Reasonable Compensation: Avoiding Red Flags on S-Corp Audits

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 a 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.
  1. 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.
  2. 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.
  3. The owner/director’s education, training and special skills.
  4. Scope of owner/director’s duties.
  5. Comparison to the similar roles in other similar companies.
  6. The size and complexity of the business.
  7. 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 arguably is being returned to the equity owners as opposed to paying the employee (even though that person is one and 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.
The Basic “Sniff Test” & Review of Comparable Salaries
Most business owners should have a general idea of what the prevailing salary is for a comparable position in their chosen industry. In that respect, a concerted effort should be made to pay yourself somewhere in that range. The less you pay yourself in salary, the greater the risk of an adjustment on audit. Additionally, surveys and databases of compensation and salaries can be obtained and reviewed to determine whether the chosen salary is comparable to similar businesses in the same industry and geographic area. These documents should be saved to support any challenge to reasonable salary.
Maintain Written Logs and Accurately Report Time Devoted to Business
The burden of proving the services an owner/director provides to the company is on the owner. The IRS does not give much weight to any haphazard recreations of time after the audit begins. The process can be as simple as saving calendars if the calendar can reasonably show when, and for how long, the owner dedicated time to the business. Such time should then be properly reflected on Form 1125-E (for all S-Corps with total receipts over $500,000). Auditors will use this information to determine if a salary is reasonable. For example, an owner who only spends 15% of his time on the business and pays himself accordingly, does not want the auditor to evaluate his salary as if he had been spending 80% of his time on the business.
Other Red Flags
If your business has evolved over the years into new or different industries, ask your CPA if your NAICS code reported on your income tax return reflects the type of business you currently operate. Auditors use the NAICS codes to gather comparable data for that industry. If your company started out as a manufacturing business, but sold the operating business and now only manages the ownership of the factory, the comparable salaries the auditor will use will likely be the salaries from manufacturing businesses, and not real estate management (which can be vastly different). Also, make sure your occupation reported on your individual Form 1040 matches your role within the business. You do not want the corporate tax return to report you having less than 10% of your time dedicated to the business, but your individual return reports you being its CEO.
Adhering to these simple rules will help keep your business out of reasonable compensation trouble.