As the 4th annual Tax Rep Summit wraps-up in Orlando, Tax Rep Network founder Eric Green gets us caught up on what “Reasonable Compensation” is, how the IRS views it, and what every Tax Professional needs to know about it now that the IRS is targeting S Corp owners that fail to meet its standards. Eric also discusses how to use RCReports to not only bullet-proof your client’s reasonable compensation but how to turn the software into a whole new revenue stream for your practice.
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What Is “Reasonable Compensation” For Tax Purposes? By Tax Rep Network
Understanding IRS Audits On S Corporations
We just wrapped up the fourth annual tax rep summit. Great time. Great energy. We booked the fifth and sixth annual summits. We’ll be posting about that shortly. One thing that came out of the summit was the concept of reasonable compensation. The IRS now is really ramping up the audits on S corporations and S corporation owners. One of the big hot-button items there is reasonable compensation. Now, this affects S corporations, C corporations, and non-profits that file in 990.
The rule is there’s supposed to be some backup data that supports the compensation taken by the shareholders or officers that determine the reasonableness of it. There’s a huge amount of confusion around this. I thought that I would just take this moment to clarify this so you understand how reasonable compensation works. First of all, let’s just dispel a number of myths.
Number one, it has nothing to do with profitability. Nothing. You might be thinking, “Wait a minute, the company’s not making money.” Think of it this way. I’ll use myself as an example. If I left Green & Sklarz and just left, the firm would have to hire somebody to take my job. What would they pay that attorney to do the job, provide the services that I was providing to the company?
That person would expect to be paid, regardless of whether the company makes money or not. That’s the employee portion. First of all, you have to figure out a reasonable compensation for that person. If you are an S-Corp owner and you are providing services to your S-Corp, you have to pay yourself reasonable compensation for those services. Let’s assume, I don’t know, that reasonable compensation is $100,000.
It doesn’t matter how much the company makes. If the company makes $5 million or loses $5 million, my reasonable compensation is $100,000. Do I need to be paid wages of $100,000? No. The first money out, up to $100,000, has to be W-2 wages. Anything above that can come out as distributions not subject to self-employment tax. That’s where the tax savings are.
Taking money out of your S Corp? The first dollars must be wages up to your reasonable compensation amount. Only then can you take distributions. Share on XUnderstanding Wages, Distributions, And Tax Savings
Let’s just run through a couple of examples. Number one, my reasonable compensation is $100,000. I’m providing services to my S corporation, and I pull $50,000 out. All $50,000 has to be W-2 wages. Next example, I pull $200,000 out. The first $100,000 would be W-2 wages. Anything above that distribution is not subject to self-employment tax. What if I don’t take any money?
The company loses money, and I take no distribution, or it made money, but I left the money in to reinvest in the company. I don’t take any distributions. Now we all know I’ll have taxable income, and as a corporation, it’s a pass-through entity, but taxable income is not the same as compensation. I’m going to have taxable income. Do I have to declare any wages? No. I took no distributions. If I don’t take any distributions, I don’t have to declare the wages.
The folks that came up to me afterwards said, “Eric, if the company’s losing money, why would it have to pay my client $100,000 salary?” It doesn’t. If the client pulls money out of the corporation, the first money out has to be compensation up to that reasonable compensation number. Let’s assume my reasonable compensation is $100,000, and the company loses money and I don’t take anything out in year one.
In year two, it breaks even, I don’t take any money out. In year three, it makes $200,000, I pull the whole $200,000 out. I didn’t take any reasonable comp for my $100,000 salary, which is what we’ve determined, I use RCE reports, is reasonable. I would have to make up those years. In years 1, 2, and 3, I should have gotten 300,000 compensation. The whole 200 I took out in year three would be my W-2 compensation, and there’s still 100,000 I need to make up.
Treat the person as if they were an independent employee. What would they expect? They’d expect those missed wages to be made up. Same thing. Again, urban myth number one. It has nothing to do with profitability. The second myth is that you have to pay those wages every single year. No, you don’t. It’s only if the S corporation owner takes money out that they would have to take the reasonable compensation number.
Number three is this. I’m trying to think of how to explain this. When it comes to cops, it’s for the services provided. I’ve got this a lot. “Eric, my client’s retired. He’s in Florida. He owns the S Corp.” I can say stop right there. This is about services provided. “Is your S Corp owner providing services?” “No, he’s retired in Florida. He doesn’t have to take any reasonable compensation. Everything can come out as distributions. He’s merely an investor at that point. This is only for the corporate owner who provides services.
Retired S Corp owners don’t need to take reasonable compensation. If they’re not providing services, their income can come entirely from distributions. Share on XI hope that that helps. Now, the other thing is, why do I use RC reports? First of all, it is by far the best of these. A 100 million data points. When you get that report, I’ve dealt with this now in three audits. When you provide that report to the auditor, they simply flip through it and say, “Can I have a copy of this for the file?” “Sure, no problem, that’s yours.”
RC Reports: Protecting Against IRS Audits
That’s the whole end of the comp audit. What the IRS is looking for are people that are not taking reasonable compensation and when they show up have no data or anything to back up the number. First of all, RC reports, it’s going to bulletproof the return. It’s going to let you and the client sleep at night. The other thing we found is when we run the reasonable comp report, we have clients who are taking too much.
A lot of people that I got to take the minimum that you need to take to max your social security. Medicare, I think it’s around $165,000, something like that. They’re taking $165,000 as their wages because some accountant told them that was a safe thing to do. You run their reasonable comp report in RC Reports, and it comes out at $92,000. I tell the client, “Drop your comp to $92,000.”
Your social security wages are going to go down, but let’s take that 15.3% on that $72,000 roughly. We’re going to save them about $10,000 or $11,000 a year, and let’s put that into your own profit sharing. Put that money into your own retirement account. I hope social security is around, but I’m not banking on it. Let’s take that and help the taxpayer save taxes. Now, put that money away.
How CPAs Can Use RC Reports To Profit
Let it accumulate and grow much faster than Social Security is going to. We’ve also bulletproofed their return so we can sleep better at night. If an audit notice comes or shows up, they can sleep better at night. Now, the other way to make money with RC Reports, if you’re a CPA or an EA or an attorney who does returns, you probably have single-member LLCs that are profitable. Run them through RC reports.
CPAs, EAs, and tax attorneys—RC Reports isn’t just a tax tool. It’s a money-maker. Use it to ensure compliance and generate additional revenue Share on XAgain, you’re taking a little bit of a rough cut. If you’ve not used the software, it asks you to break down how much time you spend on this job, that job, whatever, out of a 40-hour, say, work week. You might find that your LLC who is netting $200,000 or $220,000. Again, maybe their reasonable comp comes in around 80 or 100. If it’s at a hundred, save them 15.3% on $65,000 and say, “Look, I can save you $9,000 a year.
Now you’ll have the corporate return. You’ve got to run the report every December to set your wages for the next year.” We can save you money, have you take that money, and put it into your own retirement account. Again, you don’t have to worry about an IRS audit because the IRS isn’t going to come up with anything better than RC reports. A 100 million data points. They’ve never been successfully challenged. Given what I do for a living, I tend to do it reactively.
There’s an audit going on. We run the report mostly to see what the damage is because the other thing is if they didn’t take reasonable comp, you might find auditors that get very aggressive in what they think is reasonable comp. That’s why I run the report because this way, we can minimize the damage because the auditors are not going to be on your client’s side.
They’re going to try to aggressively pump up that reasonable comp number as high as they can, creating more payroll tax liability, penalty and interest, and all the rest. Hopefully, you learned a little bit about how reasonable comp works. Hopefully, I have told you how you can deal with it. For those of you interested in RC reports, I’ll put a link in the description to this video where you can go and save money through the tax rep discount. I’m telling you this is an investment that is worth every dime. By the way, as a CPA or EA, this should be a moneymaker for you.
This is not just part of the 1040 prep or the 1120S prep. The client’s got to pay for this. It’s got to be part of the deal. I would just bake it in. If you’re doing a flat fee, this has to get baked in, so you’re going to have to increase. If the client wonders, by the way, just as a practice point, why they have to do this all of sudden. You can tell them. The IRS is auditing this. This is a hot-button item. We haven’t dealt with it up until now. We need to deal with it. Hopefully, you learn something about reasonable comp. You learn something about RC reports. I’ll see you in tax rep.
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