CPA Tcp Quiz: Evaluate Reasonable Compensation Strategies

What this quiz covers

This quiz focuses on Evaluate Reasonable Compensation Strategies, giving you a quick way to practice the rules, question types, and explanations that matter most for CPA Tcp.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

Question 1

1. The compensation equals the compensation paid to non-shareholder employees in similar roles.
2. The compensation is excessive relative to the services performed, suggesting it is a disguised dividend - allowing the corporation to deduct a distribution that would otherwise not be deductible. (correct answer)
3. The shareholder-employee owns less than 50% of the corporation's stock.
4. The compensation is paid in the form of bonuses rather than a fixed salary.

Explanation: Unreasonable compensation in a C corp context typically involves overpaying shareholder-employees to disguise nondeductible dividends as deductible compensation. Answer B is correct. Market-rate compensation (A) is the safe harbor. Small ownership (C) doesn't trigger IRS concern. Bonus form (D) is not itself improper.

Question 2

1. The shareholder-employee takes little or no salary while receiving large distributions - allowing avoidance of payroll taxes (FICA) on amounts that should be characterized as wages. (correct answer)
2. The shareholder-employee receives compensation above industry benchmarks.
3. The S corporation has multiple shareholders receiving different compensation amounts.
4. The shareholder-employee works fewer than 40 hours per week for the corporation.

Explanation: S corp shareholders who work for the company must receive reasonable compensation as wages - distributions avoid FICA, so underpaying wages and overpaying distributions is a common IRS target. Answer A is correct. Above-market pay (B) is an S corp shareholder-employee concern, but lower pay is the typical S corp abuse. Different amounts (C) are acceptable. Hours worked (D) alone don't determine reasonableness.

Question 3

1. The employee's qualifications, experience, and duties.
2. Compensation paid to comparable employees at similar companies.
3. The financial condition of the company and the size of the business.
4. Whether the employee is related to the company's founder. (correct answer)

Explanation: Family relationship to a founder is generally not a factor in the reasonable compensation analysis - courts look at economic, market, and performance factors. Answer D is correct. Qualifications (A), market comparables (B), and company financials (C) are all commonly used factors.

Question 4

1. The IRS recharacterizing a portion of compensation as constructive dividends - the lack of dividend history combined with high compensation is evidence that compensation is being used as a substitute for dividends. (correct answer)
2. The accumulated earnings tax based on excessive retained earnings.
3. The personal holding company tax if income is predominantly from passive sources.
4. Criminal prosecution for tax evasion.

Explanation: Using all-compensation/no-dividend policy to avoid double taxation is the classic IRS target - compensation may be recharacterized as dividends to prevent deductibility. Answer A is correct. The AET (B) applies to accumulated retained earnings, but the scenario shows no retained earnings. PHC tax (C) relates to passive income. Criminal prosecution (D) requires fraudulent intent.

Question 5

1. Paying compensation equal to the prior year amount adjusted for inflation.
2. Paying a large year-end bonus if the corporation had a profitable year.
3. Documenting that compensation was authorized by related-party shareholders at an annual meeting.
4. Establishing compensation using an independent compensation study, board approval by disinterested directors, a contemporaneous employment contract, and benchmarking against industry data. (correct answer)

Explanation: Best practices to defend reasonable compensation include independent studies, objective board approval, contemporaneous documentation, and market benchmarking. Answer D is correct. Inflation adjustment (A) doesn't establish market reasonableness. Profit-based bonuses (B) may be challenged if total compensation is excessive. Related-party approval (C) lacks independence.

Question 6

1. The bonus is deductible by the corporation only if paid before year-end.
2. The bonus is deductible by the corporation as compensation expense, included in the shareholder-employee's gross income as wages, and subject to FICA taxes. (correct answer)
3. The bonus is taxed at the capital gains rate since it is paid by a corporation.
4. The bonus reduces the corporation's E&P directly without being deductible.

Explanation: Reasonable compensation (including bonuses) is deductible by the corporation and taxable as ordinary income/wages to the recipient, subject to payroll taxes. Answer B is correct. Accrual-basis corps can deduct bonuses paid within 2.5 months after year-end (A - not limited to year-end). Bonuses are ordinary income (C). Deductible compensation reduces E&P (D - incorrect characterization).

Question 7

1. Whether the corporation has ever paid dividends to the shareholder.
2. Whether the $500,000 is consistent with the shareholder's prior year salary.
3. Whether $500,000 is reasonable for the type and quality of services provided, considering market comparables - the fact that it leaves minimal corporate income is relevant as evidence of disguised dividends. (correct answer)
4. Whether the compensation is paid in equal monthly installments.

Explanation: The near-total absorption of corporate income as compensation is circumstantial evidence of disguised dividends - the key test is whether the amount is reasonable for the services. Answer C is correct. Prior dividend history (A) is relevant but not the key factor. Prior year consistency (B) is one factor but not determinative. Payment timing (D) is irrelevant.

Question 8

1. Is subject to FICA taxes since it flows through the corporation.
2. Is treated as self-employment income subject to SE tax.
3. Is not subject to FICA or SE tax - S corporation distributions (beyond reasonable wages) are excluded from employment taxes, which is the key tax advantage of S corporation status for active owner-employees. (correct answer)
4. Is subject to the 3.8% net investment income tax automatically.

Explanation: S corporation distributions are not subject to FICA or SE tax - only the reasonable salary portion is subject to payroll taxes. The 3.8% NIIT doesn't automatically apply to S corp active owners. Answer C is correct. Distributions are not subject to FICA (A). S corp income is not SE income (B). Active S corp owners are generally excluded from NIIT on their S corp income (D).

Question 9

1. Maximizing distributions to minimize payroll taxes.
2. Determining what a similarly qualified non-owner employee would earn for performing the same duties - the compensation must reflect the actual market value of services. (correct answer)
3. Setting compensation equal to 30% of gross income as a safe harbor.
4. Ensuring compensation equals the amount in the shareholder's employment contract regardless of current market rates.

Explanation: Reasonable compensation must reflect the actual value of services - what the market would pay a non-owner employee for the same work. Answer B is correct. Minimizing payroll taxes through low compensation (A) is the IRS's target concern. No 30% safe harbor exists (C). Contract amounts must still be market-reasonable (D).

Question 10

1. The IRS will reclassify $90,000 of distributions as wages (up to reasonable compensation of $120,000) and assess back FICA taxes plus penalties and interest. (correct answer)
2. The IRS will disallow all of the $90,000 in distributions as nondeductible.
3. The $30,000 will be treated as a distribution rather than wages.
4. No adjustment since the total compensation received ($120,000) equals the reasonable amount.

Explanation: The IRS will reclassify distributions to reach the $120,000 reasonable compensation level - the $90,000 shortfall in wages will be recharacterized as wages subject to payroll taxes. Answer A is correct. S corp distributions are deductible (B - irrelevant since distributions aren't expenses). Reclassifying wages as distributions (C) is the opposite of what the IRS does. Total compensation includes distributions reclassified as wages (D is misapplied).

Question 11

1. Potentially unreasonable - wages must reflect the value of services, not ownership percentages. The 30% shareholder performing equal work should receive compensation comparable to the 70% shareholder's wages. (correct answer)
2. Reasonable - it is standard practice to pay compensation proportional to ownership.
3. Reasonable - all that matters is that the total compensation is reasonable.
4. Unreasonable only if the 30% shareholder files a complaint with the IRS.

Explanation: S corp wages must reflect services provided, not ownership percentages. Equal work should command comparable compensation - tying wages to ownership to shift income tax or payroll taxes is improper. Answer A is correct. Ownership proportionality is not the standard (B). Individual compensation must each be reasonable (C). The IRS may raise this independently (D).

Question 12

1. The shareholder's income tax increases by the tax on $40,000 of additional income.
2. The S corporation pays additional income tax on the $40,000 recharacterization.
3. The shareholder loses the basis reduction from the $40,000 distribution.
4. Both the employer and employee portions of FICA (7.65% each = 15.3% total) are assessed on the $40,000 - the S corp owes the employer portion plus penalties, and the employee owes the employee portion. (correct answer)

Explanation: The primary impact of reclassifying S corp distributions as wages is FICA taxes - both employer and employee FICA apply to the reclassified wages. Answer D is correct. Income tax on $40,000 is minimal since the shareholder already paid income tax on the distribution (A). S corps are generally not taxpayers (B). Basis adjustments are affected but the primary impact is FICA (C).

Question 13

1. $80,000 of the distributions will be recharacterized as wages, subject to FICA taxes for both the employee and employer - plus potential penalties for failure to withhold. (correct answer)
2. The full $200,000 will be treated as wages.
3. The corporation's income will be increased by $80,000.
4. The shareholder will owe self-employment tax on $200,000.

Explanation: The IRS will reclassify $80,000 (the reasonable compensation amount) as wages subject to FICA, not the full $200,000. Answer A is correct. Only the reasonable compensation amount is reclassified (B). Income recharacterization (C) is not the primary adjustment. S corp shareholders pay wages, not SE tax (D).

Question 14

1. Compensation is reasonable if an independent investor would receive the same amount.
2. Compensation is reasonable if, after paying the compensation, the return on equity is sufficient to attract an independent investor - if the return on equity is adequate, the compensation is presumed reasonable. (correct answer)
3. Compensation must be approved by independent directors of the corporation.
4. Compensation is benchmarked against payments to independent contractors performing similar services.

Explanation: The independent investor test asks whether the return on equity after paying the compensation would still be acceptable to an outside investor - if yes, the compensation is reasonable. Answer B is correct. The test is about investment returns, not compensation amounts to investors (A). Board approval (C) is a governance practice. Independent contractor benchmarking (D) is a different approach.

Question 15

1. The disallowed portion is nondeductible - the corporation has additional taxable income equal to the disallowed compensation, taxed at the 21% flat rate. (correct answer)
2. The disallowed portion is deductible as a dividend paid deduction.
3. The corporation receives a refund of taxes previously paid on the amount.
4. The corporation's basis in the shareholder-employee's stock is increased.

Explanation: Disallowed compensation increases the corporation's taxable income - it is not deductible as a dividend. Answer A is correct. Dividends are not deductible for C corporations (B). No refund arises from compensation disallowance (C). Stock basis adjustments are not affected (D).

Question 16

1. Distributions are always taxed at higher rates than compensation.
2. Compensation is not subject to income tax while distributions are.
3. Compensation (wages) is subject to FICA/payroll taxes while distributions are not - minimizing wages and maximizing distributions reduces payroll tax burden, which the IRS monitors. (correct answer)
4. Distributions affect the shareholder's at-risk amount while compensation does not.

Explanation: The key difference is FICA treatment - wages are subject to payroll taxes, distributions are not. This creates the incentive to minimize wages in S corps. Answer C is correct. Distributions are not taxed at higher rates (A). Both compensation and distributions are subject to income tax (B). Distributions reduce stock basis affecting at-risk, but FICA avoidance is the main concern (D).

Question 17

1. Sole proprietors pay no payroll taxes on their business income.
2. Sole proprietors may deduct their own compensation as a business expense.
3. Sole proprietors pay self-employment tax on their net self-employment income regardless of how they label it - there is no opportunity to recharacterize SE income as distributions to avoid SE tax, unlike with S corporations. (correct answer)
4. Sole proprietors are subject to higher tax rates making compensation planning unnecessary.

Explanation: Self-employment tax applies to all net SE income of a sole proprietor - there's no corporate distribution mechanism to avoid SE tax, so the reasonable compensation issue doesn't arise in the same way. Answer C is correct. Sole proprietors do pay SE tax (A). Sole proprietors cannot deduct personal compensation (B). Tax rates vary (D).

Question 18

1. A publicly held corporation's CEO who receives $10 million in compensation.
2. A physician who is the sole shareholder-employee of a medical S corporation, performing all patient services, and paying herself $40,000 in wages while taking $300,000 in distributions from $340,000 of net income. (correct answer)
3. A non-owner employee who receives above-market compensation based on performance.
4. A C corporation that pays its employees compensation equal to industry averages.

Explanation: A physician with low wages and high distributions from a professional S corporation is a classic IRS reasonable compensation target - the services are worth far more than $40,000 and the excess is clearly wage income being disguised as distributions. Answer B is correct. Public company compensation (A) has different issues. Non-owner above-market pay (C) is not a reasonable compensation concern. Market-rate C corp compensation (D) has no issue.

Question 19

1. Whether family members have filed joint tax returns.
2. Whether compensation paid to family members reflects the actual value of their services or is inflated to shift income within the family - particularly compensation to family members in lower tax brackets. (correct answer)
3. Whether all family members receive the same compensation.
4. Whether family members have signed employment agreements.

Explanation: Income shifting through inflated compensation to lower-bracket family members is an IRS concern - compensation must reflect actual value of services regardless of family relationships. Answer B is correct. Joint filing (A) is irrelevant. Equal compensation (C) is not required. Employment agreements (D) are good practice but don't ensure reasonableness.

Question 20

1. The independent investor test.
2. The hypothetical market rate test.
3. The internal consistency test.
4. The market comparables approach - benchmarking compensation against what similarly qualified individuals earn in similar roles at comparable companies in the same industry and geographic area. (correct answer)

Explanation: Market comparables benchmark the shareholder-employee's pay against industry and regional data for similar positions. Answer D is correct. The independent investor test (A) focuses on investment returns. Hypothetical market rate (B) and internal consistency test (C) are not standard approaches in this context.