Discussion:1120S corp reasonable salary-audit issues
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Discussion Forum Index --> Advanced Tax Questions --> 1120S corp reasonable salary-audit issues
Discussion Forum Index --> Tax Questions --> 1120S corp reasonable salary-audit issues
| 17 June 2009 | |
| I have researched the reasonable salary issue on this site til I'm blue in the face. It seems the
50/50 or 60/40 salary vs distributions is the most common theme. My question is for those of us that do quite a few 1120S returns. Has anyone experienced any unusually high IRS audit activity in regards to this subject and if anyone has, what has been the outcome? | |
| 17 June 2009 | |
| I'm in the middle of one of these right now. See the discussion on "reasonable compensation audit". She will be here tomorrow to discuss further. | |
| 17 June 2009 | |
| the outcome is that a 'reasonable' salary must be taken (assuming there is cash/profit). That's what is supposed to be happening before/without the audit. If there is only $50,000 profit/cash flow from which to take a salary, they probably don't need to be an S corp in the first place. Who would believe you can hire someone to do what the owner does for only $28,000 salary per year? That's idiocy on the part of the client, reinforced by us 'blessing' it by allowing it to happen. | |
| 17 June 2009 | |
| Granted, we can all have a different idea of what a reasonable salary is, but my question only relates to anyone (waynecpa) for example, that is experiencing an audit on that issue and to get some feedback on what kind of stance the IRS is going to take on this subject. Waynecpa, I would like to know what outcome you come to if that is possible. | |
| 17 June 2009 | |
| We received a 60/40 "handout" about 3 years ago from an IRS speaker at a tax conference. She would not commit to ANYTHING as defining "reasonable compensation". I suspect the IRS audit computers MAY be set to trigger compensation audits at somewhere near the 60/40 split. We've all noticed that K-1s now include distributions and the 1120S has the officer's compensation -- EZ to set up a trigger point for automatic compensation audit notices. | |
| 17 June 2009 | |
| [[1]]
[[2]] It seems the 50/50 or 60/40 salary vs distributions is the most common theme. I disagree TexCPA 12:20, 17 June 2009 (CDT) | |
| 17 June 2009 | |
| If you thought 60/40 was the prevailing view here, you definitely missed the granddaddy of all the reasonable comp discussions, Discussion:S_Corp_Owner_Salary_vs._Distributions (with 47,000 views as of today). In this discussion, you will see people being told over and over again that 60/40 is meaningless, and that there is no ratio that can take the place of doing the research on what a comparable salary would be. I can't guarantee that it'll cover the "audit activity" part of your question, but I'd be surprised if it didn't. | |
| 17 June 2009 | |
| Thanks to everyone for the comments and ideas. I'm getting the impression that no one out there has
experienced a sharp increase in IRS examinations or audit soley in regard to salary vs distribution issues, even though IRS has sorta/kinda made everyone aware that it is watching. If they are on the lookout for zero salary instances, then I can fully understand. If a reasonable salary is taken based on hours actually worked in the business, then I guess I don't see any problem with that. Comments? | |
| June 18, 2009 | |
| Ellie, you're looking for what probably doesn't exist. A. Yes, there are guidelines for what constitutes reasonable salary, and your opinion, mine, and even Riley's, are irrelevant. The guidelines do NOT come from IRS, however, and probably never can or will. The guidelines are in the case law, and you have to do some real research via BNA, RIA, CCH to dig up those guidelines. The reason that I say IRS won't provide them is that IRS' mission is different. They want to collect all the tax they legally can, and in their mind, since there are no proscribed rules, they're free to be aggressive. So we must be defensive, but using the court guidelines and documenting the heck out of it, and then preparing to fight.
B. It's changing waters. Congress keeps threatening to treat S's like sch. C's and just SE tax everything without regard to the corporate form. C. The increased audits are still sporadic, and if you do have something resembling reasonable salary, it probably won't come up. So keep reading. You've only just begun. | |
| 19 June 2009 | |
| Based on what JR1 said, I'm speculating that if we get burnt on this issue at audit we would have a great chance of success going to appeals, since the IRS would be inclined to cave, their thinking being that if the issue goes to court and they lose, it could open a floodgate . . . | |
| 19 June 2009 | |
| My client went through one of these last year. He owns a construction company which one year showed a profit but showed a loss for the second year. The IRS determined that a reasonable salary was $55,000 versus the $30,000 he was paying himself. The $55,000 came from some sort of occupational handbook. We conceded on the first year but argued for a lower salary on the second year taking the stance that he should not have to take a salary if he is not working. IRS agreed. We could have gone to court over the reasonable issue but its just not worth it for $5000 in tax. We have advised client to keep time records of actual hours worked to justify a lower salary since construction is down right now. By the way.. I was told by agent it does not matter if company is showing profit or not. There should be a reasonable salary paid. | |
| 19 June 2009 | |
| Lisa, did the client take cash withdrawals from the S corp in the loss year that he didn't report as salary? If not, I don't see how IRS can require ANY salary in that year. Surely they can't force you to pay yourself a salary if the corporation isn't making any money and you haven't taken any cash out.
It's been a while since I've read the cases, but I don't recall ever seeing one where salary was imputed in excess of cash withdrawn. If that's what IRS agents are requiring these days, I think we are in a new ballpark. | |
| 19 June 2009 | |
| Just to play Devil's advocate....why does profit matter? Doesn't somebody have to be working the Company to generate revenue? Seems to me if you're "working" you need a salary whether you're profitable or not. Sure, you get hosed for the payroll taxes but that's just part of the game. Otherwise don't you risk a higher salary in more profitable years? | |
| 19 June 2009 | |
| cashflow, Rodney.
It wouldn't necessarily make sense to lend your company $40,000 just to pay your salary of $35,000. | |
| 19 June 2009 | |
| The IRS S-Corp technical advisor out here in the west told me he was advising agents to answer the following questions to determine if a reasonable salary adjustment was necessary:
1. Is the Shareholder an Employee? (If yes go 2, if no NO SALARY ISSUE) 2. Were distributions made? (If yes go 3, if no NO SALARY ISSUE) 3. Was the salary taken by the employee shareholder that received distributions reasonable? (Let the wrestling begin!) | |
| 19 June 2009 | |
| I understand the cash flow part but if you hired someone wouldn't you borrow to make payroll? Isn't the owner who is also working wearing two different hats? Again, devil's advocate here but I could see it coming up at some point. Is this a tradeoff for not being a Sch. C? If I'm really, really profitable should my salary be higher or is that return on investment? | |
| 25 June 2009 | |
| You might lay off someone or reduce their hours rather than borrow to make payroll. You have more wiggle room for profits taken as distributions if you have other employees adding to the profit margin and significant capital investment. If you are a service business with little or no capital invested, and you are the MAIN profit maker for your business, then the distributions get less and less credence. | |
| 25 June 2009 | |
| I had a client who came to me because he didn't like the service received from another firm. The second year I had the client the IRS sent a notice they wanted to audit the past three years of returns. It turns out the first firm filed returns with a high salary, then decided to get very agressive about reclassifying about 80% of salary to distributions to get refunds back. The firm did this on so many returns that they were investigated by the IRS. I took the approach of the 60-40 salary/distribution split and the IRS didn't bat an eye. I think they were more interested in obtaining evidence for a court case against the first firm. Looking back maybe I could have gone 50/50 or lower.
Later I went to a CPE conference where the speaker indicated that if the s-corporation paid zero wages then there would be problems. However if the corporation paid some amount in wages, then the IRS would not want to go to court to have a reasonable wage established because then the amount would be in writing and a standard would be established. Interesting stuff out there. | |
| 25 June 2009 | |
| A salary is not based on revenue. Therefore, a fraction of revenue for the allocation of income would not appear to be a valid assertion. The best way to handle the situation is to pay a salary that is equivalent to the amount the company would need to pay a hired individual to do the officer's job. As long as the amount is reasonable and the conclusion is documented there shouldn't be a problem. There are many websites that provide standard salary information. They can be used to document your conclusions. | |
| June 25, 2009 | |
| Exactly. We must get the 'professional' community to stop thinking of ratios. It has NO basis in the law, either legislative or judicial, merely old wives' tales still promoted. | |
| 26 June 2009 | |
| JR1 - I agree that salary is based on the facts, not some magic ratio -- however, I assume the audits are triggered by ratios. Maybe these wives tale ratios are a "hint" from IRS that will at least avoid an automatic audit.
I agree that we must document our salary recommendations based on facts, ie salary surveys. It is indeed murky ground -- several people have commented on IRS reluctance to take salaries to court, so maybe ratios really do work, as a practical matter. | |
| June 29, 2009 | |
| Excellent point, Illini. I haven't heard how or if IRS is yet comparing S corp returns to pick on the reasonable comp issue, but it wouldn't surprise me to learn that they're using some sort of ratio to test for reasonable parameters....and then we have to know what those are, which becomes a de facto way of treating salary and profit even tho' it's not the right way. Great point. | |
