Politics & Finances

Sec 199A Encourages Reasonable Compensation Non-compliance

Sec 199A Encourages Reasonable Compensation Non-compliance

With the advent of the Sec 199A deduction the issue of "reasonable compensation" takes on a whole new meaning for S-Corporation shareholders. This has been an issue of contention in past, with shareholders that are actually working in the business and not just being investors taking the minimum or no salary and having all the income pass-through via the K-1 as investment income, thus avoiding payroll taxes on the income that should have been treated as W-2 compensation.

For S-corporations, the Sec 199A deduction only applies to the K-1 pass-through income, not wages paid to the shareholder. The lure of this new 20% deduction will only tempt more employee/shareholders to ignore the reasonable compensation requirements.

So what is reasonable compensation? There currently is no bright line definition but courts have consistently imposed reasonable compensation based on facts and circumstances.

In the early stages of tax reform (Tax Cut and Jobs Act) the bill included a safe harbor definition of reasonable compensation of 70% compensation and 30% flow-through income. It also allowed a larger (more taxpayer favorable) allocation to flow through income where a taxpayer could prove investment in the business justified a larger allocation. Unfortunately, that provision did not make the cut.

As a result, this places an increased burden on tax practitioners, who will find themselves between a rock and hard place (client and IRS) in determining what is reasonable compensation. Further guidance is needed from IRS; hopefully, they can come up with safe harbor guidelines. Otherwise, practitioners are exposed to potential preparer penalties and client litigation.

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Lee Reams, BSME, EA

Lee Reams, BSME, EA

Editor-in-Chief

Besides his role at CountingWorks as an educator and speaker to thousands of accountants nationwide, Lee manages a technical research service for a large group of tax accountants which sharpens his technical skills. Lee served on the Board of Blackline Systems, is a former Board of Director for the California Tax Education Council, is a Past President of the San Fernando Valley Chapter of Enrolled Agents, Member and Past Director for the California Society of Enrolled Agents.

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