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Avoiding Red Flags on S-Corp Audits Related to Reasonable Compensation
June 25, 2015
By: Lawrence J. Gregory
A compelling reason for a business to operate as an S-corp. is the beneficial income tax treatment afforded to its owner/directors. Generally speaking, net income from a partnership (or LLC taxed as a partnership) will be subject to the self-employment tax on the owner’s income tax return, while the net income of an S-Corp will not. However, to combat potential abuses by the owner to escape all employment taxes, the IRS requires that owners who work for the S-Corp. pay themselves a “reasonable salary.”
What constitutes reasonable is very fact specific inquiry, and the IRS uses two primary approaches to make the determination: (1) the multifactor approach and (2) the independent investor approach.
Multifactor Approach. Under the multifactor approach, the following factors are considered in determining whether a salary is reasonable.
- Company’s gross revenue – Arguably, the CEO of a comic book store will have a different salary than the CEO of a multinational shipping company.
- Source of the revenue – Revenue generated from the owner’s personal service (i.e. a consultant, architect, etc.) will more likely be considered payment for services, as opposed to revenue generated from the work of non-owner employees and/or equipment and other assets
- The owner/director’s education, training and special skills.
- Scope of owner/director’s duties.
- Comparison to the similar roles in other similar companies.
- The size and complexity of business.
- The prevailing economic conditions.
Independent Investor Approach. Under the independent investor approach, the test is whether the expected return on investment from the owner’s equity (after the owner is paid his/her salary) is similar to the return of other comparable companies. If similar, the salary may be deemed reasonable. However, if the return is higher than expected, the salary may be unreasonable since too much income is being returned to the equity owners as opposed paying the employee (even thought that person is one in the same).
Given the determination of the reasonableness of a salary is so fact specific, auditors find this area fertile for challenge. To give yourself the best chance of not being selected for audit, or to survive an audit intact, you or your CPA should review the following items to lower your chances of landing in the audit pile.