Rule of Thumb Used to Calculate Reasonable Compensation Shot Down in Court

By Paul S. Hamann & Jack Salewski, CPA, CGMA

Accountants are facts and figures folk. Accountants rely on data and analysis, not myths and tales.

Well, not always. In 2020 we asked 4,671 Tax Advisors if the IRS recognized Rules of Thumb such as a 50/50 split between distributions and reasonable compensation. Thirty-three percent said yes.

The IRS “Rule of Thumb” is a myth. But it’s a fact that we found 1,555 professional accountants who relied on this myth.

It’s not that they didn’t have the facts.  All of those surveyed had just attended a continuing education class on reasonable compensation that walked them through, step by step, recent court cases, the IRS’s definition, rules, guidelines, and criteria for determining reasonable compensation outlined in IRS Fact Sheet 2008-25. Nowhere in the class were they taught that the IRS accepts “rule of thumb” or “safe harbor” calculations based on percentage of distributions, sales, or revenue.

So why do so many professionals (a third!) believe the myth? Economist John Kenneth Galbraith may have had the answer.  “We associate truth with convenience, with what most closely accords with self-interest and personal well-being or promises best to avoid awkward effort or unwelcome dislocation of life”.

Have you been relying on Conventional Wisdom, Rule of Thumb, or Safe Harbor calculations when advising your S Corp clients? Suggesting they split their distributions and reasonable compensation 50/50? Or use a percentage of net sales, gross receipts, or the Social Security maximum? If so, you are leaving you and your clients vulnerable to an IRS reasonable compensation challenge.

“But, but!” you’re thinking.  [We’re reading your mind here.] “I read somewhere that 50/50 is an accepted rule of thumb. In a reputable source, maybe Entrepreneur magazine, or Forbes!”

Entrepreneur magazine and Forbes did in fact publish articles written by CPA’s that proffered the following advice:

“[Reasonable Compensation] …should not be more than 50% of the total amount you take out of your business.” ~ Entrepreneur Magazine November 19, 2020

and

“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

So you can be forgiven for believing that a quick and easy 50/50 or 40/60 calculation will deliver a defensible Reasonable Compensation figure. But it’s still a myth you must disregard. All the Forbes and Entrepreneur articles prove is that the myth is so deeply ingrained in the professional that even experts are duped.

In the United States, Courts decide tax disputes and the 2013 McAlary case shot down the “Rule of Thumb” in no uncertain terms. In McAlary, 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 experts) report to be persuasive or helpful.”

All 4,671 accountants we surveyed had learned about the McAlary case, including the 33% who continued to believe a 50/50 split between distributions and compensation was a reasonable rule of thumb. It’s a fact that mythology is exceedingly difficult to dislodge. But in court, myth makes a weak legal defense.

So, what do you rely on? Legal fact or convenient myth? For those who want to get it right, check out these links:

What Is Reasonable Compensation?

How Do You Know If Compensation Is Unreasonable?

Step By Step Guide: How To Calculate Reasonable Compensation

Then the next time you gather with your peers, hopefully again soon, look to your left, then to your right. Statistically, one of them is relying on myth, but not you, because you will have the facts.



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