Question of the Week
Reasonable Compensation for S-Corps
Happy Friday, all!
I’m having a lot of business structure conversations this week. The vast majority of my clients are S-Corps, so I spend a lot of time diving deep into making sure I set them up for success for potential pitfalls. And the biggest stumbling block for most of them is determining reasonable compensation.
I’ve talked a bit about reasonable compensation pertaining to single-member S-Corps. But today, I wanted to dive a bit deeper into what it is, why it matters, and how you determine if your compensation is reasonable.
The IRS requires that all shareholders of S Corps who perform services for their company pay themselves Reasonable Compensation and need to pay it before taking any distributions. There are two ways to think about Reasonable Compensation:
- Replacement Cost: What would it cost your company to pay another person(s) to provide all the services you currently offer?
- Fair Market Value: What would other businesses in your community pay you for the services you currently provide to your company?
There has been a substantial underreporting of reasonable comp, so it’s more important than ever that you research and document how you determined your Reasonable Compensation figure.
How do we figure out reasonable compensation?
The IRS has provided a fact sheet and job aid to guide what to consider when determining reasonable compensation. But it all boils down to a facts and circumstances test.
A Reasonable Compensation Report is an independent unbiased report that establishes your Reasonable Compensation using criteria outlined by the IRS and Courts and provides a defensible position to an IRS challenge.
Courts use nine factors to analyze reasonable comp. The top three are the most often cited.
- Training and experience: Does $X seem like enough for someone with that training and experience?
- Duties and responsibilities: What does the person do for the firm? Is $X enough for someone who does all of that?
- Time and effort devoted to the business: How many hours a week are you working? Is $X for someone who works year-round.
- What comparable businesses pay for similar services: What are other people who perform similar tasks making?
- The use of a formula for determining compensation: Income Approach Model aka Independent investor test. How much money can an independent investor make from this?
- Payments to non-shareholder employees: Are employees making more than you?
- Compensation agreements: agreed-upon compensation (not practical if there isn’t an independent board
- Timing and manner of paying bonuses to key people: when and how much are key people paid?
- Dividend history: When is money taken out of the business.
In the job aid, the IRS suggests these valuation approaches to reasonable compensation like we do other valuations. So that’s what we use!
- Cost Approach: Takes into account all tasks performed and apportions the time, skill, and proficiency. We primarily use this approach in businesses where shareholder-employees wear many hats. The comparability data used is cross-industry.
- Market Approach: Looking at the compensation of employees and businesses of similar sizes and industries. We used this approach chiefly for medium-sized companies where the shareholder-employee is more of a manager, not working as much in the business.
- Income approach: How much money would an investor make from this? It’s a formula based on the FMV at the beginning of the year, the FMV at the end of the year, and the target return. We used this approach primarily on outlier cases – unique occupations or skill sets. It does not use comparability data.
You’ll often hear some shortcuts from other advisors regarding how they figure out a reasonable compensation. But unfortunately, the rules of thumb below aren’t IRS or Court recognized approaches
- Industry Rule: set wages as a percentage of sales or revenue based on industry standards
- 50/50 rule (50% distributions/50% wages
- Safe Harbor Rule (set wages at the SS. Max)
Quote of the Week
“Death and taxes may be inevitable, but they shouldn’t be related.” – J.C. Watts
The task of the week
Reasonable compensation is often overlooked until it’s too late. So do the work now to make sure you can substantiate how you determined your salary if the IRS comes knocking.