Reasonable Compensation Under the Tax Cuts and Jobs Acts

By Mark E. Battersby / Published May 2018

To keep the owners of pass-through entities from underpaying taxes, last December’s Tax Cuts and Jobs Act (TCJA) required many pressure cleaning businesses to pay a “reasonable” amount of compensation for the service of their owners. And, now the government is considering whether the reasonable compensation rules should be applied to partnerships and sole proprietors.

       The new tax law included a tax break for the income of pass-through businesses with a unique “deduction.” However, the TCJA limits that 20-percent deduction to what lawmakers call “qualifying business income.” The law says reasonable compensation paid by an S corporation or guaranteed payments paid by a partnership don’t qualify for the deduction.

Reasonable Compensation

       The term “reasonable compensation” has a long history. For many years, the issue was whether the owner/employee of an incorporated pressure washing business—since dividends paid to shareholders can’t be deducted by an incorporated business, but compensation is—was paying him- or herself more compensation than was reasonable.

       The IRS continues to keep an eye on what they label “disproportionate allocations” of salary and bonuses. Should the IRS successfully recharacterize compensation as disguised dividends, the pressure cleaning business would, of course, lose its tax deduction and face interest and penalty payments.

       It’s a similar story with the distribution allocations involving S corporation owner/employees. Since the compensation is subject to employment taxes (FICA and Medicare taxes), and shareholder distributions are not, many S corporation owner/employees have attempted to lowball personal compensation. The less employment taxes paid, the more of the distribution the owner keeps.

Owner Wages

       S corporation shareholders who also work in the pressure cleaning business pay themselves in order to avoid self-employment taxes. What’s more, S corporations are required to have the shareholder who works in the business pay themselves a “reasonable” wage and the associated self-employment taxes. But, to date, there aren’t any rules requiring partnerships to pay their active owners a guaranteed payment.

       Although the law distinguishes between guaranteed payments and reasonable compensation, should the IRS require all active partners in a pass-through business have a portion of their earnings pegged as reasonable compensation, the unique tax benefit accorded to pass-through businesses under the TCJA could be reduced substantially.

       Since compensation is subject to payroll taxes, while distributions are not, tax savings often result from simply reducing a shareholder’s compensation and increasing the amounts of dividends distributed.

       Officers in incorporated pressure washing businesses are usually also employees with wages subject to withholding. But, what is considered reasonable compensation for the efforts that an individual contributes to conducting the trade or business? Quite simply, wages paid to an officer of an incorporated pressure cleaning business who is also a shareholder should be commensurate with the duties performed. Not too surprisingly, the IRS frequently questions whether a corporate officer is substantially underpaid for services provided.

       As with a regular corporation, S corporations are expected to pay reasonable compensation to share-holder/employees. The IRS long ago determined that S corporations, where the owners perform services for their business, should be required to pay the owner a reasonable salary as compensation for those services. And, the rules also clearly stated that reasonable salary was subject to self-employment tax.

       In the eyes of the IRS, for a sole proprietor or a partner in a partnership, money and other forms of payment taken from the business should be accounted for in a “draw” account. Since a sole proprietor cannot deduct his or her own salary or personal withdrawals, the draw account ensures the amount of benefits provided by the business is clearly stated.

Determining Reasonable

       The IRS has yet to provide S corporation owners with guidance on how to determine the reasonableness of an owner’s salary. Congress’s watchdog, the U.S. Government Accountability Office, issued a study showing S corporations had underreported shareholder compensation by nearly $25 billion over a two-year period—with those having three shareholders or less accounting for the lion’s share of the underreporting.

       The courts, for their part, weigh such factors as the compensation of non-owner employees, past salary history, industry formulas and the financial condition of the business. However, despite the fact that all these factors are considered, the consideration carrying the most weight with the courts appears to be “the replacement cost to the company of hiring an outside party to perform the business owner’s duties.”

TCJA

       The TCJA has contributed more questions about reasonable compensation and, once again, failed to provide guidance of what is “reasonable.” The TCJA created a 20-percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by pressure washing businesses operating
as pass-through entities such as S corporations, partnerships, LLCs, and sole proprietorships.

       All businesses under the income thresholds, regardless of whether they’re “service” professionals or not, can take advantage of the 20-percent deduction. For pass-through income above this level, the new law also allows the 20-percent deduction, but only for “business profits,” reducing the owners’ top marginal tax rate to as much as 29.6 percent.

       With strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income, the TCJA places limits on who can qualify for the pass-through deduction. Thus, that 20-percent deduction applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner.

Avoiding The Issue Now

       The pain of having compensation found unreasonable by the IRS has long meant additional taxes and penalties. Now, it can mean being denied the 20-percent deduction from pass-through income. The IRS is suspicious whenever the compensated employee controls the operation of the employer, such as when an employee is also the owner.

       Documentation may be a method to save taxes on the distribution of profits—and the pass-through deduction. Researching and documenting now, versus guesstimating, makes it much harder for the IRS to challenge the numbers of any pressure cleaning business owner. Naturally, any disparities with regional or industry averages stick out like a sore thumb to the IRS.

       A well-designed and documented compensation plan may avoid a challenge in the first place. If the compensation plan is recorded in advance, the employer has created a paper trail justifying the plan. The time and expense of an after-the-fact reconstruction and proof of reasonableness can be quite expensive and result in a loss to the pressure washing business even if the IRS ultimately loses the challenge.

       Factors such as the employee’s qualifications, the nature of the work and the complexity of the business also lend themselves to a reasonableness determination. Comparing salaries versus dividends, the salary policy for all employees, and the amount of compensation paid to employees in previous years are also ammunition in the argument. Industry pay standards can also provide an objective set of data for determining the reasonableness of the compensation paid for the services performed.

Determining Reasonable

       Fortunately, there are several tried-and-true strategies that might work.

• Pay yourself more than the IRS reports as the average S corporation in your area pays its typical corporate officer. While corporate officers are not necessarily corporate shareholders, few IRS auditors will argue shareholder/employees should receive more than the industry average corporate officer salary.
• Find the job within the U.S. Bureau of Labor Statistics salary database most closely matching the actual job performed by the shareholder/employee. Note that the IRS gives more weight to federal government statistics than data from sources such as payscale.com or salary.com.
• Consider what the pressure washing operation’s other employees are paid. Logically, owning and operating the pass-through entity means the employee/shareholder should be the highest paid employee.
• As much as possible, pad shareholder/employee compensation with legitimate, nontaxable fringe benefits.

Fringes—A Reasonable “Reasonable Compensation”

       Obviously, the tax treatment of fringe benefits paid to employees who are not shareholders, or owner/employees who own two-percent or less of the operation’s outstanding stock, is different from owners/employees who are shareholders. The fringe benefits paid non-shareholder employees are tax-free. They are excluded from the employee’s taxable wages. Those non-shareholder fringe benefits are deductible by the corporation.

       Employee/owners owning more than two-percent of the S corporation stock, on the other hand, are not considered employees for fringe benefit purposes, and their fringe benefits may not be tax-free. More-than-two percent owners are treated in the same manner as partners in a partnership.

       Naturally, shareholders who are officers of a corporation who do not perform any services or perform only minor services in that capacity and who do not receive or are not entitled to receive direct or indirect compensation are not considered employees. Thus, since most shareholder/officers of closely-held, incorporated businesses do provide more than minimal services for the business, they are usually considered employees.

       The ongoing argument of what is “reasonable” compensation for those who own and operate a pressure cleaning business has increased in complexity thanks to the new pass-through income deduction. The need for professional assistance when determining—and supporting—the amount of compensation paid the operation’s owners can’t be emphasized enough, as the IRS is watching.