Why there is no Safe Harbor for Reasonable Compensation Figures

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

Maybe instead of a ‘Safe Harbor,’ we should look for ‘Any Port in a Storm’.  The IRS and Court Guidelines for determining Reasonable Compensation for an S Corp are anything but smooth sailing.  We are often asked if there are any guarantees that the IRS will accept a Reasonable Compensation figure.  The short answer is NO.  Why?  Because calculating a Reasonable Compensation figure is not included in any of the thousands of pages of IRS Code or Regulations.  Therefore we are left to look at how the Tax Courts interpret Reasonable Compensation in S Corp cases.

The IRS points us to a list of factors the courts may consider when determining Reasonable Compensation, but the list is more of a ‘Stress Test’ to determine if the Reasonable Compensation figure is ‘reasonable’ rather than a ‘how to’.  If you would like more info on ‘How To’ see: Step by Step: How to Determine Reasonable Compensation for an S Corp Owner

When looking for direction from the courts, three recent cases that are helpful are:

  • David E. Watson, P.C, v. United States of America 2010
  • Sean McAlary Ltd, Inc. v. Commissioner of Internal Revenue 2013
  • Glass Blocks Unlimited v. Commissioner of Internal Revenue 2013

If you would like more info on these cases see: Three Court Cases that Define the Modern Era of Reasonable Compensation

So what can you offer your clients if there are no guarantees?  A defensible position.

To build strong defensible Reasonable Compensation figures, follow three steps:

  1. Research – What are others paid who provide similar services and perform similar tasks
  2. Document – Memorialize research; save notes printouts and screenshots
  3. Corporate Minutes – Take all research, documentation, and reasoning and add it to the corporate minutes.  This adds an additional layer of defensibility to a Reasonable Compensation figure should it be challenged.

Being proactive is the key when creating a defensible Reasonable Compensation figure.  It is extremely difficult to convince anyone, much less an IRS examiner, that the research and documentation you did yesterday is a reliable backup for the Reasonable Compensation figure you paid yourself three years ago…

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