As the owner of an S corporation, you can legitimately cut payroll taxes by thousands of dollars by paying yourself a lower salary and taking the rest of your income as distributions. But you need to make sure that you don’t drop your salary below what the IRS considers “reasonable compensation.”
What Does the IRS Consider Reasonable Compensation?
The IRS, of course, has some definite ideas on what constitutes Reasonable Compensation.
The reasonableness of compensation is one of the most frequently debated issues between business taxpayers and the IRS.
Only 12% of S corporation owners research and document how they reached their Reasonable Compensation figure. In other words, 78% are at risk of having distributions reclassified as wages if the IRS believes the wages paid were not reasonable for the services provided.
Stress Testing for Reasonable Compensation :
A Reasonable Compensation Stress Test protects the owner and tax preparer by determining how much the salaries are exposed to IRS audit challenges. The report summarizes a blend of IRS criteria, Court Rulings, Bureau of Labor Statistics, U.S. Census data, and a private database of wages to accurately assess and protect Reasonable Compensation risk for S corporation owners and their tax preparers.
The High Cost of an IRS Reclassification:
Business owners should be prepared to substantiate that their compensation is, in fact, Reasonable Compensation. Otherwise, the cost to the business owner – and his or her tax preparer – can be high.
- The total cost to the taxpayer is typically more than double the original tax that would have been due. The IRS average recommended adjustments have increased from $50,000 to $150,000 in recent tax years.
- The tax preparer is subject to a penalty if she or she takes an unreasonable position on a tax return that results in an understatement of tax. The IRS has handed out $5,000 penalties to preparers who signed a return with an unreasonable low compensation figure.
Tax planning is done best in advance and proactively. S corporation owners and their tax preparers with Reasonable Compensation concerns should start stress testing early in the year – and indeed, before they receive a letter from the IRS to schedule an audit.
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