How to Stress Test a Reasonable Compensation Figure

Stress testing a reasonable compensation figure is simple. The courts have listed the factors they consider when determining whether a reasonable compensation figure is indeed reasonable. We can use those factors to “stress test” any reasonable compensation figure.

There are six factors* or tests, but applying just the first three will usually tell you whether a compensation is reasonable or not. In other words – three strikes and you’re out.

As an illustration we will use a well-known court case: Watson v. IRS. Background and facts:

• Watson was a CPA and worked full time for his firm (approx. 40/week)
• Watson had a graduate degree in tax and 20 years of experience
• Watson paid himself $24,000 in reasonable compensation
• Watson received approximately $200,000 in distributions

The IRS challenged Mr. Watson’s reasonable compensation and determined a fair amount to be just over $91,000. The courts agreed.**

Let’s stress test Mr. Watson’s reasonable compensation figure of $24,000 against the first three factors:

1. 1. Training and experience: Does $24,000/year seem like enough compensation for somebody who has a graduate degree in tax and 20 years of experience? No. Strike 1
   2. Duties and responsibilities: Does $24,000/year seem like enough compensation for a CPA and managing partner? No. Strike 2
   3. Time and effort devoted to the business: Does $24,000/year seem like enough compensation for someone who worked full time for their firm? No. Strike 3 – You’re out!

Now let’s modify the facts a little bit and apply these three factors again. What if Mr. Watson only worked 10 hours per week for his firm?

1. 1. Training and experience: Does $24,000/year seem like enough compensation for somebody who has a graduate degree in tax and 20 years of experience? No. Strike 1
   2. Duties and responsibilities: Does $24,000/year seem like enough compensation for a CPA and managing partner? No. Strike 2
   3. Time and effort devoted to the business: Does $24,000/year seem like enough compensation for someone who worked 10 hours/week for their firm? Yes, actually it does. The IRS calculated $91,000 as a fair reasonable compensation figure for Mr. Watson who worked 40 hours per week. Calculate 25% of that figure and you get $22,750. Very close to the $24,000 figure Mr. Watson used.

This is why we need to look at these three factors together before we pass judgment. Once we have a reasonable compensation figure that passes the first set of criteria above, we should consider a couple other factors that sometimes come into play.

1. 4. What comparable businesses pay for similar services: Was comparability data used and was it reliable? Mr. Watson had no research or documentation to justify is $24,000 salary.
   5. Payments to non-shareholder employees: This is an internal check to see if Mr. Watson was paying himself fairly when we look at what other employees in the firm were paid. This factor is sometimes misconstrued by some to mean that the owner must be paid more than anyone else. This is not true, but instead we must compare the duties and responsibilities of Mr. Watson against employees that perform similar duties and responsibilities, and then compare their respective salaries.
   6. Compensation agreements: Although this factor rarely comes into play, because an arm’s-length agreement between the shareholder-employee and the officers of the company is generally not feasible (since they are usually the same person or related parties). However, if an independent Board of Directors negotiates a compensation agreement the courts will put significant weight on this factor.

All RCReports Subscribers can access a copy of our reasonable compensation stress test in the Resource Tab of your RCReports Dashboard. Demonstrate to your clients that their compensation is either reasonable or unreasonable.

With increased scrutiny of S Corp.’s reasonable compensation [IRS Aims Big Data at Officer Compensation] on the way, now’s the time to get your S Corp clients reasonable compensation in order before you’re looking down the barrel of an IRS reasonable compensation challenge.

*The IRS lists 9 factors on their web site that the courts take into consideration when looking at the reasonable compensation for a shareholder-employee of an S Corp. They can come into play depending on the facts and circumstances of a case but are not generally not used to stress test a reasonable compensation figure:

1. 7. The use of a formula to determine compensation: Think of this as showing your work. In math class you didn’t give credit for only having the answer, you also needed to show your work. If you prefer to use a formula over comparability data you can use the Income Approach.
   8. Timing and manner of paying bonuses to key people: This factor has some of its roots in C Corp.’s, but also refers to the fact that compensation does not have to be cash; it can be other things of value. Timing refers to the fact that reasonable compensation issues can span multiple years and include look-back periods.
   9. Dividend history: For more on this factor please see What if an S Corp Owner can’t afford to pay Reasonable Compensation?

**Mr. Watson appealed the lower court’s ruling to the District Court level and lost. Following that he appealed his case to the Supreme Court, and that appeal was denied.