Running an S Corp can be tricky when it comes to an owner/shareholder’s involvement and salary. Many owner/operators base their pay on a guesstimate of the worth of the work performed on a daily basis. It’s usually an honest estimation, but not one that is based on supportable data. So what’s the problem with that?

What happens if the IRS Audits your Reasonable Compensation?

Let’s say you run a business doing graphic design, and you perform services on a daily basis. You figure, based on what you’ve researched online, to hire someone to do the services you perform would cost an annual salary of $48,000. After all, that sounds reasonable, and after discussing with your current accountant, he thinks it’s feasible.

A year passes by since you’ve implemented your salary, and the IRS decides to audit your business. During the audit, they start reviewing your reasonable compensation and determine that it should be $60,000 rather than the $48,000 annual salary you’ve been paid. The result of this is an increase in taxes plus penalties and interest.

You don’t agree with what the IRS’ estimated reasonable compensation is, so you decide to hire a CPA that specializes in S Corp Reasonable Compensation. 

The Data Needed to Calculate Reasonable Compensation

Your new CPA specializes in S Corp Reasonable Compensation, and knows from experience that the IRS’ estimations are subjective. So what are the next steps?

The CPA evaluates your services performed for the business and breaks it down by time spent for each job function using cost approach methodology. Using this info, the new CPA then runs a reasonable compensation analysis specific to your facts and circumstances. The reasonable compensation report provides a detailed valuation of your reasonable compensation based off of each service you provided, the percentage of time spent for each service, and the cost to hire someone to replace to you perform those services based off of local average salaries amongst other things. The report provides pages of credible breakdowns proving all the components of your job and what your reasonable compensation should be based off of a data-driven estimate, not guesswork.

The CPA reviews the IRS’ estimation and determines that they used the cost approach. Since the CPA is using a cost approach as well, backed up by current data, it turns out that the $12,000 difference in reasonable compensation was due to time spent for each service. The IRS indeed took a guess at how much time you spent with performing design services and business operations – they split it 50/50. Your CPA now has the correct amount of time spent on both design services and operations, which is actually 80/20. Showing this to the IRS, the new CPA successfully presented the facts, and you receive a no change letter. Success based off of facts, not estimations.

All of this could have been avoided. Running a business is stressful and time-consuming, so it’s easy to push things like this to the side. Take the correct approach – skip the penalties and time wasted dealing with the IRS. Be prepared and have a CPA specializing in S Corp Reasonable Compensations provide you a professionally detailed reasonable compensation calculation so that you can accurately pay yourself and other shareholders.

Request a consultation today.