S-Corporations and a “Reasonable”​ Salary

When people say, “Let’s be reasonable” I often wonder….what exactly is reasonable? Reasonable to whom?

When referring to the IRS “reasonable salary” requirement of S-Corp owners, that answer has been a bit mysterious Until now. If you are being taxed as an S-Corp I encourage you to spend some time and even some money, to make sure the salary you are paying yourself and other officers meets the IRS expectations of “reasonable salary.” I promise you will be thankful you did. CLICK HERE to check out the nightmare experienced by one business owner. Nancy will have lots of company within the next 1-2 years.

Why is this an issue now?

I’m sure you’ve heard about the massive new budget awarded to the IRS last fall. The promise of those funds came with the responsibility of the agency to increase revenue by roughly $127 BILLION. We don’t know how many new agents will be hired or when. But we do know that they are coming and are looking to find that new revenue by enforcing compliance and collecting back taxes, penalties, and interest. Of particular interest are wealthy individuals and businesses. For S-corps they will be scrutinizing salary levels and distributions.

What can you do?

• If you and other active officers aren’t receiving a paycheck DO IT NOW. It’s the law.
• If you aren’t receiving a paycheck but you’ve taken distributions, you’ve put a massive target on your back.
• If you can’t afford to take a paycheck, you had better not take a single penny as a distribution. That means if you accidentally use the company card to pay for personal expenses, you must pay the company back before the end of the year.
• If your salary is challenged by the IRS you must have documentation to back it up. It’s your burden to prove how you arrived at your figure.

How to determine if your salary meets the “reasonable” sniff test?

It used to be that one could simply say “Well this is what I would pay someone else to do the same job.” Well that’s a good place to start but will no longer stand up if you are challenged by the IRS.

There are a few methods for determining a reasonable salary. Below is a brief comment on each but you can learn more by reading this article from RC Reports.

1. The cost approach, which is a good option for business owners who play many roles within the company. Your salary amount is a cumulative figure based on the amount of time spent performing each role and the median wage assigned to each.
2. The market approach follows the old “what would you pay someone else” theory but it requires you have documented comparisons for business owners operating businesses of like purpose, size, and location.
3. The income approach is less commonly used when it’s difficult to find the comparison data used in the other approaches. Basically it asks whether an investor would consider the salary acceptable in relation to the financial performance of the business.

None of these approaches is as simple as I made them sound here. I encourage you to do your homework. Outline the exact duties of each officer. Collect as many comparisons as possible. Check the track record of the data; meaning has it stood up to previous challenges.

Whichever approach you use, I can’t stress enough the importance of documenting the entire process and add it to your corporate minutes.

What does my tax preparer have to say about my salary?

Tax preparers are required to do their due diligence and verify certain things; however, for most line items they rely on the information provided by you. For many tax professionals, verifying that our S-Corp clients are being paid a salary that will stand up to an IRS challenge, is one of those things we will now be verifying.

You may be wondering why we care. We care because the IRS isn’t just tightening the screws on taxpayers. For every S-Corp client that is determined to have underpaid themselves, the tax professional can be charged a total of $5000, not to mention substantial legal fees we will incur to fight it. I mean if you think Nancy of Nancy’s Nail Salon experienced a nightmare, check out what this tax professional went through.

For this reason, your tax preparer will likely be asking to see the documentation you have to support your salary amount, may require you to pay for an extra report so they can produce that documentation, or refuse to file your return. If your tax professional is requiring a report you should expect to pay $200 or more. Before you scoff at the price, consider a couple of things. How much time will it take you to compile the proper documentation? How much will you incur in tax penalties if you don’t have the documentation?

This is a hot issue for both S-Corp owners and tax professionals and if either one fails to be diligent it can be costly for both parties. Be sure to talk to your tax advisor before filing your 2022 and be willing to work with them to cover both your behinds.

One other thing. This isn’t a one & done thing. Presumably your business is going to grow year after year. It’s also a safe bet that your role and responsibilites are going to change as you grow. For these reasons, this should become an annual conversation between you and your tax professional,

FYI If your tax professional isn’t requiring you to do this, they don’t offer a Reasonable Salary Assessment, or you don’t have time to do your own legwork, schedule a free call with us. We’ll happily help you CYA even if you aren’t a regular client.

Written by Tina Nail