Over the last decade, the IRS has steadily and methodically tackled the compliance hassle that is reasonable compensation over the last decade.
Several years ago, 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 other words, it isn’t the law, but this is how we going to enforce it. Wow!
With the likelihood of increased audit attention on S Corps coming after we gave a ton of money we might not have. Moving your approach from myths or guessing to employing a fact-based strategy (as outlined in the IRS Job Aid) will greatly reduce your risk if you are an S-Corp.
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 on 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 but how do I actually put this information into practice? Relax, we won’t leave you hanging (like so many blog posts do) with nothing more than a summary of the IRS document:-). Give us a call and we will walk you through how to do this simply, in detail, and most importantly, affordably. Contact us at 509-543-7600 or send a request HERE.
June 2021
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