One of the primary targets for IRS audits is S Corporation compensation. S Corporation owners should understand IRS strategies for compensation audits and work with Allen Barron to reduce these risks while minimizing tax and maximizing income opportunities. One of the most contentious issues is “reasonable compensation.” The IRS guidelines specifically state:
“S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.”
The IRS will evaluate reasonable compensation in light of the source of the S Corporation’s gross receipts. The three primary sources of income are:
- The services of a shareholder
- The services of non-shareholder employees
- Capital and equipment
If most of the income is associated with a shareholder’s personal service the amount of compensation should be increased. When services of employees or the corporations capital and equipment account for revenues the IRS may expect more of a distribution/compensation formula. The IRS will use to principle methods to determine reasonable compensation: the multi-factor approach and the independent investor test.
The multi-factor approach is just what it sounds to be: a calculation based upon multiple factors from qualifications, training and experience to time, economic conditions, bookkeeping, payments to non-shareholders and the extent of the officer’s duties and responsibilities. The independent investor test considers the ROI (return on investment or equity) a hypothetical investor would have received after compensation had been paid. The hypothetical calculation of ROI must balance with other similar companies in order to be considered reasonable compensation.
If you are a shareholder in an S Corporation the developments of the past few weeks combined with increased tax audits for S Corporation shareholders requires the advice, counsel and services of an integrated tax, legal, business advisory and accounting service provider. Allen Barron integrates these professional disciplines in a cost-effective manner while providing more comprehensive insight into the problems and challenges you face. S Corporation shareholders should understand IRS strategies for compensation audits and how to avoid them. We invite you to contact us or call 866-631-3470 for a free consultation today.