How a Reasonable Compensation Report Can Save Thousands On Taxes
For business owners, the primary allure of the S Corporation business status lies in the enticing prospect of its potential tax benefits.
For small businesses with stable profits and shareholders who are actively involved as employees, the S Corp label can help avoid the burden of double taxation and could lead to significant tax savings in the long term.
However, it has one caveat—the requirement of reasonable compensation.
Reasonable Compensation, Scylla, and Charybdis.
By law, S Corporation shareholder-employees must pay themselves a wage via W-2, which must be deemed logical and fair according to multiple factors related to skills, tasks, business size, profits, and more.
Rather than a mere formality, this is a matter of survival for businesses. The IRS is strict about scrutinizing compensation among owners and shareholders, particularly in S-corporations. Failing to justify the compensation amount with reliable data can lead to audits and, eventually, losses in the thousands.
However, not any compensation qualifies as reasonable.
In Greek Mythology and The Odyssey, the hero Odysseus must sail through a narrow water passage between two dangers: Scylla, a sea monster, and Charybdis, a giant whirlpool. Both were equally deadly, just in different ways.
It might sound dramatic, but setting a reasonable compensation can be similar to Odysseus’ struggle. If the amount is too high, you risk getting caught by Charybdis, while a very low or nonexistent compensation ensures you will, sooner or later, get eaten by the monster.
Your goal is to find that very narrow water passage in between—and for that, you need a lighthouse.
The Many Benefits of Reasonable Compensation Reports
A reasonable compensation report can help you find the perfect middle ground. Much like a lighthouse illuminating the path ahead, a comprehensive guide can provide relevant data and careful studies that help define the optimal value.
Most importantly, it is a tool that can help you avoid many common S Corps pitfalls and their costly consequences.
1 – Can Help Reduce Payroll Taxes.
As an S corporation, each shareholder-employee has to take a reasonable wage before any distribution, as this will be the one subjected to payroll taxes. Naturally, this means you only pay these taxes on wages, not business income, which can save you thousands in taxes.
To make a simple example, this would mean that in an imaginary business with a $100,000 profit and a reasonable compensation of $30,000 in wages, only the latter will be the target of payroll taxes. The remaining $70,000 will only be subjected to income taxes, which can let you keep more of your hard-earned profit.
However, this all can come crumbling down without a reasonable compensation report.
If you fail to set the optimal reasonable compensation amount, you could overpay. Doing so would mean that shareholder-employees receive a higher wage than they ought to, translating into a more significant portion of the profit being subjected to payroll taxes. That’s a waste of money and a costly mistake.
With a reasonable compensation report, you can use reliable data and studies to determine the optimal reasonable compensation amount that ensures fair payments without losing money.
2 – Can Protect You Against Non-Compliance Penalties
Many S corporation owners might go to a different extreme to avoid paying excessive payroll taxes. However, underpaying would also qualify as unreasonable compensation and carries its own consequences.
Many business owners find it tempting to reduce—or avoid—payroll taxes, which can be an incentive to underpay compensation. As such, they think lowering their wages and making up for it with increased profit distributions is the perfect loophole for fooling the system.
However, this choice can be yet another costly mistake. Reasonable compensation is legally mandatory, and the IRS is aware of this unscrupulous practice. As such, they continue to increase scrutiny of wages in S Corporations to detect any failure to comply, which could lead to the following penalties:
- Back Taxes: The S Corporation would have to pay the difference in payroll taxes.
- Penalties: The penalties could be underpayment, failure to comply with tax obligations, or back taxes.
- Interests: Interests on back taxes will be charged until the difference is paid.
- Legal Costs: The legal ramifications carry additional costs that can stretch for years.
A reasonable compensation report can help you develop and maintain an accurate payroll plan and record, which leads to well-informed choices with their corresponding data support.
Having these numbers available means you will always have the information required to ensure that your compensation is reasonable, defensible, and accurate to the IRS’s demands. This gives you peace of mind and the necessary tools to defend your business against audits and penalties—or prevent them in the first place.
3 – Can Protect Your S Corporation Status
At the end of the day, a regular reasonable compensation report can protect your money by protecting what matters most for your business: the S-Corporation status.
Having a reasonable compensation report is one of the many practices that should be a regular mainstay for S Corporation owners, as it determines viable, rational, defensible, and beneficial wage ranges that will ensure your business remains on the good side of the IRS.
Prevention is the best solution; therefore, keeping your reasonable compensation benchmarks under continuous monitoring through regular reports ensures your business never undergoes audits that could eventually lead to losing the S Corporation label.
Leave Your Reasonable Compensation Report To The Experts
If performed by competent professionals with extensive expertise in the field, reasonable compensation reports can help you avoid both Scylla and Charybdis—extremes that can cost you thousands and may even put your business at risk.
Luckily, a high-quality reasonable compensation report can only cost a fraction of that amount.
Sources
Internal Revenue Service (2014, October 29). Reasonable Compensation: Job Aid for IRS Valuation Professionals. IRS. https://www.irs.gov/pub/irs-lbi/Reasonable%20Compensation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf.
Kirkland, Stephen D. (2013, September 1). Preventing a challenge to (un)reasonable compensation. Journal Of Accountancy. https://www.journalofaccountancy.com/issues/2013/sep/20137412.html.
Washington, Kemberley (2023, March 2). How To Pay Your Back Taxes And Get Relief: The Forbes Advisor Guide. Forbes Advisor.
Wolters Kluwer (2021, January 13). Understanding the tax consequences of compensation. Wolters Kluwer.