks performed, together with specific geographic influences to come up with a multi-page report. Details. Specificity. Undeniably reasonable. And the IRS has been known to like it.
As a South Jersey CPA thoroughly exhilarated by working with small business owners, I would love to run a report for you! Give us a call.