What is Reasonable Compensation?

What is Reasonable Compensation?

Back to basics. “What is Reasonable Compensation?” (Or, what is meant by Normalizing Owner’s Comp.?)

You get it. CPAs, EA’s, tax and business advisors learn about reasonable compensation in college and continuing education. Not so for business owners. Most business owners have only heard about reasonable compensation from one person – you. Are you explaining it so they “get it” as well as you do?

Here’s how. First, refresh yourself about the basics. Then simplify the basics, expect pushback, and finish with a good story.

Here’s your refresher.  Three of the more popular definitions of reasonable compensation are:

  1. IRS: Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. ~ IRS Code: Section 162-7(b)(3)
  2. Valuation: The hypothetical replacement cost of an owner or key manager of a business.
  3. As a question: How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship, at a similar company?

Then, simplify the basics. If you just read the definitions above to your clients, they will either feign understanding or look at you with blank stares. To simplify:

  1. Replacement Cost: If you had to go out into your community and hire someone to replace yourself and perform all the services and tasks that you perform, what would you have to pay them?
  2. Fair Market Value: If you were to close your business, and go across town and work for a competitor performing the same services and tasks for your competitor that you currently perform, what would the competitor pay you (FMV) for those same services?

Be ready for pushback. Here are the two most common objections that arise when explaining reasonable compensation to a business owner.

  • What’s the end game? Believe it or not, some business owners attempt to drive their reasonable compensation up or down for some perceived benefit. No really, I’m not kidding.
  • But I’m awesome! When a business owner incorporates their ego into their reasonable compensation, it will likely be anything but “reasonable.”

End with a memorable story. There is a tremendous amount of information and research that illustrates how powerful a story can be. To diffuse the objections, tell your own story, or try one of our failsafe examples:

The End Game Story:

A successful S Corp. has ten employees and $5 million per year in sales. The S Corp. has a single shareholder. We’ll call him Alan. Alan is a workaholic, easily exceeding 60+ hours a week, and wears multiple hats.

Alan is adamant that he only wants to pay himself $24,000 a year. His CPA, let’s call him John, asks Alan to write a short job description for himself. Then John asks him to use that job description to imagine a “help want ad” for his replacement – an annual salary of $24,000. Then John asks Alan, would you apply for this job? A job that expects 60+ hours a week, a high level of competency in sales, bookkeeping, and management, for $24,000 a year? The answer isn’t generally no, it’s “(Insert your favorite 4- letter word) No!”

The Ego Story

A very successful business is pulling in $50 million a year gross revenue. The business is a C Corp. with a single shareholder. Let’s call her Jane. Jane has set an annual salary for herself at $7 million.

Her CPA, John, shakes his head. That’s not reasonable, he tells her. But Jane just can’t understand why $7 million per year would not be deemed “reasonable” for the services she provides her very successful company. John asks her to consider taking a year-long cruise around the world with no worries because he’ll take excellent care of her company while she’s gone. Just pull out your checkbook, he says, and write out a check for $7 million for my year’s salary. (I suspect John may really hope this would happen) Her response won’t just be no, it’ll be “(Insert your favorite 4-letter word) No!”

The answer to “What is reasonable compensation?” has wide-reaching implications for closely-held business owners in the areas of tax compliance, entity choice, retirement planning, business valuation, and divorce.  It’s important to get it right.

Refresh, simplify, be ready, and end with a good story.

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