Surviving An IRS Reasonable Compensation Challenge

By Paul S. Hamann & Jack Salewski, CPA, CGMA

In the past, the IRS generally challenged Reasonable Compensation for being too low (for S Corps). That will not be the case in the future, with the passage of the TCJA, making it critical to properly dial in your client’s reasonable compensation figure. Surviving a challenge requires credible backup data to defend your figure.

The IRS and tax courts have made it clear that “companies have the burden of showing that compensation is reasonable… and should keep records indicating the duties performed by its employees and the hours those employees worked.” (IRS Job Aid pg 12) To put it another way companies have the responsibility to demonstrate the reasonableness of the S Corp owners compensation and the best way of doing so is with credible independent research and documentation.

Should a challenge be made by the IRS there are two ways to survive.

The first is a Proactive Strategy, getting all your clients ducks in a row ahead of time so you are prepared if the Reasonable Compensation figure is challenged.

  1. Create a list of all the services the S Corp Owner provides for his or her company. The courts have taken into consideration ALL the services provided by the S Corp Owner, not just their primary function or industry.
  2. Research what the going rates are for your list of services in your community. Document your findings and sources of information and file them with your final Reasonable Compensation figure.
  3. Adopt your finding into your corporate minutes. This simple but often overlooked step gives your Reasonable Compensation figure an added layer of defensibility.

(A former IRS agent commented that then adopting that research and documentation into the corporate minutes would, in his opinion, make the RC figure bullet-proof, as long as it was done in the year in question, not the day after an audit commenced).

Follow this simple process year after year and you will build a consistent, defendable Reasonable Compensation policy.

The second is a Reactive Scenario to defend a Reasonable Compensation figure that may not have any basis in reality. If the S Corp owner has no research and documentation to support their Reasonable Compensation figure you have two options.

  1. Accept what the IRS examiner is proposing, pay your tax, penalties and interest (usually in the neighborhood of twice the original tax that would have been owed), lick your wounds and move on.
  2. Create a list of all the services the S Corp Owner provides for their company in the year being challenged. Research what the going rates are for your list of services for the year in question. This requires the same effort as the proactive strategy; except you no longer have the high ground.
  3. Compromise. Usually the Reasonable Compensation figure you came up with in the last step falls somewhere between the figure originally submitted to the IRS and the figure the IRS examiner is proposing. Now the challenge. At this point the best negotiator normally prevails and a compromise is struck.

Traditionally the IRS targeted compensation that appeared unreasonably low. Not the case moving forward. With the passage of the TCJA the IRS may have an incentive to challenge a Reasonable Compensation figure for being too high. Today more than ever it is crucial to nail down your S Corp client’s Reasonable Compensation with credible research and documentation. This protects your clients from costly penalties and interest and your firm from preparer penalties and expensive litigation from an unhappy (former) client.

Article complements of: RC Reports