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Reasonable Compensation Audit Risk

How do you fast track yourself into an IRS audit? Do not pay yourself Reasonable Compensation.

Why is the IRS auditing what you pay yourself? The IRS Agents know that it is easy to find large mistakes. $105,000 is your median new tax bill risk.

If you try to fight the audit, you could add $20,000 or more in tax attorney and CPA defense costs. You will spend 50 to 100 plus hours, too. These are big reasons for you to build a good S Corp owner-employee compensation process. 

Are you ready for an IRS business tax audit? We predict 2018 to 2023 to be the biggest years for S Corp IRS audits ever. With the IRS, you are guilty until you prove you are innocent.

For an S corporation,
When a shareholder’s compensation is lower than “reasonable”, it violates IRS Codes and brings additional taxes and penalties.
          b. If the compensation is higher than reasonable, the shareholder could pay substantial unnecessary taxes, and violate codes.

Your Reasonable Compensation AnalysisSM  is a salary or wage (reasonable compensation calculator) that you complete based on your data and choices. Choices the IRS says you must make every year. 

The fastest way to kill your financial future is to do something the IRS targets. Let's go over a sample report, your first step in the audit prevention process.

The RCASM analytic tool helps set your groundwork. You can build a better way to establish your salary and wages, avoid doing the time-consuming salary or wage research and documentation, and guard against an IRS “Reasonable Compensation” audit. e-Mail Us for More Information.

You Have Big Money at Risk By Not Setting Reasonable Compensation

The IRS is targeting you, and they are getting smarter about how they are doing it. Their new task force uses Artificial Intelligence (AI) to audit your business and personal returns. They know people game their taxes. They know the tactics used. That is how they find when your compensation is not “reasonable” by their definition.

WARNING. The latest data shows the IRS has won 25 cases, and lost only one. The odds against you are costly. Do not wait for the IRS Notice in the mail

Compensation chosen by owners to reduce payroll and income taxes will get them into IRS hot water.

With the IRS, you are guilty until you prove you are innocent. If your records cannot refute the IRS claims for tax, penalties, and interest, you can expect more IRS troubles. Never use a ‘Rule of Thumb’ to set Reasonable Compensation. You need supporting facts, not guesses, facts shown in a proactive process.

If you just pull your salary or wage number out of thin air, use ‘artificial safe harbors’ or other ‘rules of thumb,’ the IRS risks get  much worse.

The Tax Cuts and Jobs Act of 2017 “TCJA” December 22, 2017 has drastic new rules affecting deductions of employee benefits and executive compensation. And, it includes a new 21% excise tax penalty when you make mistakes. For-profit, not-for-profit, S Corporations and C Corporations have unique individual hurdles to overcome.

For the IRS and others “Executive Compensation” and “Reasonable Compensation” are very different.

In addition, if your salary or wage is off, then your distributions on your K-1 are likely off the mark, and you have a growing problem. So you win the prize, they levy additional tax, penalties, and interest. A surprise bill estimated at double the original tax due.

We will show you there are many more costly surprise problems that follow.

Contact us, we are an independent, objective third party, who is experienced with reasonable compensation salary and wages analysis. Your analysis gives you support for your selected s reasonable compensation when challenged by anyone including the IRS, DOL, and a host of others.

For S Corporations with Five or Fewer Shareholder-Employees

If you have a process to set wages and salaries shareholder-employees, you are welcome to call, meet with us or e-mail an outline and description of your steps for a no obligation complimentary review.

We also offer a complimentary review your last year’s federal tax return. You are also welcome to ask any setting "reasonable compensation” questions.

If you do not have a process to set compensation, e-mail, call or meet with us and we will give you a place to start. Let’s talk.

Here are more ways to benefit from knowing reasonable compensation.

In a divorce,

  1. If the compensation is too high, it can understate the company’s value, and overstate support and/or alimony.
  2. If the compensation is too low, it can overstate the company's value, and understate support and/or alimony.
  3. As part of an Occupational Earnings Appraisal, OEASM (Fair Job Income) for an under-employed or unemployed person for Child and Spousal Support Issues. Some choose not to work, when a fair expectation would be they could work and earn more.

Internal Promotion, Employee Retention, and Outside Recruiting Plans. 
          A pay package offer that is “unreasonable” has obvious problems. Making a good salary or wage offer is critical to acquiring and keeping the right people at a fair price. 71% of your employees are looking for a new job now. A big, but controllable risk.
          Showing a candidate your completed Reasonable Compensation AnalysisSM salary or wage calculation gives both you and the candidate two advantages. They know you care by doing your homework to have proof to show staff; and that the salary or wage offer is fair and reasonable for the position’s job description in the current market.

Business Valuation-Reasonable Compensation AnalysisSM Driver Fairness Adjustment.
          When valuing a business (or professional practice), compensation should represent the Fair Market Value economics. The adjustment prevents misleading business valuations. For mergers and acquisitions, M&A and buy/sells, the risks surrounding compensation are 1 of 15 major reasons deals fail.

Family in the Business.
          Paying your family or yourself too much raises an IRS audit flag. Companies with related shareholders and employees rank high on the IRS suspect list.

For a C corporation.
          When a shareholder’s compensation is too high, it violates IRS Codes and brings additional taxes and penalties.

For Subcontractors and Other Outsourcing Options.
          These are great ways to add expertise and experience. However, they both are expensive and time consuming. Each has its own IRS compliance risks. Our new clients start with a free Contractor Stress Test to avoid IRS audits. A Reasonable Compensation Analysis, RCASM makes the cost to benefit evaluation much easier. You’ll know when an outsourcing option is better than a new hire. Request yours today.

Your Reasonable Compensation AnalysisSM  is a salary or wage calculation that you complete based on your data and choices. Choices the IRS says you must make every year. 

The fastest way to kill your financial future is to do something the IRS targets.

The RCASM analytic tool helps set your groundwork. You can build a better way to establish your salary and wages, avoid doing the time-consuming salary or wage research and documentation, and guard against an IRS “Reasonable Compensation” audit. e-Mail Us for More Information.  

You tell us which of the above compensation areas concern you now.

You will be walked through your process choices. In summary, we use very sophisticated Cloud Technology where clients enter their job parameters and other facts through an e-mailed link.

We do NOT use an Excel Spreadsheet like 77% of others do, and many others still use Google, pencil and paper.

You control the extent of the project’s included services, and the budget for the services. You determine how you will use the analysis results. You set how far the analysis process will drill down.

Your selections, issues, and provided data determine the project’s fee and the confidence level of your result to reach your goals. Your invoice lists your specific issues and choices, your fee, our agreement, and is paid by check to David A. Dinsmore before analysis begins.

A Reasonable Compensation AnalysisSM  salary and wage-planning estimate starts at $100.00 for a single defined job description. Your needs may call for a mix of job descriptions to best fit your “Working Title” (see the definition in the Glossary linked at the end of the page) job parameters. Each additional job description blended into the calculation adds $25. Example: Base of $100 plus three additional job descriptions, a total of four, would be $275.00.

For Shareholder-Employee IRS Compliance and other more complex goals, projects start at $375.00 and may include analyst interview assistance. Your project’s amount is set in a complimentary 30-minute telephone conference before you pay and start the online interview.

The e-mail with your link to your Cloud Interview includes a job description worksheet, and may include other supporting information to help you prepare. Remember when dealing with the IRS, you are guilty until you prove you are innocent.

Our Cloud Process for Your - Reasonable Compensation Analysis, RCASM

Your Reasonable Compensation Analysis, RCASM  is a salary or wage calculation that you complete based on your data and choices. 

How to Setup Your Compensation Calculation

Your online interview questionnaire personalizes and fine-tunes your calculation report’s salary or wage factors, and issues. Use the following list to prepare and keep notes about your reasoning for future reference.

  • First, you select a report option from the several choices outlined depending on how you will use the report. A fresh  HR Audit is often a starting place for growth focused leadership.
  • Gather the needed data and documents. We can provide you with informative articles to support your data and document gathering.
  • Match the single or a blend of multiple job categories using their duties and required skills. We can help with this. For example, some choose to be called the CEO, however for small businesses, Management - Supervision positions are more accurately described by other titles. CEO can also stand for Chief Everything Officer.
  • Describe the subject's job profile by making a list of the person’s hours worked or scheduled, and their work duties. You can select a percentage for the time spent on each category.
              Then in the subject's My Business Section select their primary work or professional focus, not included in the above categories, and its time allocation.
              Examples: Physician, Engineer, Architect, Veterinarian, Analyst, Manager, Construction Trade Specific, Electrician, and Many Other Careers.
  • Review and record the person’s education level and background, and a rating for each job category's performance and competence.
  • Gather facts about your company’s profile for perspective in researching pay rate appropriate resources; we use several sources depending on your profile.
  • Finally, connect online using the e-mailed link, and complete the questionnaire. Directions are shown at each step. When you finish, we are notified automatically.
  • As an added service, we can help you evaluate the need to adjust the salary or wage amount for non-cash compensation sources.

How The Treasury Department (IRS) Defines Reasonable Compensation

 What's a Reasonable Salary or Wage?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

Reasonable compensation.
Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to "Employee's Pay, Tests for Deducting Pay" in Publication 535, Business Expenses for more information. IRS

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.  However, if cash or property or the right to receive cash and property did go (to) the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Internal Revenue Code Section 162 states that to be deductible for federal income tax purposes, executive compensation must be (1) “reasonable in amount” and (2) “based on services actually rendered.”

Note: “Executive Compensation” and “Reasonable Compensation” are not the same thing.

Treas. Reg. §1.162-7(b)(3) defines “reasonable” compensation as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances."

Reasonable is fair (honest, equitable, even-handed, impartial, free from prejudice, bias, greed, and not self-serving), proper, just, moderate, suitable under the circumstances. Dictionary

Reasonable compensation is a term used by the IRS to define the compensation amount that is a deductible business expense.

The issue comes up because stockholder-employees can alter their wages and income distributions to avoid taxes. (Comment: This is where costly problems start.)

Under IRC 162 (a), wages are a deductible business expense to the extent wages are reasonable.

In an S Corporation, under-payment of wages occurs in order to maximize pass-through income and avoid payment of FICA and Medicare contributions.

In a C corporation, wages are maximized and dividends eliminated or minimized to avoid the double taxation of dividends. Economic Research Institute, Inc.

Note: IRS Definitions and Rules Change, Check Rules with a Professional Adviser Before Taking Any Actions.

David A. Dinsmore’s specialized compensation analysis education, training and experience

  • started in 1979 with the Life Underwriting Training Counsel, LUTC program,
  • advanced through the Certified Financial Planner, CFP designation in 1986,
  • refined by the Compensation Analysis with Ohio Department of Job & Family Services, 2006 and
  • concentrated by the business credentials as a Board Certified Business Appraiser, BCBA in 1998 and a Registered Business Consultant, RBC in 2011.

Our HR Audit services and reasonable compensation analysis adds two sharp tools to help your company’s leadership.