Reasonable Compensation (pass throughs)

[Gumption]

I've been a pass through (S Corp) for 15 years now.
The IRS gives what seems like vague guidance on what is deemed as "Reasonable compensation."

Google "Tax Geek Tuesday: Reasonable Compensation" for a through history on the topic.

My question is for fellow pass through folks and CPAs: How do you determine what a reasonable compensation is?

I have no doubt with the new legislation there is going to be a flurry of questions on the topic.

My experience is that is lies somewhere between what the going rate is for a similar position and around the same or more of what your pass-through income is.

[jleo]

I was told it is what it would cost to replace yourself and hire someone to do your exact job.

[SeattleCPA]

Here are a handful of reasonable compensation tips that may help:

https://evergreensmallbusiness.com/s-corporation-reasonable-compensation/

[Gumption]

Thanks SeattleCPA
I certainly feel better about simply going to the BLS, using that salary and then adding another 20k or so as I am providing other CEO related activities for my (one person) company.

I was always confused by an accountant one year who told me he know some auditors and felt that they like to see equal amounts wages and distributions for a one person Scorp. I do also bump up my salary with company funded 401k, medical and hsa contributions as you rightly suggest

One item from your list that I have a question with is the following:

 "The easiest way to minimize distributions to shareholders is to leave funds inside the corporation. You might choose to leave your rainy day fund or emergency reserves inside your corporation for example."

Isnt this retained earnings? Isnt this money still considered profit and there for I (personally) will pay taxes on it. Guessing it shows up in my K1 even if I choose to leave in the company (as my personal rainy day fund)?

[GetSmart]

 "The easiest way to minimize distributions to shareholders is to leave funds inside the corporation. You might choose to leave your rainy day fund or emergency reserves inside your corporation for example."

Isnt this retained earnings? Isnt this money still considered profit and there for I (personally) will pay taxes on it. Guessing it shows up in my K1 even if I choose to leave in the company (as my personal rainy day fund)?

I'd also like to know about this.  I would like to leave money in the business to fund next year's purchases.  Is the only way of doing this is to pay the taxes on that money as pass-through income and then basically using that same income for COGS for the next year ?   So the new 20% deduction on the new tax law will be helpful in this regard I'm guessing.  Is there any other way of handling this ?

[SeattleCPA]

So the business about leaving money inside the S corp is sort of a "finesse"... but it works because if you were found to have paid unreasonably low compensation, what the IRS  would do is recategorize distributions and other payments to the shareholder as wages.

This means that the lower the distributions, the less money to recategorize...

One way to lower distributions is to leave money inside the S corp... such as by keeping your rainy day fund there...

Hopefully that explains things?

[Midwest]

It should be reasonable and more than zero.  If it is zero, the clock never starts ticking on the payroll tax side despite the filing of income taxes.  If you pay something and the IRS disagrees, you have at least limited your exposure.  We inherited a client who was making $'s and paid no wages.

MW

disclosure - the above is not to be considered legal or tax advice.

[Gumption]

One way to lower distributions is to leave money inside the S corp... such as by keeping your rainy day fund there...

Hopefully that explains things?

Thanks SeattleCPA. I guess my question is, how do you categorize this rainy day fund so as to not show up as profit/retained earnings? All my distributions (post wages, expenses, 401k, HSA, Med..etc) go into a Vanguard rainy day; but I would certainly prefer to keep them in the company and paying out at a later (lower tax bracket) date post FI.

[SeattleCPA]

One way to lower distributions is to leave money inside the S corp... such as by keeping your rainy day fund there...

Hopefully that explains things?

Thanks SeattleCPA. I guess my question is, how do you categorize this rainy day fund so as to not show up as profit/retained earnings? All my distributions (post wages, expenses, 401k, HSA, Med..etc) go into a Vanguard rainy day; but I would certainly prefer to keep them in the company and paying out at a later (lower tax bracket) date post FI.

Shareholders get taxed on the distributive share... even if they don't pay it out (distribute it).

For an EXTREME example, if you have two shareholders, one who pays zero distributions and one who pays $100,000 in distributions, only the one paying the distributions risks having distributions recategorized as wages. Even if they both pay zero in wages.

So practically what this means maybe... the first guy spent down his rainy day fund of $100,000, left $100,000 in the biz, and sort of accidentally "moved" his rainy day fund from his personal balance sheet to the S corp balance sheet.

One other remark: This "technique" if we can even call it that, is pretty far into the weeds. It is not a grand strategy or anything...