Reasonable compensation for a new client.

Technical topics regarding tax preparation.
#1
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I picked up a new client (Contractor) who has an S Corp.

Upon review of the 2021 and 2020 S Corp tax returns, I can see that the prior accountant had his salary at $26,000 in 2020 and $89,000 in 2021 (fluctuating with income :roll: )

His income for 2022 is similar to 2020. However, I don't believe in adjusting salary based on what you make.

Just looking for some validation that the salary should be pretty steady year over year regardless of income.

I'm wondering if I can find some middle ground number and just stick with it going forward.
 

#2
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Reasonable compensation is what you would ordinarily pay an unrelated party to perform the same tasks that you performed for the S Corp during the year. The ability of the S Corp to pay reasonable comp does not factor into the analysis as you noted.

I might advise the client on the phone (not in writing), that they can forgo both paying reasonable comp AND distributions if the company is cash deficient as the IRS position is that they will only reclass to RC up to the amount that distributions are taken, if they find that RC was not paid during the year. There is risk here that there may be a lookback period to combat abuse and timing issues, but I haven't seen precedent for that.

Any distributions taken in lieu of RC may be reclassed to RC. If he can't afford to pay RC consistently, that's a pretty big sign he shouldn't be an S Corp.
 

#3
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ManVsTax wrote:Reasonable compensation is what you would ordinarily pay an unrelated party to perform the same tasks that you performed for the S Corp during the year. The ability of the S Corp to pay reasonable comp does not factor into the analysis as you noted.

I might advise the client on the phone (not in writing), that they can forgo both paying reasonable comp AND distributions if the company is cash deficient as the IRS position is that they will only reclass to RC up to the amount that distributions are taken, if they find that RC was not paid during the year. There is risk here that there may be a lookback period to combat abuse and timing issues, but I haven't seen precedent for that.

Any distributions taken in lieu of RC may be reclassed to RC. If he can't afford to pay RC consistently, that's a pretty big sign he shouldn't be an S Corp.


This is great information, thank you so much!
 

#4
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I understand the RC issue is supposed to be based on what would be paid to an unrelated person for those services. It's one thing to advise the client that there is exposure to employment taxes and penalties, but it's not the preparer's job to determine RC. If the client chooses to play the audit game and takes no compensation, that's what gets reported (and the preparer has no further duty.
Steve
 

#5
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gatortaxguy wrote: If the client chooses to play the audit game and takes no compensation, that's what gets reported (and the preparer has no further duty.


A CPA is bound by professional standards. In situations like these we have a duty to re-evaluate the relationship, and determine whether or not to withdrawal and terminate the relationship.
 

#6
JR1  
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ziprecruiter now has an extremely easy and fast place to find comparable salaries.
Go Blackhawks! Go Pack Go!
Remembering our son, Ben Jan 22, 1992 to Aug 26, 2011.
For FB'ers: https://www.facebook.com/groups/BenRoberts/
 

#7
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I don't see this as a situation calling for a re-evaluation, although I can appreciate that others may disagree.
Steve
 

#8
Nilodop  
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True, gatortaxguy, it's not the preparer's job to "determine" reasonable comp. Nor do I think this issue is such that it makes a CPA who is an AICPA member re-evaluate his relationship with the client, at least not under the SSTS's as I understood them over the years. If the preparer reports the facts, he's OK, so long as SSTS #1 is followed.

But gator seems to draw a bright line between what a preparer does and what an adviser does. I'd say that unless an engagement letter specifically precludes it, it is just fine, and even a really good idea, to let the client know the risks involved and what his professional advice is.

I'm aware of upcoming changes in the SSTS's but I don't recall they'd change the substance of SSTS #1 as it applies here.
 

#9
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taxaflaxa wrote: I don't believe in adjusting salary based on what you make.

Many people receive bonuses based on company profit. Over the years, I've had a few clients with small salaries and large bonuses every year.
Dave

Taxation is the price we pay for failing to build a civilized society. ~ Mark Skousen
 

#10
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Maybe I should clarify. I would re-evaluate based on his response to my advice and recommendations. If the client wanted to continue the status quo (and is taking distributions in-lieu of RC) after that advice, I would part ways. There are too many good potential clients out there to put up with sub-par clients.
 

#11
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Hi, taxaflaxa,

You wrote: "I don't believe in adjusting salary based on what you make."

Lighten up. Advise the client, the client decides and report the facts.

Regardless of the reasonable comp issue, advising a client to take a salary when his or wholly-owned S corporation is losing money strikes me as ridiculous.
Steve
 

#12
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Agree 100%.
Go Blackhawks! Go Pack Go!
Remembering our son, Ben Jan 22, 1992 to Aug 26, 2011.
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#13
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gatortaxguy wrote:advising a client to take a salary when his or wholly-owned S corporation is losing money strikes me as ridiculous.


I guess Glass Blocks Unlimited v. Commissioner strikes you as ridiculous too.
 

#14
JR1  
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MVT, did you miss his point about LOSING money? Blodgett sure didn't. Granted, a little care would have just made those note repayments....but he did have profit and did take money.
Go Blackhawks! Go Pack Go!
Remembering our son, Ben Jan 22, 1992 to Aug 26, 2011.
For FB'ers: https://www.facebook.com/groups/BenRoberts/
 

#15
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They didn't stop reclassing in GBU vs. Comm. once taxable income hit zero. They drove taxable income of the S Corp negative, materially negative. I see no reason to believe it would have gone any differently had the S Corp been in a tax loss position prior to payments to the owner.

My point is, it comes down to whether RC was paid and if it wasn't, whether distributions were taken. That's it, nothing more. The tax loss or income position of the S Corp does not matter.

If a client is has a tax loss and is taking money out of the company (nearly all of these small S Corps are), I would advise that the distributions will generally be found to be payments in-lieu of RC and therefore would be reclassed as such. I fail to see how doing so is ridiculous.
 

#16
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Is the business losing money from something like depreciation, or is it literally running operating losses? If the latter, I’d say it sounds like shareholder-employee isn’t really working in the business.
 

#17
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Increasing a tax loss by paying the owner a salary makes no sense to me.
Steve
 

#18
Nilodop  
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I fail to see how doing so is ridiculous.. It pains me to act as mediator, but what gatortaxguy said was ridiculous was advising client who is losing money tot ake a salary. If he takes a distribution, even when losing money, yea, it can be claaified by IRS as salary. To quote the very experienced and knowledgeable and practical JR!, My point is, it comes down to whether RC was paid and if it wasn't, whether distributions were taken. That's it, nothing more. The tax loss or income position of the S Corp does not matter.
 

#19
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Just do what everyone else does and avoid an audit.

Use the 60/40 split. The profits of the S corporation before shareholders salaries are split as 60% salaries and 40% for distributions. So yes, it differs every year.
 

#20
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This is a gray area where it's both easy to avoid distributions and easy to play the audit lottery by giving "winking" advice.

FWIW, I generally advise to take a salary at the low end of reasonable when there is profit and leave it up to the client to pick the number. It is noteworthy that the client can avoid quarterly payments by not taking a salary until 12/31 and then withholding enough to pay the income tax for the year.
Steve
 

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