Step by Step Guide: How to Calculate Reasonable Compensation

step by step guide how to calculate reasonable compensation

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 road map 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:

  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 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.’
  1. 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.
  1. 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)

  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 Cost Approach, or
  • Industry-specific management salary data for Market Approach, or
  • Financial performance data and formula for Income Approach.

When choosing a data set, investigate the following:

  • Track Record: Has this data been successful when challenged?
  • Collection Method: Was the data collected in a scientific manner?
  • Complete Data: Will you be able to 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 – easy peasy

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.  (This tip shared with us by a retired IRS examiner with 30+ years’ service.)

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