The IRS may have something to say about how much you pay yourself (think W2 wages) from your S Corporation. If your S Corporation nets $100,000, how much do you pay in W2 wages, leaving the rest to be taken as draws? Hint: It’s not zero, although that can be tempting because of the hefty FICA tax of 15.3% you’ll save on every draw you take rather than taken as a wage. But.. there’s a thing called “reasonable compensation.
Reasonable Compensation is the salary or wage that you, a shareholder-employee of an S Corp, must pay yourself for the work you perform for your company.
The Qualified Business Income (QBI) deduction (created with the passage of the TCJA) is tied to Reasonable Compensation and creates new risks (think tax, penalty and interest), if successfully challenged by the IRS.
Therefore, it is more important than ever that we have credible documentation to back up your Reasonable Compensation figure. The IRS criteria and guidelines state that “companies have the burden of showing compensation is reasonable”. To accomplish this and to avoid the 20% accuracy penalty the IRS states that:
- The dollar amounts must be verifiable.
- The taxpayer must be able to demonstrate the origin of the amount claimed.
- The taxpayer must be able to show that he entered the amount in good faith.
At Finch CPA Firm, we have tools, available for you, that meet the above requirements and mitigate the risks associated with an IRS Reasonable Compensation challenge. Please contact me if you would like to discuss this issue further and/or to have Finch CPA Firm complete a Reasonable Compensation analysis with your input.
A Reasonable Compensation analysis is an independent, unbiased report that establishes your Reasonable Compensation, using criteria outlined by the IRS and Courts, and provides a defensible position to an IRS challenge. A Reasonable Compensation challenge can be costly. Typically, taxes, penalty, and interest are more than double the original tax that would have been owed – plus costs for amending returns (all totaled, usually in the tens of thousands of dollars).