S-Corporations and “Reasonable Compensation”

“What is reasonable compensation?” It’s a question that gives even the most seasoned tax preparer heart burn.   The goal has typically been to minimize the taxpayer’s employment taxes by keeping the sharehold’s wages as low as possible.  It would be nice if all S-Corp earnings could be distributed as return of capital but, for some reason the IRS keeps getting in our way.

More recently, the IRS put the brakes on a CPA firm in the case Watson, P.C. v. U.S.  In this instance, the Court of Appeals for the Eighth Circuit agreed with the District Courts decision to recharacterize an additional $67,044 from profit distributions to wages. At first look, the case appears to be a big loss for the professional services industry. But at a second look, it’s not all bad news. The court accepted a methodology for determining the shareholders wages that we could safley applied to some of our clients.

In determining reasonable compensation, the court allowed a calculation that primarily relied on a “Management of an Accounting Practice Compensation Survey” conducted by the AICPA. The calculation approximated the salary of a director of a similar firm size and in a comparable region and came up with $70,000.  Then, it compared the billing rates of a director and an owner and came up with a 33% difference.  This difference was then applied to the $70,000 and after making a downward adjustment for fringe benefits, the court accepted a reasonable compensation of $91,044.

This case sets a presidence for determining a “reasonable compensation” for professional service providers with a simular fact pattern. The method is summarized as follows.

  1. Look at several compensation surveys and studies for your particular industry and determine the average salary for the position directly under the owner.
  2. Divide the increase in billable rate between owner and position under the owner by the owners rate.
  3. Multiply (1 + rate rate in step 2) times the salary in step 1.
  4. Finally, subtract any fringe benefits from the amount calculated in step 3.

Keep in mind that your particular fact pattern will be different from the one in the case described above.  We believe that the above calculation provides a good guide, but make sure to use good professional judgement.

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