I am a tax attorney in New Haven, Connecticut that help taxpayers dealing with IRS audits and back balances all over the country. For S Corporation owners having a grasp and making the right call on compensation is not just smart business practice—it's a vital part of following IRS rules. Reasonable compensation ensures that shareholder employees are fairly paid for their efforts while steering clear of tax complications. In this piece we'll delve into what reasonable compensation involves, its importance and how S Corporation owners can smoothly navigate IRS guidelines.
Reasonable compensation as defined by the IRS refers to the pay that would typically be given for services in circumstances by comparable businesses. Essentially it's the salary a shareholder employee would earn for their work in a business context. This pay should be both fair and proportional to the work provided.
The IRS uses methods to ensure compliance with compensation standards for S Corporations. These methods include audits or examinations to verify payment classification and prevent tax evasion. Moreover educational initiatives aim to educate S Corporation owners on their responsibilities regarding compensating shareholder employees.
Revenue Ruling 74-44 explains that officers of corporations including S Corporations are seen as employees stressing the importance of following norms, in compensation practices. This means the owner must take a W-2 if they provide services to the corporation.
The IRS also has the power to reclassify S Corporation distribution payments as wage payments to employment taxes. This highlights the necessity of documentation and categorization of payments to prevent tax obligations.
When determining compensation for S Corporation owners various factors come into play. These factors include training and experience, duties and responsibilities time and effort dedicated to the business and what comparable businesses pay for services. Additionally formulas, compensation agreements timing of bonuses and dividend history are taken into account.
It's important to recognize that courts may consider one or all of these factors based on each cases circumstances. While assessing these factors can be intricate time consuming and expensive it is crucial for complying with IRS rules and avoiding fines.*
Understanding and correctly determining compensation for S Corporation owners not only encourages compliance but also establishes a just and reasonable framework for compensating individuals within S Corporations. By adhering to IRS guidelines and considering all of the factors S Corporation owners can ensure they are appropriately compensating themselves while reducing the risk of IRS scrutiny.
If you or someone you know needs help with their S Corporation or an examination regarding reasonable compensation or other tax issue, please contact me at (203) 285-8545 or by email at egreen@gs-lawfirm.com.
1 Audubon Street, 3rd Floor
New Haven, CT 06511
Ph. (203) 285-8545
Eric Green is one of the managing partners of Green & Sklarz LLC where he focuses his practice on civil and criminal taxpayer representation. Eric is a nationally renowned tax expert and author/commentator of IRS civil and criminal tax matters. Having lectured to more than 70,000 practitioners on civil and criminal tax topics, he is one of the nation’s best known lecturers in continuing professional tax education. Eric is the host of the weekly Tax Rep Network podcast, founder of Tax Rep Network and the author of the Insider’s Guides to IRS Representation, including The Insider’s Guide to S Corporation Reasonable Compensation and IRS Enforcement.
* The author uses, and has his clients use, RCReports to generate an annual report of reasonable compensation. To date the IRS has never successfully challenged a report by RCReports.
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