The Risks of Letting your Clients Set Reasonable Compensation: Cautionary Tales

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

Imagine this: You are a specialized heart surgeon who has spent the better part of 40 years training and perfecting your craft. This morning, you have a tricky procedure scheduled with a patient who is in desperate need of medical intervention. You go to greet the patient, and start explaining the procedure and what they can expect, when the patient stops you and says:

Patient: “That’s all-great doc, but I want you to do this other procedure that my friend had done instead.”

You (renowned heart surgeon): “I’m sorry, but given your unique circumstances, that procedure is not an option for you.”

Patient: “It worked great for my friend! I want it done!”

You: “If we perform that procedure it will result in certain death for you. We really need to stick to our original plan today.”

Patient: “Do what I want or I’m leaving.”

Do you, with all of your expertise, perform a surgery that will result in death just because the patient requested it?

I’m guessing you answered no to that question. So why, oh why, do CPAs and other accounting professionals so often defer to their clients when they know the client is on the wrong path?

Sure, a tax decision isn’t life or death like heart surgery, but an uninformed decision can still have big consequences for both your client and your firm. Remember that you are the expert, who has trained for many years and understands the intricacies of your client’s financial situation. Be ready to clearly lay out the consequences of your client’s decisions and be ready to walk away if necessary.

Let’s take a common example that we see here at RCReports – letting your client set their own reasonable compensation. On the surface, this doesn’t seem like a high-stakes decision, but let’s take a look at some of the consequences of not handling reasonable compensation appropriately:

• Back taxes, penalties, and interest. If your client took distributions from their business and did not take any reasonable compensation or took compensation that the IRS determines to be too low, they can be assessed back taxes, penalties, and interest which can add up fast.
• Preparer penalties. Yep, you read that right, the IRS has a history of imposing preparer penalties up to $5,000 (per client, per year) if one of your clients doesn’t take appropriate reasonable compensation.
• Audits are contagious. If one of your client’s undergoes a reasonable compensation challenge and loses, it is highly likely that the IRS will go audit more of your S-Corp clients. This puts your entire firm at risk while now managing multiple clients going through audits.

When you take those risks into account, along with the impending increase in audits specifically targeted at S-Corps and reasonable compensation, it becomes a very important area for you to properly advise your clients and ensure they (and your firm) are protected.

Here are some important factors to keep in mind when calculating a reasonable compensation figure:

• Reasonable compensation is not tied to the income or profits of the business. The IRS defines reasonable compensation as: the value that would ordinarily be paid for like services by like enterprises under like circumstances. ~ IRS Code: Section 162-7(b)(3)
• The IRS has outlined three approved approaches to determining reasonable compensation in their internal Job Aid: the Cost Approach, Market Approach, and Income Approach.
• Just as important as having an accurate reasonable compensation figure is ensuring you have proper documentation to back up that figure. Tip: Make sure you are using unbiased data that will hold up under scrutiny. These types of sources include the Bureau of Labor Statistics, the U.S. Census Bureau, and proprietary databases such as RCReports.
• If you’re not sure if your client’s salary would be considered reasonable, stress test their figure and make adjustments as needed.

As you can see, reasonable compensation is nuanced and dependent on your client’s unique situation. There are many factors to consider, and the final figure used should be the result of a thorough reasonable compensation analysis led by you as an accounting expert with input from your client (not the other way around). With so many real-world consequences at stake, you can’t afford not to take reasonable compensation seriously.