How Reasonable is Your Compensation?

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

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The IRS requires “Reasonable Compensation” be paid to S-Corporation Shareholders and General Partners in a Partnership in order to avoid a notice or audit.  The question, therefore, is, “What is reasonable?”  Below are three methods to determine a reasonable salary with a focus on the Cost Approach preferred for closely held entities which represent the majority of clients in my practice.

The Three Methods of Determining Reasonable Compensation 

It is important to match each method with the business’ size and business owner’s job duties.

1. Method #1: The Cost approach. Generally, this works best for small businesses where the owner wears multiple hats. This approach breaks the time spent by the owner down into the various tasks performed.  Wage levels are then assigned for each task based on the owner’s proficiency and then added together to obtain a hypothetical replacement cost for the owner. The Cost approach is generally the best option for determining reasonable compensation for a small business owner.

Since most small business owners wear a variety of different hats in their business, the cost approach takes all those hats into consideration. The Cost approach relies solely on comparability data. In other words, what are other workers paid with similar job duties, or similar experience that live within the same geographical area? Let us explore step by step best practices for determining Reasonable Compensation using the Cost approach.

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Step One: List all of the services the business owner provides to the company. be compensated for administrative work performed for the other income-producing employees or assets.” Don’t leave any out even if they are not income producing. The IRS guidelines on determining reasonable compensation for an S Corp. states: “In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also

Step Two: Estimate the amount of time devoted to the business and break it down by each service listed in Step One. “Time and effort devoted to the business,” is one of the key factors the courts look at when determining Reasonable Compensation.

Step Three: After listing all the services, the business owner provides to the company, find reliable wage data to match to the services listed. Keep in mind that the wage data should match both the services performed and the proficiency level of the business owner. The wage data should also be drawn from the location of the business or where the services are performed (usually the same, but not always) since wage data varies widely, county to county, city to city, state to state, etc.

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Step Four: Do the math. Multiply the time spent on each service by the wage, This is also what valuation experts call the “Hypothetical Replacement Cost of an Owner or key manager of a business.” The IRS compares the Cost approach for determining reasonable compensation for a business owner to the replacement cost for valuing real estate. In the cost approach for valuing real estate, the appraiser would value the subject property by adding up the replacement cost of all its components; i.e., bricks, shingles, two by fours, windows, etc.
then tally everything up. You have now calculated what the IRS and courts call the business owners “Replacement Cost” or “Fair Market Value.”

2. The Market approach, aka the industry comparison approach: Generally, this approach works best for SMB’s where the owner performs predominantly managerial tasks.

3. The Income approach, aka the independent investor's test: Generally, this works best for outliers.

Over the next three months, we will explore each approach in depth. In the meantime, if you have any questions regarding the setting of a reasonable value for compensation, feel free to contact me with your questions via email.

Article content provided by Paul S. Hamann & Jack Salewski, CPA, CGMA. If you would like help with these kinds of accounting and tax questions, call Ben Kinsey, CPA of Small Business Group at 904 731-2221. He works with closely held corporations in the Northeast Florida region.  Contact Small Business Group if you would like to know more about strategies for your business. To make an appointment click here. http://www.smallbg.com/appointment.htm