Simple Guide To Reconcile S Corp Reasonable Compensation

By Paul S. Hamann & Jack Salewski, CPA, CGMA

With the last month of the year here, it’s time to reconcile Reasonable Compensation for your S Corp clients. If you are not familiar with the process of reconciling your S Corp owners’ Reasonable Compensation, you are not alone. On the other hand, it is typically a simple process, but can be a bit of a chore if your clients have strayed from your plan or best practices.

You will need a few pieces of information to get started:

• Reasonable Compensation Report for the S Corp owner from the beginning of the year
• An updated Reasonable Compensation Report as we finish up the year
• Payroll records and records of distributions

If your clients followed last year’s plan, best practices or nothing has changed in their world you should have little, if any, needed adjustments. If not, we’ll lay out how to make adjustments based on a few common scenarios.

Best case scenario (Scenario One): Your client’s beginning and year-end Reasonable Compensation Reports are similar to one another – no adjustments needed for a big change in the amount. Next check the payroll records – has the S Corp Owner actually paid themself the amount outlined in the report? If yes, pat yourself on the back, your client followed your plan. Send your client a well-deserved thumbs up for keeping themself compliant and making your job easier.

OK – but what if all the stars don’t align and adjustments are necessary? Not uncommon and generally lets tax advisors do what they enjoy most – giving advice. A few common scenarios when a client’s Reasonable Compensation does need adjusting:

Scenario Two:

• The S Corp Owner has not paid enough Reasonable Compensation;
• The S Corp Owner has taken distributions;
• The business has enough money to catch up before the end of the year.
• Pay the S Corp Owner the amount needed to make up the shortfall before year end.
• If the amount is relatively small, your job is done.
• If the amount is large – think all of it – get the S Corp owner set up on a regular payroll schedule starting in the new year. The S Corp has some risk of penalties and interest for late payment of payroll tax deposits when payroll is not paid regularly throughout the year. The IRS and courts have taken the position that it is unlikely employees would be paid only once a year. See [ASPRO]

“If the company has the cash flow in the last quarter of the year to make up the shortfall in payroll, they should do so and pay the payroll taxes in a timely manner moving forward. The IRS may assess penalties and interest for late filing of payroll tax deposits and non-filing of payroll tax returns.

What I have seen both firsthand and from talking with practitioners throughout the country is if the taxpayer is doing the correct amount of payroll and making timely payroll tax deposits immediately after becoming aware of an issue, the Service has not assessed penalties or interest. This does not mean the agents must do this. Apparently, the agents have a certain amount of discretion when they see the taxpayer is trying to abide by the rules.” Jack Salewski CPA, CGMA, VP of Education – RCReports

Scenario Three:

• The S Corp Owner has not paid enough Reasonable Compensation;
• The S Corp Owner has taken distributions ;
• The business only has the money for paying the payroll taxes, not the entire payroll.

“If they only have the money for paying the payroll taxes, then it would be best to take the most current distributions and gross them up to calculate what the gross payroll would have been to net what the distribution was. Then repeat this process in reverse order (most current to least current) until there is enough in payroll for it to be considered reasonable. The reason for doing this in reverse order is to minimize the amount of penalties and interest in the event the IRS looks at this detail of payroll and they assess penalties and interest. Care should be taken when preparing the 941 and 941 schedule B to make sure payroll tax deposits are reflected to minimize or eliminate penalties.” Jack Salewski CPA, CGMA, VP of Education – RCReports

Scenario Four:

• The S Corp Owner has not paid enough Reasonable Compensation;
• The S Corp Owner has taken distributions ;
• The business does NOT have the money for payroll taxes or payroll.

The advice for this scenario is similar to the advice Jack gives when a client comes to you after the first of the year:

"Let’s say a client comes in after year end and after the filing deadline to file payroll tax returns. In a case like this, if you file the payroll reports late, there are going to be lots of penalties. This is a case to file a 1099 for the shareholder. The shareholder will then pick up the income on the individual tax return as Schedule C income, subject to self-employment tax. There may be a penalty for late filing of the 1099, however, that will be less than the penalty for late filing and late payment of payroll tax returns. It is important that the taxpayer at this point starts to do payroll correctly. When doing this the Schedule C should not take the 199A deduction. Most IRS agents will see that the taxpayer is trying to be compliant and will be reasonable." Jack Salewski CPA, CGMA, VP of Education – RCReports

Getting your S Corps in line this year should make next year’s reconciliation a breeze.