Help Determining Reasonable Comp

Technical topics regarding tax preparation.
#1
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Hello!

I need help figuring out how to determine reasonable compensation and would like to know how you guys determine this. I only recommend the S Corp route to my clients who it will really make sense to, not just at a certain income level.

The hardest thing I face (and most I would assume) is determining reasonable compensation. I have a subscription to RC Reports, but I want some of the community's take on this. RC reports and bureau of labor statistics in this area say a psychologist makes on average 80K, but net income is going to be closer to 200K, which would leave a 40/60 split of wages vs income, which seems low to me. I also feel that maxing wages out 140 really defeats the purpose of the S Corp route.

Any suggestions/input is greatly appreciated!

Thank you!
 

#2
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This is a tricky one, as I doubt this S corp has anyone other than the owner actively generating income.
The theory behind RC Reports, I believe based on the sales pitch, is that the report can be used in audit defense.

I don't have RC reports, but I typically go over the 3 questions with clients.
If you hired someone to do your job, how much would you have to pay them per hour?
If someone were to hire you away from running your own business, how much would they have to pay you?
How many hours a week do you work?

The reasonable comp for business owners, on an hourly rate, is typically somewhere between the first and second question, multipled by the number of hours.

In your example, a CPA might be quoted to make $80k on average (first result on google actually), but most of us know those in an equity position would not work for that little.

Actually I would be curious to know what RC Reports says in an average salary for a CPA.
 

#3
JR1  
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In addition to what Recked suggested, which are all the adjustments to the range, I use payscale.com and salary.com. Both have free sections which you have to dig for, but break out salary ranges by job description and zipcode.

Then adjust for all the other variables. I think if you have that printed, you have a very defensible position if questioned.
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#4
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ReckedCPAEA wrote:In your example, a CPA might be quoted to make $80k on average (first result on google actually), but most of us know those in an equity position would not work for that little.


So I guess my follow-up question is, is the S Corp vehicle for "saving taxes" overrated? If everyone needs to be on a salary of $140,000, where is the tax savings?
 

#5
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Reasonable salary can be at the low end of reasonable. It's a matter of pig theory. Where you draw the line depends on the client's tolerance of uncertainty. I don't think there are valuation penalties, so ...
Steve
 

#6
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Almost no one needs to be 140k. There's a range, I'm usually happy at midpoint before any adjustments.

You need to understand that many accountants are very conservative...so they just set salary at SS ceiling, which is just dumb. Case law rules. Read some. It's about what it would cost to hire someone else to do your job. Not as an owner, but the worker bee part.
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#7
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As an attorney, my sense is that the preparer should inform the client, listen to the client's decision and then decide whether to sign the return.
Steve
 

#8
BTJig  
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We had our client hire an officer compensation consultant, and they come up with a salary range, and it includes adjustments for geographic location. The consultant was hired for corporate governance reason's but we also utilized their services to document a "reasonable salary".
 

#9
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Our firm has never used RC reports or a consultant but the firm has been in existence since the 1950's and we were all in on S Corps when they came out with the Tax Reform Act of 1986. So just about everyone of our business clients operates as an S Corp. Despite what many on here might think, I consider our firm very conservative on setting salaries.

We have S Corps that are making $4-$5 million per year and we have the shareholders taking salaries of $400k-$600k. We have many doctors, law firms, etc

If that $200k net income psychologist was my client, I 'd be thinking $120k salary just because they are a Doctor. I do not think that is aggressive. The Fica ceiling is $142,800 this year and going up so even at $120k, you are saving close to $3,500 in fica and another $2,300 in medicare. I'd leave the $120k salary in place for 3 years or so before bumping.

If the client is getting health insurance through the S Corp, you might even be able to lower the salary to $100k if you are going to be reporting another $20-$30k of 2% health insurance on the W-2

Nothing scientific here just based on our experience. Lots of savings to be had even for clients with salary of over $140k

Look up the Biden tax tax returns from 2018-2019 and see how they used S Corps to save big $$$ on royalties from book deals.
 

#10
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I hate to use the term "rule of thumb" but when we have an S Corp that makes say $300k before officer comp, we would say let's play it safe and max out the Fica ceiling and go with $150k salary and $150k S Corp profits. Even looking at the medicare savings shows it is worthwhile. Plus you are now saving on the additional .9% medicare so the 2.9% becomes just 3.8%

I am not saying our methods are correct, just giving insight into our thought process.

Our market area is filled with CPA's still practicing in their mid 60's and 70's and many of them despise S Corps and still push C Corps. I think that is a big mistake
Last edited by BerkshireCPA on 22-Sep-2021 12:43pm, edited 1 time in total.
 

#11
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That's a very thoughtful explanation....and certainly you're in a different land than most of us with all those medical pros. I, too, have some therapists, and definitely have salaries higher than most owners. Pretty hard to not argue it's all personal service when they actually sit with the patient! lol
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#12
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BerkshireCPA wrote:Our market area is filled with CPA's still practicing in their mid 60's and 70's and many of them despise S Corps and still push C Corps. I think that is a big mistake


I would argue there is potential for malpractice in certain circumstances taking that approach.
~Captcook
 

#13
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What Captain said was drilled into our head in the late 1980's, early 1990's that we would be at risk if we ignored the whole S Corp wave. I do not think it ever came to that point but it opened our eyes.

There is a CPE provider, Boston Tax Institute, whose founder really jumped on the S Corp bandwagon and that probably influenced us. He is very good but has a tiny practice (like 3 or 4 clients) so I am not sure he relates all that well to the average CPA. But Peter Reilly from Forbes magazine always refers to him as an S Corp expert as they are friends.

I wonder now if maybe we are too tied to the S Corp mantra. Maybe we are like those old timers who need to move beyond with what we are comfortable with.
 

#14
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BerkshireCPA wrote:I wonder now if maybe we are too tied to the S Corp mantra. Maybe we are like those old timers who need to move beyond with what we are comfortable with.


There is always a risk of this and I'm willing to accept that.
That said, I'm, generally, slow to recommend an s-election and strive to think through all the variables before doing so, which should mitigate that risk.

If it weren't for the FICA savings, I'd suggest everyone be in LLCs taxed as partnerships. I think there are far more interesting results you can affect via that vehicle than any corporate structure allows. Exit strategy is also MUCH more flexible.

You also don't have this "reasonable comp" issue to worry about (to tie this comment back to the OP...weakly).
~Captcook
 

#15
JR1  
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I came from Indiana, where, due to the state tax, all our corps were S's...and didn't realize the rest of the country had C corps. When I moved to IL, had to learn why C corps existed and decided that most of them shouldn't! That was in the early 80's. And I can still remember Jerry Riles pounding the podium about how wonder C corps were and just wouldn't/couldn't leave them be....I knew more about S's than he did apparently!
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#16
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As a "small guy" who does very small business clients, many of my client demographic see quite a benefit from s corporations.

Let's say I have a client who owns a tiny smoothie shack on the beach. She nets $120,000. It is very easy to substantiate that a manager could replace her labor and make $60,000 per year. This makes for a large and legitimate savings (normally I'm not so aggressive, but this is just an example).

I would argue that a therapist who is a practitioner does MUCH more than just therapy labor. I know that, as a tax practice owner with 4 non-owner employees, "labor as a tax pro" makes up less than half of my work. Laboring employees generally don't negotiate rent, decide how much is needed in the account to cover expenses, make large administrative operational control decisions, talk to accountants and tax preparers, etc. etc. etc. I could go on and on.

Let me also mention that the reasonable salary must be paid in reference to distributions, complicating the concept further. If a client has $20,000 net profit, and thus only distributes that much, does he still pay himself the $60,000 and show a $40,000 loss?

One more thing to add is that there is a service (they are not cheap) that figures this out for preparers/clients. It's very involved and they claim that their methodology has held up in court each time. I forgot the name of the service.
 

#17
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It would be interesting to see how many members here are operating as an SCorp for their own practices. We are and I am shocked when I see others are not, especially if there is only 1-4 shareholders. No added cost for 1120s tax prep, already doing payroll. It is a much easier sell to clients on structure when we tell them we operate as S Corp with fiscal year end and own the office building through an LLC that files a partnership return.

I think they say well if you do if for yourself then we should too.

Again only push it for companies consistenly making $$$$
 

#18
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I am a sole trader. My profit does not yet justify an S Corp. I have good insurance in lieu of paying the state $202 per year for the privilege of putting LLC after my name.
 

#19
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I'm an S, likely no surprise to my fans. lol

Been since 1998....took about 10 years for profits to get there to justify the move.
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#20
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I'm an S at my new firm. Not necessarily how I'd prefer given the options I have when buying out my partner in the near future, but I'm comfortable with the deal we've worked out.
We'll likely restructure as an LLC (currently a PS) in WA due to a long-term care tax going into effect Jan 1, 2022. LLC members are exempt even after making an S election.
~Captcook
 

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