- August 1, 2021
- Posted by: Paul Hamann
- Category: Blog
By Paul S. Hamann & Jack Salewski, CPA, CGMA
We recently polled 993 CPAs, EA’s, and other tax professionals to find out if they could recognize fact from fiction as it applies to the IRS’s guidance on how to determine reasonable compensation. 81% believed the fiction.
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
81% selected A,B,C or D – all of which are myths. Congratulations to the 19% who got it right.
So, what gives? Why do so many accountants believe these myths are “rules”?
Because (surprise!) there’s a lot of wrong and outdated information on the internet. 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”. Some posts go back 15-20 years (understandable) but even today, with IRS resources and case studies at everyone’s fingertips, highly respected publications are still perpetuating myths:
“[Reasonable Compensation] …should not be more than 50% of the total amount you take out of your business.” ~ Entrepreneur Magazine November 19, 2020
“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
It is easy to see why so many tax professionals believe that a quick and easy 50/50 or 40/60 calculation will deliver a defensible Reasonable Compensation figure. But tax law is not a popularity contest. In this case the popular answers are wrong.
How did these myths get so entrenched in the profession? For a long time, the IRS provided no guidance. Turns out it’s not just nature that abhors a vacuum, so do professionals. Without official guidance, the industry made up its own “rules of thumb” and “safe harbors” to fill the void. These rules of thumb and safe harbors were initially strategies to keep off the IRS’s radar and nothing more. All the recent Forbes and Entrepreneur articles prove is that the myths became so deeply ingrained it doesn’t even occur to experts that they should seek out more up-to-date guidance.
Reasonable compensation first appeared as an IRS issue in 1918. Fast forward 75 years (my kind of history lesson 🙂 ) to the 1990’s. This is our best estimate of when the 50/50 myth caught on. Tax professionals were looking for guidance on how to determine reasonable compensation. With no help from the IRS, two “rules of thumb” emerged. There are varying accounts of who first suggested these rules of thumb and when, but one thing we do know – over time Tax Professionals began to believe they were actual “rules”.
- The “50/50 Rule” – Split distributions and reasonable compensation 50/50 (or use a percentage of net sales, gross receipts etc.)
- The “Safe Harbor Rule” – Pay the Social Security (SS) Max as reasonable compensation and take the remainder as distribution, a more cautious approach.
It wasn’t until 2005 that the IRS decided to address its shortcomings on the issue. I won’t bog you down in details – here is the short version: the IRS launched a compliance study of S Corp.’s and radically changed its enforcement and compliance strategy based on the findings. (See GAO report) and provided, for the first-time, guidance on how to determine reasonable compensation. (See Fact Sheet 2008-25). Spoiler alert, no mention of rules of thumb.
Beginning in 2010 we started to see the results of the IRS’s new enforcement and compliance strategy in a new series of court cases beginning with Watson in 2010 where we saw for the first time an attempt (albeit clumsy) to determine reasonable compensation using comparability data instead of the previous all or nothing adjustments from a decade earlier.
Followed by McAlary in 2013 where the Court rejected the rule of thumb relied upon by the IRS Subject Matter Expert (SME), stating: “(IRS Expert) did not explain how a comparison of compensation measured as a percentage of gross receipts with compensation measured as a percentage of net sales would aid the Court … In the end, we do not find this portion of (the expert’s) report to be persuasive or helpful.”
McAlary also determined reasonable compensation using comparability data and we get an early glimpse at what we now call the cost approach (aka many hats approach) for determining reasonable compensation.
And let’s not leave out Glass Blocks, also in 2013, where we learned that an S Corp can lose money and still be required to pay reasonable compensation (click HERE for more on all three cases).
In 2014 the IRS put together an internal job aid that outlined three fact-based approaches for determining reasonable compensation, putting an end to any lingering myths on the subject. These approaches have dominated how reasonable compensation is determined for the last decade and will likely continue for the foreseeable future.
Now, the next time you gather with your peers look to your left, then to your right. Statistically, four out of five of them are relying on myth, but not you, because you’re up to date.