How the IRS Determines Reasonable Compensation Using the IRS Job Aid
Over the last decade the IRS has steadily and methodically tackled the compliance hassle that is reasonable compensation. According to an exhaustive 2009 GAO Report, S Corps were under-reporting shareholder compensation by more than $23 billion (for tax years 2003-2004) (Ruh-Roh Reorge!)
A few years later the IRS put together a game plan for its staff. This internal “Job Aid” sets out when and how penalties should be assessed and details three approaches for determining reasonable compensation. It also comes with a warning: “This Job Aid is not an official pronouncement of law…” In sports lingo, the courts are still going to referee, but at least now we understand the rules of the game. We’re no longer playing Calvinball, making it up as we go along (shout out to you Calvin & Hobbes fans!) and that was a huge win for tax preparers and taxpayers.
With the likelihood of increased audit attention on S Corps (more on this next month), moving your approach from myths or guessing to employing a fact-based strategy (as outlined in the IRS Job Aid) will greatly reduce risk for the preparer (Are You at Risk for Preparer Penalties?) and S Corp that may be relying on myths such as “Rules of Thumb” or “Safe Harbors”.
The three approaches discussed in the Job Aid are:
The Cost Approach (AKA Many Hats Approach) – Breaks the duties of the business owner into its components such as: company administration, accounting, finance, marketing, advertising, engineering, purchasing, etc.
The Cost Approach breaks down the time spent by the business owner into the various duties performed and quantifies the amount of time devoted to the different duties. Salary surveys determine a comparable wage for each job duty performed by the business owner, then added up to arrive at the total “cost” to replace the services of the business owner.
The Cost Approach is most commonly used for small businesses where the business owner provides multiple services for the business (wears many hats).
The Market Approach (AKA Industry Comparison Approach) – Compares the business owner’s compensation to compensation within the same industry. The market approach focuses as much as possible on the owner’s business and the specific position being analyzed (often the CEO or General Manager who also owns the business).
The Market Approach is generally used for medium and large businesses where the business owner provides only one duty: managing the business.
The Income Approach (AKA Independent Investors Test) – Seeks to determine whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.
The income approach can only be correctly applied when the beginning and ending Fair Market Value (FMV) of the company is available for each year that compensation is examined.
The rationale behind the Independent Investor Test is that investors pay employees to work to increase the value of the assets entrusted to their management. A high rate of return indicates that the assets’ value increased, and that the employee provided valuable services. Thus, if investors obtain returns above what they should reasonably expect, an employee’s salary is presumptively reasonable.
The Income Approach is generally used when there is no comparability data available.
Great, you’re thinking (we dabble in mind reading) but how do I actually put this information into practice (also feeling your frustration). Relax, we won’t leave you hanging (like so many articles do) with nothing more than a summary of the IRS document:-) Follow any of these links for real hands-on help, tools and case studies on how to determine reasonable compensation and educate your clients:
RCReports is a tool for Tax and Financial advisors to determine Reasonable Compensation for a client. RCReports provides a defensible position to an IRS challenge (for S-Corps), and is an excellent planning and valuation tool. RCReports synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and our EXCLUSIVE database of wages to accurately assess Reasonable Compensation for S Corp, Small & Closely Held Business Owners.