How Are You Determining Reasonable Compensation – Legal Fact or Convenient Fiction?

Accountants are facts and figures folk. Accountants rely on data and analysis, not myths and tales.

Well, not always. In 2020, we asked 4,671 tax advisors whether the IRS recognized rules of thumb such as a 50/50 split between distributions and reasonable compensation. Thirty-three percent said yes.

The IRS “rule of thumb” is a myth. But it’s a fact that we found 1,555 professional accountants who relied on this myth.

It’s not that they didn’t have the facts. All of those surveyed had just attended a continuing education class on reasonable compensation that walked them through, step by step, recent court cases, the IRS’s definition, rules, guidelines, and criteria for determining reasonable compensation. Nowhere in the class were they taught that the IRS accepts “rule of thumb” or “safe harbor” calculations based on percentage of distributions, sales, or revenue.

So, what gives? Why do so many accountants believe these rules of thumb are actually “rules”? And more importantly, does the IRS follow the same?

Try searching for some variation of “S Corp salary 50/50 rule,” and the results will dumbfound you. They include everything from the prestigious (Journal of Accountancy) to the part-time blogger all referencing “the rule.” Some posts go back 15 to 20 years (understandable) but even today with facts at everyone’s fingertips, highly respected publications are still perpetuating the myth:

“[Reasonable Compensation] …should not be more than 50% of the total amount you take out of your business.” – Entrepreneur Magazine, November 19, 2020

and

“Determine your reasonable compensation. There are multiple ways to do this, and a good starting point is 40% of your profits.” – Forbes Magazine, October 15, 2020

So, you can be forgiven for believing that a quick and easy 50/50 or 40/60 calculation will deliver a defensible reasonable compensation figure. But it’s still a myth you must disregard. All the Forbes and Entrepreneur articles prove is that the myth is so deeply ingrained in the profession that even experts are duped.

OK, this is not a history lesson; however, it does help to have a little perspective.

• 1918–2004: A Myth Is Born – All or Nothing
• 2005–2009: Say Goodbye to the Myths – Hello to Guidance
• 2010–2020: Facts NOT Fiction – Enforcement

1918–2004: A Myth is Born – All or Nothing

Reasonable compensation first appeared as an IRS issue in 1918. Fast forward 75 years (my kind of history lesson) to the 1990s. This is our best estimate of when the 50/50 myth caught on. Tax professionals were looking for guidance on how to determine reasonable compensation. With no help from the IRS, two “rules of thumb” emerged. There are varying accounts of who first suggested these rules of thumb and when, but one thing we do know: Over time tax professionals began to believe they were actual “rules.”

• The “50/50 Rule” – Split distributions and reasonable compensation 50/50 (or use a percentage of net sales, gross receipts etc.)
• The “Safe Harbor Rule” – Pay the Social Security (SS) max as reasonable compensation and take the remainder as distribution, a more cautious approach.

“Rules of thumb were likely strategies to keep off the IRS’s radar and nothing more.”

Beginning with the new millennia, the IRS won a series of court cases establishing its authority to reclassify distributions as wages if paid in lieu of reasonable compensation. (See Joly^[1]) and reinforced the employment status of shareholders as employees (See Veterinary Surgical Consultants^[2] and Joseph M. Grey^[3]) kicking off a decade long assault on the status quo.

The court cases from this timeframe are what we refer to as the “all or nothing” cases. The IRS pursues taxpayers who paid no reasonable compensation and took large distributions. The IRS reclassifies the entire distribution as reasonable compensation – all or nothing from both sides of the aisle (a.k.a. pigs get fat, and hogs get slaughtered).

2005–2009: Say Goodbye to the Myths – Hello to Guidance

Let’s not get bogged down in details. Here is the short version: The IRS launched a compliance study of S Corporations^[4] and radically changed its enforcement and compliance strategy based on the findings (see GAO report^[5]) and provided, for the first time, guidance on how to determine reasonable compensation. (See Fact Sheet 2008-25^[6]). Spoiler alert, no mention of rules of thumb.

2010–2020: Facts not Fiction – Enforcement

 The IRS took its new enforcement strategy out for a test drive based on the GAO Report findings and recommendations. The result? Recommended adjustment to S Corp examinations more than doubled from $50,739 (GAO report for tax years 2003-2004) to $105,534 (TIGTA Report tax years 2007-2011).

Taxpayers fought back, but the IRS prevailed in a new series of court cases beginning with Watson^[7] in 2010 when we see for the first time an attempt (albeit a clumsy one) to determine reasonable compensation using comparability data instead of the previous all or nothing adjustments from a decade earlier.

Followed by McAlary^[8] in 2013 when the Court rejected the rule of thumb relied upon by the IRS Subject Matter Expert (SME), stating: “(IRS Expert) did not explain how a comparison of compensation measured as a percentage of gross receipts with compensation measured as a percentage of net sales would aid the Court …. In the end, we do not find this portion of (the expert’s) report to be persuasive or helpful.”

McAlary also determined reasonable compensation using comparability data, and we got an early glimpse at what we now call the cost approach (a.k.a. many hats approach) for determining reasonable compensation.

And let’s not leave out Glass Blocks^[9] also in 2013 where we learned that an S Corp can lose money and still have to pay reasonable compensation. (Click here for more on all three cases).

In 2014, the IRS put together an internal job^[10] aid that outlined three fact-based approaches for determining reasonable compensation, putting an end to any lingering myths on the subject. These approaches have dominated how to determine reasonable compensation for the past decade and will likely continue for the foreseeable future.

Lately IRS enforcement has been a hodgepodge of cobbled together initiatives and training including:

• Preparer Penalties (circa 2015)^[11]
• Reasonable Compensation added to IRS examiners’ checklist (2018)^[12]
• 2,500 agents trained on reasonable compensation (2019)^[13]

2021+: Enforcement?

So, what will this decade bring? COVID aside, it appears the IRS has all the tools, knowledge and personnel to pursue this issue, but maybe the bigger question is: Will they? If the IRS continues to stumble along as it has during the past six to seven years, those who fall in the web (around 1 percent) will face large adjustments resulting in massive tax, penalty, and interest assessments. However, if the IRS focuses its tools and trained personnel on this issue, a tsunami of reasonable compensation challenges are headed our way.

Great, you’re thinking to yourself, the information above helps me understand why I should avoid rule of thumb approaches and that a lot has changed over the past 10 to 15 years, but what I really need to know is how to determine reasonable compensation that meets IRS guidelines and provides a defensible position for my clients and me. Wait no longer…

Here 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:

1. Cost Approach (a.k.a. Many Hats Approach): Considers all tasks a business owner provides, such as administration, accounting, marketing, purchasing etc., then breaks down the time spent by the owner 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.”
2. Market Approach (a.k.a. Industry Comparison Approach): Looks at compensation of employees and businesses of similar size from the same industry. This approach then compares both the business and the owner’s position to those of their peers. This approach is common for medium businesses when the owner is predominantly or exclusively performing management duties.
3. 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. The approach is common when the owner is an outlier, and comparability data cannot be found or as a secondary method in examination and litigation.

Step Two: Gather the appropriate information on your client and the business: (sample questionnaires below)

1. Cost Approach Questionnaire Download
2. Market Approach Questionnaire Download
3. Income Approach Questionnaire Download

Step Three: Gather Comparability Data (or apply the formula for the Income Approach).

(Note: Cost or market approach fits almost all closely held business owners.)

• Task specific wage data for the cost approach, or
• Industry-specific management salary data for the market approach, or
• Financial performance data and formula for the income a

When choosing a data set, investigate the following:

• Track Record: Has this data succeeded when challenged?
• Collection Method: Was the data collected in a scientific manner?
• Complete Data: Can you find what you’re looking for all in one place, or will you have to use data from multiple sources?
• User Friendly: This point is not imperative; however, it will save you a boatload of time.

Step Four: Do the math.

Step Five: Take all your research, documentation, and reasoning and add it to the corporate minutes. This will add an additional layer of defensibility to the reasonable compensation figure should it be challenged.  (A retired IRS examiner with 30+ years’ service shared this tip.)

Just so you are prepared, you should budget 8 to16 hours to work through the process above.

Now, the author is a big DIY guy but not for everything, just stuff he enjoys and/or has the time for, and reasonable compensation analysis is not one of them, which is why RCReports was founded in 2010. We took a 1-to-2-day process and condensed it to 5-15 minutes.

For more on RCReports and why Editor-in-Chief, Dominique Molina, CPA, CTC and the TOTTB.tax team recommend us follow this link.

The next time you gather with your peers (hopefully again soon), look to your left, then to your right. Statistically, one of them is relying on myth, but not you, because you have the facts.