By Paul S. Hamann & Jack Salewski, CPA, CGMA
A few months ago an internal IRS Job Aid (Appendix) for determining Reasonable Compensation became public. The Job Aid was developed by a team of IRS valuation professionals from the Large Business and International Division. Can this job aid provide insight on determining Reasonable Compensation for Small Closely-Held businesses? Yes, however sifting through the 54-page document and pulling out the relevant information can be mind-numbing.
The Job Aid describes three Approaches for determining Reasonable Compensation:
What you should know about each approach and its relevance to Small Closely-Held companies.
Income Approach is based on an “Independent Investors Test,” which seeks to determine whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.
The income approach can only be used when the Fair Market Value (FMV) of the business is known. The FMV of a small business often varies significantly year to year and can be challenging and time-consuming to determine. Even if an FMV for the business can be established, it can be a challenge to determine what an “independent investor” would require as a return on their investment given the level of risk involved etc.
Because of this, the Income Approach is not a practical method for determining Reasonable Compensation for most Small Businesses Owners. The process can take weeks, sometimes months, a valuation expert would need to be retained and the cost can range from $3,000 – $10,000 depending on the level of complexity.
Market Approach determines the owner’s compensation by looking at the compensation of employees in businesses of similar size and from the same industry (also referred to as Industry Comparison Approach). The market approach focuses strongly on the owners business and the specific position held by the owner, typically CEO, or General Manager. This approach then compares both the business and the position to that of its peers to draw a conclusion for what a Reasonable Compensation amount should be.
This approach works well if the business is a large public entity, annual reports can be requested and compensation comparisons can be made between companies in the same industry and of similar size. In addition with businesses this size you would typically pull from a national pool of candidates to find a suitable replacement for the owner, so in addition to annual reports, national industry-specific wage data can be found through the Bureau of Labor Statistics (BLS), industry associates and private data providers.
The negatives with using the Market Approach with small businesses are twofold.
1) The majority of small business owners perform more than one job task for their business, often performing several tasks. The market approach works well when only one occupation, (usually upper-management), is being compared to peers in the same industry, with similar company size and geographic area.
2) The data itself: Small businesses hire from a local talent pool – not a national one, so what looks like a good source of data, (the BLS industry-specific wage data) is not helpful because it is only provided on a national scale, rather than a local scale. To further complicate the issue, small businesses are not required to disclose financial information; therefore, available data has been disclosed voluntarily (usually to obtain financing). Private sources of such data include the Risk Management Association (RMA), Economic Research Institute (ERI) and Trade Publications. This data does not come ready to use; the compensation levels must be interpolated using the financial reports from these sources. A valuation or compensation expert would need to be retained to gather the raw data, run the proper analysis, make the needed adjustment and prepare their opinion of what the Reasonable Compensation figure should be.
Again, both the time involved and the cost would be prohibitive for most small businesses. More significantly, the judge in a recent reasonable compensation case involving a small business owner Sean McAlary threw out the market approach stating: “(The IRS Valuation 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”. (The cost approach was ultimately used.)
Cost Approach takes into consideration all the tasks a business owner provides to their company, such as administration, accounting, marketing, purchasing etc. (also referred to as the Replacement Cost Approach). The cost approach breaks the time spent by the owner down into the various tasks performed; wage levels are assigned for each task based on the owner’s proficiency, and then added back together to obtain a hypothetical Replacement Cost for the owner. Of the three approaches, the Cost Approach is the only practical method for most small business owners.
The good news – typically small business owners can perform this analysis on their own. The wage data does not have to come from within the same industry (as it does for the Market Approach); therefore cross-industry wage data can be used. Reliable, local, cross-industry wage data is much more prevalent than industry-specific wage data, and can usually be found from free sources such as the BLS. The bad news – the process of inventorying all the job tasks performed by the owner, finding and assigning wage levels can be very time consuming, and even though the BLS has a significant free database of wages, it is far from complete and not at all user-friendly.
The best news – a subscription service that uses the Cost Approach, along with IRS guidelines and court rulings, is available to Tax and Financial advisors whose Small Business clients need to determine Reasonable Compensation. Although it is not a free source of wage data, it is inexpensive compared to enlisting a valuation or compensation expert.
The two best features of the software are: 1) its proprietary wage database – no holes; subscribers will find a wage for over 800 occupations, for every county in the U.S. – three times the size of the BLS wage database. 2) It is fast! A quick & simple online interview takes about 20 minutes (+/-) to complete and can be completed by the Small Business Owner or their Advisor. Learn more at RCReports.com.