The most popular methods for computing reasonable compensation are, like the cool kids in high school, cute and fun to hang around with, but not who you need at your side come finals week. Conventional Wisdom, Rule of Thumb, and Safe Harbor methodologies win the popularity contest among accountants, but all three get an “F” in front of tax court judges.
We recently polled 4,541 CPAs, EA’s, and other tax professionals. Here’s what we asked: Which of the following methods of determining reasonable compensation are recognized by the IRS?
A. Industry Rule (Set wages as a percentage of sales or revenue based on industry standards)
B. 50/50 Rule (50% distribution – 50% Wages)
C. Safe Harbor Rule (Set wages at the S.S. Max)
D. All the above
E. None of the above
More than three-quarters selected A, B, C or D. Fail! Only 23% passed the test. “E” (None of the above) is the right answer.
Accountants are facts and figures folk. You all studied for the exam! So why did so many get it wrong? Because instead of hanging out with the nerds, they were studying with the popular press and Google.
Entrepreneur magazine and Forbes did in fact publish articles written by CPAs that proffered the following advice: “[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
Also, there’s a lot of wrongs and outdated information on the internet (surprise!). Google some variation of “S Corp salary 50/50 rule” and up pop the myths. Sources include everything from the prestigious Journal of Accountancy to part-time bloggers, all referencing “the rule.”
So, what gives? Why do so many accountants and business journalists believe myths are “rules”? The answer comes from economics itself. The famed John Kenneth Galbraith opined that “We associate truth with convenience, with what most closely accords with self-interest and personal well-being or promises best to avoid awkward effort or unwelcome dislocation of life”.
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. Even facts and figures professionals are still human. But just because Forbes and Entrepreneur got duped, doesn’t mean you can’t be smarter.
To ace the test, the one you may have to take for real someday beside your client in front of a tax court judge, sit down with the nerds in the library and check out these articles: