There are three generally accepted methods for determining reasonable compensation for the owner of a closely-held business. It is important to match each method with the business’s size and business owner’s job duties.
- The Cost approach, aka many hats, approach: Generally works best for small businesses where the owner wears multiple hats.
- The Market approach, aka the industry comparison approach: Generally works best for SMB’swhere the owner performs predominantly managerial tasks.
- The Income approach, aka the independent investors’ test: Generally works best for outliers.
Over the next three months, we will explore each approach in depth. This month we explore the Cost approach for determining reasonable compensation for a closely-held business owner.
The Cost approach takes into consideration all the tasks a business owner provides to their company, such as administration, accounting, marketing, etc… The Cost approach breaks the time spent by the owner down into the various tasks performed; wage levels are assigned for each task based on the owner’s proficiency, and then added back together to obtain a hypothetical replacement cost for the owner.
The Cost approach is generally the best option for determining reasonable compensation for a small business owner. Most small business owners wear a variety of hats in their business and the cost approach takes all those hats into consideration.
The Cost approach (and the Market approach) rely solely on comparability data. In other words, what are other workers paid with similar job duties, similar experience and within the same geographical area? Let us explore step by step best practices for determining Reasonable Compensation using the Cost approach.
Step One: List all of the services the business owner provides to their company. Don’t leave any out even if they are not income producing. The IRS guidelines on determining reasonable compensation for an S Corp. 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 business owner provides to their company, find reliable wage data to match to the services listed. Keep in mind that the wage data should match both the services performed and the proficiency level of the business owner. The wage data should also be drawn from 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.
You have now calculated what the IRS and Courts call the business owners “Replacement Cost” or “Fair Market Value” or what Valuation experts call the “Hypothetical Replacement Cost of an owner or key manager of a business.”
The IRS compares the Cost approach for determining reasonable compensation for a business owner to the replacement cost for valuing real estate. In the cost approach for valuing real estate, the appraiser would value the subject property by adding up the replacement cost of all its components; bricks, shingles, two by fours, windows etc… As you can see both share a very similar process.
