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Reasonable Compensation to Officer of a Company
(The rules apply even if losing money)
This is a new requirement (IRS sent out the notice on 12-29-2020 for all business tax returns, effective 2021 filings.
1. IRS trained 2,500 employees out of Austin Texas in 2018 to perform Reasonable Audit Compensation Audits. Of course, these exams were delayed from 2020, since nearly all exams were halted for about a year.
2. If all small businesses paid in reasonable compensation – social security would be solvent, it was stated 20 years ago and it is still true today.
3. Government is looking to add 87,000 new IRS employees over the coming years, with heavy emphasis on examinations / audits.
1. IRS definition
2. Compensation must be reasonable and must be for services
3. Notice of acceptance of S election
4. Revenue ruling 74-44
5. IRS Reasonable Compensation guidelines
6. Fact sheet 2009-25
7. Factors in determining reasonable compensation
IRS will now assess Tax Preparers a Penalty of $5,000 (per instance) for lack of documentation of reasonable compensation. They do not even have to do an audit to find out if documentation is present, they could just ask for it.
What is at stake for taxpayers –
1. Taxes, interest, penalties
2. Multiple years
3. Retirement plan impact
4. S corp status revoked
Rev Procedure came out on December 29, 2020 – Adequate Disclosure
Rules go into effect for 2021 year end tax returns.
We cannot rely upon the Watson case from 2010 as we once did. Nor McAlary from 2013, Glass Blocks Unlimited 2013 among several other cases.
What is required:
Did the taxpayer provide through independent research and documentation to support reasonable compensation? The tax preparer should have this on file and the tax preparer must assess if the documentation is sufficient after reviewing.
IRS just completed an exam; they ran 4 to 6 different reports / different sources to arrive at reasonable compensation. I have them in hand. It follows the IRS notice exactly.
Planning and Preparation in advance:
We have the tools to create and document reasonable compensation based upon IRS criteria, court rulings and we use industry salary intelligence data to support reasonable compensation. Then we can maintain the figure annually to adapt to changes in your business and from the IRS. .