S-Corp Reasonable Compensation

[Terry D EA]

I attended a webinar from the NAEA regarding S-Corp officers and reasonable compensation. I have had a good understanding of this for a number of years but the part that caught my attention the most was the onset of preparer penalties that was discussed.

I don't think we need a huge discussion on how to determine the amount of S-Corp officers compensation if he/she provides some type of services, including administrative, should be, or whether the S-Corp officer is taking a distribution or salary. I'm well aware the IRS can and will recharacterize a distribution as wages. Recently, I've worked with a number of S-Corp owners/officers that do not pay themselves a wage and indeed provide services to the S-Corp, and have had the reasonable compensation discussion. I currently have two S-Corps that cannot provide sufficient books or accounting records. One has receipts in excess of the 250K and is required to complete Sch L and M-1, M-2. This officer does not take a salary either. My position on this is for this client to seek other help and break the engagement. 

During the webinar I mentioned above, there was discussion where an IRS auditor pulled one S-Corp return from a CPA but later pulled an additional 25 returns. 20 of those returns, the officer did not take any reasonable compensation. The IRS recharacterized the distributions as wages and penalized the preparer (CPA) 100,000 for negligence, reckless disregard and assisting clients in evading taxes. The CPA/preparer provided copies of letters to the IRS explaining to his clients they must take a reasonable wage or the IRS will recharacterize it. The IRS said the letters proved the preparer knew.

My questions are:

1. If you take on a new S-Corp client and he/she is taking distributions only, do you or should we attempt to get the client to allow us to recharacterize the distribution before preparing the return. I realize all of the penalties for late payroll filings; etc, will be explained. If the client refuses, do you or should we send him packing??

2. I've tried, but not extensively, to find out what our responsibilities are in this situation.

[kathyc2]

This is a few years old, so there may be some changes, but it does a good job of explaining preparer penalties.  https://www.thetaxadviser.com/issues/2017/feb/preparer-penalties-sec-6694-6695.html

When you prepare and sign a return you are stating that it is true and correct.  If there is reasonable doubt, I wouldn't sign. 

If client can not provide financial statements that make sense, I will tell them:

1.  Where I have issues for them to try to fix them or

2. That they need to hire a qualified bookkeeper or

3. They need to provide me with all documents to create accurate statements, or

4. Go somewhere else

 

If they don't take any compensation and come to me after year end, I may or may not prepare one return based on that with a clear understanding that they immediately start taking compensation.  If they appear to have a genuine interest in doing so, I'll likely prepare the return.  If they want to argue with me, I'll decline the engagement.  Same thing if they take what I believe is substantially lower than reasonable compensation.

Remember that clients talk with other business owners.  If they see that they can push you around to doing things the way they want rather than what you know to be an accurate return, they will tell others.  Do you want your business built on a client list like that?  

I've walked away from quite a bit of fees over the years if the potential clients didn't live up to my expectations.  I've also left jobs where I was the internal accountant and pressured by owners to provide misleading financials for bank or tax purposes.  One of the main reasons I started my own firm was so that I am the one making the decisions that effect my integrity.  

 

 

[Max W]

Also, bear in mind that the preparer should advise the client of "Reasonable Compensation".  Failure to do so could result in a $5000 penalty for each year involved.

[Terry D EA]

I'm well aware of the penalties. I agree completely with kathyc2. I've following those rules. I have prepared some S-Corp returns as an overload from a CPA that I was not the signer. Some of those returns lacked the proper information while others did not contain any reasonable compensation for the shareholder. I questioned too much apparently and got pulled from those assignments which was 100% fine with me. if it's not accurate then I'm not signing it.

But... what course do you take if your client says okay let's get it right? Recharacterize the distribution, advise of the payroll penalties and related issues, then prepare the return? I don't see any other way to do so.

[DANRVAN]

On 12/10/2023 at 11:03 AM, Max W said:

Also, bear in mind that the preparer should advise the client of "Reasonable Compensation".  Failure to do so could result in a $5000 penalty for each year involved.

The $5,000 penalty falls under sec. 6694(b) for understatement due to willful or reckless conduct on behalf of the preparer.

Have you seen an actual  "Reasonable Compensation" case where sec 6694(b) was imposed on the preparer?  I have not.

11 hours ago, Terry D EA said:

But... what course do you take if your client says okay let's get it right? Recharacterize the distribution, advise of the payroll penalties and related issues, then prepare the return? I don't see any other way to do so.

Yes, that would be the correct thing to do.

There appears to be a common practice of reporting the distribution on 1099-NEC for the year in question, and then bringing client into compliance in following year.  I think that would be a questionable practice.

[DANRVAN]

On 12/10/2023 at 7:22 AM, kathyc2 said:

When you prepare and sign a return you are stating that it is true and correct.  If there is reasonable doubt, I wouldn't sign. 

Good policy!

[Terry D EA]

The $5,000 penalty falls under sec. 6694(b) for understatement due to willful or reckless conduct on behalf of the preparer.

Have you seen an actual  "Reasonable Compensation" case where sec 6694(b) was imposed on the preparer?  I have not.

I cannot answer that. What I did find a bit concerning is the presenter in the webinar gave the story of the CPA/Preparer did get the penalized under 6694(b) for each year mentioned. However, there was not any court case cited to back up the story. I'm sure the penalties are highly possible but was this a real case???? Not sure, but stuff like this really gets my attention to make sure I'm in complete compliance.

[DANRVAN]

1 hour ago, Terry D EA said:

I'm sure the penalties are highly possible but was this a real case????

I question that.  The $5,000 penalty falls under sec. 6694(b) for understatement due to willful or reckless conduct on behalf of the preparer.

First of all, the unreasonable wage issue does not result in an understatement  of tax on the return.

Secondly, I don't think the preparer really acts in a willful or reckless manner in these cases, he/she is just reporting on the actual facts and representations of the client.

I am not trying to justify a non-reasonable wage case, but question the potential preparer penalties.

1 hour ago, Terry D EA said:

make sure I'm in complete compliance.

And I agree 100% with you!

[mcbreck]

From an attorney I spoke to about this YEARS ago, as long as you explain to the client their obligation within the IRS rules and explain to them the penalties and interest which could be applied, you weren't willfully negligent (document it). I couldn't tell you if that's true as I'm not with the IRS but I recall it with Circular 230 that notifying them of their obligations and penalties is a big deal in your liability. I'm lucky because all my 1120S corps show a loss and I'm doubting the IRS is going after them. I've had them in the past and when I harped on their obligations, they left for a preparer who was less worried about it.

I realize people would throw a fit but 1120S tax rules need to change. They are just ripe for abuse.

 

 

[kathyc2]

On 12/11/2023 at 12:03 PM, Terry D EA said:

But... what course do you take if your client says okay let's get it right? Recharacterize the distribution, advise of the payroll penalties and related issues, then prepare the return? I don't see any other way to do so.

If you go that route, remember that you will need to gross up pay to account for FICA withholding at a minimum. 

[kathyc2]

58 minutes ago, DANRVAN said:

First of all, the unreasonable wage issue does not result in an understatement  of tax on the return.

It understates payroll tax matching.  Also, if QBI is involved it may cause an understatement of FIT.

[Lee B]

2 hours ago, mcbreck said:

I realize people would throw a fit but 1120S tax rules need to change. They are just ripe for abuse.

 

 

What kind of abuse ?   What should be changed?

[DANRVAN]

1 hour ago, kathyc2 said:

It understates payroll tax matching. 

But that does not understate the tax return as signed by the preparer; 1120-S.  Therefore section 6694(b) does not apply.

 

1 hour ago, kathyc2 said:

Also, if QBI is involved it may cause an understatement of FIT.

Same thing, there is no understatement on the 1120-S.

 

On 12/9/2023 at 12:51 PM, Terry D EA said:

The IRS recharacterized the distributions as wages and penalized the preparer (CPA) 100,000 for negligence, reckless disregard and assisting clients in evading taxes.

 

3 hours ago, Terry D EA said:

However, there was not any court case cited to back up the story. I'm sure the penalties are highly possible

There cannot be an understatement penalty if there is no understatement, I would question the CPE provider.  So he is saying 20 x $5,000, I say prove it.

The only penalty I can see would be under section 6701 as to the resulting understatement on the clients form 1040 for reporting a distribution vs a wage. 

Maybe the IRS could take the position that preparer's role in preparation of the 1120-S was an act of aiding and abetting understatement of tax liability on the individual's 1040.

However, the maximum section  6701 penalty is $1,000 for an individual tax return.

So I question how the presenter came up with $100,00.  

 

 

On 12/9/2023 at 12:51 PM, Terry D EA said:

20 of those returns, the officer did not take any reasonable compensation.

[kathyc2]

5 hours ago, DANRVAN said:

Same thing, there is no understatement on the 1120-S.

 

QBI income is calculated at the corporate level and reported on K1.

[DANRVAN]

2 hours ago, kathyc2 said:

QBI income is calculated at the corporate level and reported on K1.

But does not result in an understatement on 1120-S by the preparer.

[DANRVAN]

On 12/9/2023 at 12:51 PM, Terry D EA said:

The IRS recharacterized the distributions as wages and penalized the preparer (CPA) 100,000 for negligence, reckless disregard and assisting clients in evading taxes.

Okay, here is a possibility.  Accountant prepares 1120-S and K-1 showing distributions and zero wages while there was no doubt shareholders were providing substantial services to the corp.

Then accountant prepares 1040 (or in this case 20 of them) based on the K-1 he prepared which shows zero wages.  

Now there is an understatement at the 1040 level and IRS as the burden of proof to show:

a. There is an understatement of liability which is due to a willful attempt in any manner to understate the tax liability by the preparer, or

b. The preparer has recklessly or intentionally disregarded rules or regulations.

On 12/11/2023 at 8:37 PM, DANRVAN said:

There appears to be a common practice of reporting the distribution on 1099-NEC for the year in question, and then bringing client into compliance in following year

In this situation, there should not be a substantial understatement on the 1040 (and lets leave off the 199A deduction) for the year in question by reporting on Schedule C instead of W-2 wages.  And since there is not a significant understatement, there is not a potential sec 6694 penalty.  Although the 1099-NEC amount could be reclassified as wages, the bottom 1040 liability should not be significantly different.

Not saying that is the proper way to handle it.

[Lee B]

It does result in a substantial understatement of employment taxes at both the federal and state level.

Income taxes are not the only consideration.

[Catherine]

15 minutes ago, Lee B said:

substantial understatement of employment taxes at both the federal and state level

Those get picked up in the SE taxes.

I am also not saying that 1099-NEC is the best-practices way to go, but to my mind it's more important to get the client straight going forward if that's the way to get them to agree. Plenty of people will not agree to do wages, file now-late 941's, and all the rest - but they will agree to a 1099-NEC plus PR starting Jan 1 of the year (already back-dating start of PR to the then-current year, since these people tend to show up in March). I would explain - in writing - the possible consequences. 

In our experience, the no-PR problem has mainly been new-and-small companies who are not making a ton of money (if even running at a profit at all). Straighten them up as best and as quickly as you can, and have a loyal client for years to come. Remember, we can only advise on changes prior to meeting the client; we cannot compel. Draw your own lines that you will not cross, but as long as the client fixes going forward, I would most likely agree to 1099-NEC the owner(s) if they balk at doing prior-year payroll with late 941s. Because we know most of them would then take their papers to some shyster who will let them continue to mess up for years to come. Better to get them in current compliance and keep them there.

[DANRVAN]

1 hour ago, Lee B said:

It does result in a substantial understatement of employment taxes at both the federal and state level.

That is true, but it is not going to result in a section 6694(b) penalty of  $5,000.

[DANRVAN]

1 hour ago, Catherine said:

Because we know most of them would then take their papers to some shyster who will let them continue to mess up for years to come.

Sound like the guy Terry mentioned in his OP specialized in those.

[kathyc2]

22 hours ago, DANRVAN said:

But that does not understate the tax return as signed by the preparer; 1120-S.  Therefore section 6694(b) does not apply.

1120S is not exempt from 6694 penalties.  You may want to review Rev Proc 2009-11

 

[Lee B]

1 hour ago, Catherine said:

Those get picked up in the SE taxes.

 

Not all of them do.   SUT & FUT don't get picked up. In my state STTX & PFML also wouldn't get picked up.

[DANRVAN]

47 minutes ago, kathyc2 said:

You may want to review Rev Proc 2009-11

In OP situation there is zero liability or understatement on the 1120-S; even though the preparer of the return is subject to 6694 per Rev Proc 2009-11, (which also includes form 1065).

As I explained in a post above, in order for 6694 to apply in this case, it would come from an understatement of the shareholder's income tax liability.

For example if a sole shareholder claimed a $50,000 tax free distribution instead of a wage, the understatement of liability would end up on his form 1040.

12 hours ago, DANRVAN said:

Okay, here is a possibility.  Accountant prepares 1120-S and K-1 showing distributions and zero wages while there was no doubt shareholders were providing substantial services to the corp.

If in fact that is the case, the 6694 penalty would be avoided by using a 1099-NEC (right or wrong) to avoid the 6694 penalty as I also mentioned.

 

 

[Terry D EA]

This is a great discussion. I am thinking more and more the presenter in the webinar made the story up. No court case, never mentioned "understatement of taxes" and now I am inundated with advertisements to buy their reasonable compensation software with a $400.00 price tag. A scare tactic maybe to get people to jump on the software??? To calculate a reasonable wage is not brain surgery. It seems that most of the court cases reviewed the shareholder was indeed providing services and taking a very low salary presenting a large gap between what it should have been and what they were doing.  The presenter never even mentioned taking distributions without sufficient basis. Maybe this should be mentioned to the NAEA as they were the one providing the webinar.

[DANRVAN]

3 minutes ago, Terry D EA said:

now I am inundated with advertisements to buy their reasonable compensation software with a $400.00 price tag. A scare tactic maybe to get people to jump on the software???

Now I am convinced it was made up as well, after I have beat it up trying to figure out how sec 6694 could apply!