The old adage “Simple isn’t always easy” perfectly sums up the IRS and Court guidelines for determining Reasonable Compensation. At first blush the IRS and court guidelines seem simple enough – but once you start to follow the roadmap the IRS and Courts have laid out – simple quickly turns to challenging.
Following are five steps for calculating Reasonable Compensation for any closely-held business owner:
Step One: Decide which approach best fits your client’s situation. The IRS Job Aid on Reasonable Compensation discusses three approaches:
Cost Approach (a.k.a. Many Hats Approach): Considers all tasks a business owner provides, such as administration, accounting, marketing, purchasing etc., then breaks the time spent by the owner down in the various tests performed. Wage levels are assigned for each task based on the owner’s proficiency, then added back together to obtain a hypothetical replacement cost. Commonly used for small businesses where the owner is wearing multiple ‘hats.’
Market Approach (a.k.a. Industry Comparison Approach): Looks at compensation of employees and businesses of similar size and from the same industry. This approach then compares both the business and the position of the owner to that of its peers. Commonly used for medium businesses where the owner is predominantly or exclusively performing management duties.
Income Approach (a.k.a. Independent Investors Test): Determines whether a hypothetical investor would consider the level of compensation justified based on the financial performance of the company. Commonly used when the owner is considered an outlier and comparability data cannot be found.
Step Two: Gather the appropriate information on your client and their business: (sample Questionnaires below)