At the recent NACVA conference in New Orleans, former IRS manager Michael Gregory (Michael Gregory Consulting LLC) did a session on the recently released IRS job aid on reasonable compensation. Gregory worked on the job aid while he was with the agency. The IRS uses three sources of data when examining reasonable compensation: Watson Wyatt, RMA’s Annual Statement Studies and the Economic Research Institute (ERI), but ERI is used only for classification purposes, not for bottom-line numbers, according to Gregory.
In examining compensation issues, the IRS looks at ratios for red flags, he points out. For example, if a company is operating in the 25th percentile and its compensation is in the 90th percentile, the IRS is likely to “take a look.” Also, if compensation reported by a pass-through entity drops materially (without a corresponding drop in financial performance), the IRS will take note but will typically not take any action. However, if this continues in a second year, an audit could be triggered if the IRS feels the company is trying to avoid payroll taxes.