Determining Reasonable Compensation using the Cost Approach


The old adage “Simple isn’t always easy” perfectly sums up the IRS and Court guidelines for determining Reasonable Compensation for an S Corp owner.  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 – something that appears simple quickly turns into a challenge.  Let us explore step by step best practices for determining Reasonable Compensation for a shareholder-employee of an S Corp:

Step One: List all the services the shareholder-employee provides for their S Corp.  Don’t leave any out even if they are not income producing.  The IRS guidelines state: “In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income-producing employees or assets.”

Step Two: Estimate the amount of time devoted to the business and break it down by each service listed in Step One.  “Time and effort devoted to the business” is one of the key factors the courts look at when determining Reasonable Compensation.

Step Three: After listing all the services the shareholder-employee provides to their S Corp, find reliable wage data to match the services provided.  Keep in mind that the wage data should match both the services performed and the experience level for each service performed.  The wage data should also be adjusted for the location of the business or where the services are performed (usually the same but not always) since wage data varies widely county to county, city to city, state to state, etc…

Step Four: Do the math.  Multiply the time spent on each service by the wage.  Then tally everything up – easy peasy.

Halftime.  You have now calculated what the IRS and Courts call the shareholder-employees “Replacement Cost” or “Fair Market Value.” Next, you need to apply this figure to the S Corp and adjust as needed.  This is where your CPA, Tax or Financial advisor is your best friend.

Step Five:  Apply the results of Step Four to the S Corp and adjust the amount of Reasonable Compensation accordingly.  Factors that need to be weighed include:

  • Dividend History
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • Compensation agreements

Extra Credit:  Take all your research, documentation and reasoning and add it to your corporate minutes.  This will add an additional layer of defensibility to your Reasonable Compensation figure should it be challenged.  (This tip was shared with us by a retired IRS examiner with 30+ years’ service.)

Or, let RCReports make this both simple and easy.  We take all IRS & Court guidelines into consideration and provide sample language for your corporate minutes.  The online interview takes your client only about 20 minutes.  Results are available immediately and editable for 30 days.

Start exploring RCReports today.

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