WHAT IS REASONABLE COMPENSATION IF YOU ARE AN S CORP

Shareholders of an S corporation love receiving distributions of profits because there is no immediate tax consequences...however, guess who has an issue with this?  You guessed it...the IRS!  They have taken a long standing position that where the shareholder is also acting as an employee of the corporation, "reasonable" compensation must be paid.  And guess what...this compensation is also subject to Medicare and Social Security  taxes whereas shareholder distributions are not.

The classification of S-Corp payments to shareholders is a long standing compliance issue with the IRS. They feel that many taxpayers convert what would otherwise be self-employment income (wages) to distributions, in order to avoid self-employment tax (Medicare and Social Security).

This past December the IRS was successful at convincing a US District Court that an S Corp shareholder-employee's $24,000 salary was not "reasonable" and allowed the IRS to reclassify as salary over $67,000, resulting in additional Medicare and Social Security tax....and...as you would guess...penalties and interest were tacked on as well!

According to IRS fact sheet #2008-25 a list of factors has been issued to help determing whether "reasonable" compensation has been paid.  They include:

• training and experience;
• duties and responsibilities
• time and effort devoted to the business
• dividend history
• payments to non-shareholder employees
• timing and manner of paying bonuses to key people
• what comparable businesses pay for similar services
• compensation agreements; and
• use of a formula to determine compensation.

By carefully addressing these factors, preferably in a written document, the chances of the IRS attacking your determination of "reasonableness" should be significantly reduced.  Please review your situation and feel free to contact our office with any questions you might have concerning this very delicate requirement.

HOW LONG DO I NEED TO KEEP MY TAX RECORDS

One of the most frequently asked questions that come into our office is "How long do I need to keep my tax papers and record?"  I would like to say never, but unfortunately that is not the case!  There are many records and documents that support your numbers that appear on your tax return that you need to hang onto should your Uncle Sam (a/k/a IRS) select your return for that unwanted and fear producing audit.  If you are well organized and can produce support for any of these numbers the examination normally goes smoothly and quickly.  However, if you are not prepared and can not prove what has been reported than audits can become your worst nightmare!  Here are some suggestions...

1.  Organize the records at the time you are providing us the information to prepare your return and keep them with your return.  If some of your records need to be stored in other locations, make a copy of these items for your tax return file.  Trying to reassemble records after a couple of years have past by can be time consuming and stressful.

2.  Records you want to keep include bills, credit cards and other receipts, invoices, mileage logs (extremely important), cancelled, imaged or substitute checks, proofs of payment, and any other records to support deductions or credits you claim on your return.  Now, how long you keep these records depends on your circumstances.  The general rule, according to the statue of limitations, is to keep tax records for a minimum of three years.....with a few exceptions.  If the document will affect a future tax return, such as the purchase of real estate, the three year rule does not start until after the transaction closes, that is when you sell the real estate! 

3.  Documents, such as medical bills and mortgage interest statements, affecting only the current year can usually be destroyed after three years.

In conclusion, being able to properly support your tax retun is important.  What to keep and how long you need to retain your paperwork can be confusing and something you should talk with us about, especially if we are familiar with your situation.

Bottom Line..stay well organized....and if you do you will be doing yourself a huge favor.  And remember, talk with us first before throwing away any of your records.