By Paul S. Hamann
“Another one bites the dust.” Just a line that popped into my head when I read the recent Reasonable Compensation (RC) case: Sean McAlary Ltd, Inc. v. Commissioner. McAlary Ltd. joins a long list of S Corps that have lost their RC challenges in court, about 25 in all. The McAlary case is not that different from the other cases but it does provide some great insights into how the IRS determines RC and how the court weights the various aspects of the IRS’s determination.
Compensation Agreements – McAlary had a Compensation Agreement, but the courts didn’t buy it: “We are not persuaded that the remuneration agreement represents a sound measure of the value of the services that Mr. McAlary provided to petitioner during 2006. We cast a skeptical eye on the agreement inasmuch as Mr. McAlary sat on both sides of the table when the agreement was executed, occupying the positions of both employer and employee. The agreement clearly was not the product of an arms-length negotiation.”
Take Away – Even though compensation agreements are 1 of 9 factors the courts will consider when determining RC they need to be reasonable, represent real value, and be negotiated between disinterested parties.
2,080 – This is the magic number for multiplying an hourly wage to get an annual salary. The Bureau of Labor Statistics defines “year-round, full-time” employment as 2,080 hours per year (40 hours per week). Both the IRS expert and the courts used this number to determine McAlary’s RC figure from an hourly wage figure, even though McAlary regularly worked 12 hours days and six to seven days a week.
Take Away – This is one of the few pieces of guidance the courts and the IRS have given us that actually makes things clearer and simpler. (RCReports has always used 2,080 as full-time year round employment in its algorithms.)
Bureau of Labor Statistics Rules – To determine McAlary’s RC, the IRS used a simple calculation: $48.44 hourly wage times 2,080 = $100,755. The $48.44 is the median wage for a real estate broker in southern California, according to the California Occupational Employment Statistics Survey.
Take Away– The California Occupational Employment Statistics Survey is produced jointly by the Bureau of Labor Statistics (BLS) and the California Department of Labor. So going to your local state agency rather than the BLS for wage data should make little or no difference in the wage data available. (RCReports uses BLS wage data as the basis for all of its RC calculations.)
Fluff – In addition, the IRS compared McAlary’s financial performance with that of his peers. However, the courts did not find this analysis helpful: “Mr. Ostrovsky (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 this case. In the end, we do not find this portion of Mr. Ostrovsky’s report to be persuasive or helpful.”
Take Away – For the majority of small business owners, injecting analysis of wages at this level is overkill. As the IRS expert stated: $48.44 per hour was “fair market value of the services that Mr. McAlary performed for petitioner that year.” Right from BLS to your table…
$40.00 v. $48.44 – In the end, the courts' final determination of McAlary’s RC figure was $40 per hour or $83,200 annually. In explaining its reasoning the court states that the $83,200 “represents reasonable compensation for the various services that Mr. McAlary performed…”
Take Away – The court cited the “totality of facts and circumstances” for reducing McAlary’s RC from the $100,755 to $83,200. However what caught our attention was the court’s reference to the various services McAlary performed versus the IRS keying on only McAlary’s “primary job function” of real estate broker. McAlary stated that: “He managed all aspects of (McAlary Ltd), including recruiting and supervising sales agents, conducting real estate sales, procuring advertising, purchasing supplies, and maintaining basic books and records.” (RCReports thoroughly accounts for all the services an SE provides to their S Corp.)
We will leave you a final thought from the court. It is some of the best advice we have heard on the issue of Reasonable Compensation: “Determining an employee’s reasonable compensation is dependent upon a number of factors and is far from an exact science.”