By Paul S. Hamann & Jack Salewski, CPA, CGMA
Although there are general guidelines to help you pick the best approach to determine reasonable compensation, there are no hard and fast rules. For the overwhelming majority of your clients, one of two common approaches that rely on comparability data should do the trick. For the occasional client that just doesn’t seem to fit any molds, there is an approach for them, too.
What we caution against is not using a recognized approach, commonly referred to as guessing or ballparking. These approaches (if we can even call them approaches) will leave your client vulnerable to an IRS reasonable compensation challenge, with no defensible position.
The three generally accepted approaches (from the IRS Job Aid: Reasonable Compensation) used to determining reasonable compensation are:
- The Cost Approach, aka Many Hats Approach: Generally works best for small businesses where the owner wears multiple hats.
- The Market Approach, aka the Industry Comparison Approach: Generally works best for medium-sized businesses where the owner performs predominantly managerial tasks.
- The Income Approach, aka the Independent Investors Test: Generally works best for outliers.
The Cost Approach (AKA Many Hats Approach) – Breaks the duties of the business owner into its components such as company administration, accounting, finance, marketing, advertising, engineering, purchasing, etc.
The Cost Approach breaks down the time spent by the business owner into the various duties performed and quantifies the amount of time devoted to the different duties. Next, salary surveys are used to determine a comparable wage for each job duty performed by the business owner, then added up to arrive at the total “cost” to replace the services of the business owner.
The Cost Approach generally works best for small businesses where the business owner provides multiple services for the business (wears many hats).
The Market Approach (AKA Industry Comparison Approach) – Compares the business owner’s compensation to compensation within the same industry. The market approach focuses as much as possible on the owner’s business and the specific position being analyzed (often the CEO or General Manager who also owns the business). The question to be answered is: 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?
The Market Approach generally works best for medium and large businesses where the business owner provides only one duty: management of the business.
The Income Approach (AKA Independent Investors Test) – 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 correctly applied when the Fair Market Value (FMV) of the company is available for each year that compensation is examined.
The rationale behind the Independent Investor Test is that investors pay employees to work to increase the value of the assets entrusted to their management. A high rate of return indicates that the assets’ value increased and that the employee provided valuable services. Thus, if investors obtain returns above what they should reasonably expect, an employee’s salary is presumptively reasonable.
The Income Approach generally works best when there is no comparability data available.
By choosing the approach that best fits the facts and circumstances of your client and their business enables you to help them accurately determine a defensible Reasonable Compensation figure.
The Many Hats of a Small Business Owner
Brought to you by the RCReports Support Gurus
If your client is an S-Corp owner and wearing many hats within their company, you as their trusted advisor can encourage them to make time to work on their business, not just in their business.
Completing a Reasonable Compensation report can help your clients identify all the varied task areas they are working in, including income-generating tasks as well as operational tasks.
An RCReports user commented that even her business coach wasn’t able to help her to understand how she spent all of her time as thoroughly as reviewing her own completed Reasonable Compensation report did.
The information and graphs on her completed report encouraged her to consider her strengths and weaknesses in operational areas and identify whether she could outsource, train up or hire for these tasks, focusing her time and attention on the higher-wage work she excelled in. This also allowed her to stay close to her customers, keeping in touch with the pulse of her market, customers’ needs and how her company is doing.
By embracing the many hats she wears for her company, and analyzing which ones she excelled in, she was able to focus more of her time working on her business which in turn, made her business more prosperous.
Everyone has spacey moments and may make the mistake of getting locked out of their car or house. Hopefully, in those times you can call the local locksmith to get you out of the bind. However, locksmiths also perform a lot of installations and repairs in addition to the emergency unlock.
This month we take a look at what Locksmiths make around the country:
- Phoenix Arizona ~ Proficiency Average ~ $20.42/hr
- Napa California ~ Proficiency Average ~ $28.24/hr*
- Kokomo Indiana ~ Proficiency Average ~ $23.96/hr*
- Ocala Florida ~ Proficiency Average ~ $17.82/hr
- Springfield Ohio ~ Proficiency Average ~ $17.20/hr*
~Each month we highlight an occupation from the more than 6,000 occupations included within the RCReports proprietary database of wages~*Wage only available from RCReports