Finding the Right Approach to Determine Reasonable Compensation

Paul S. Hamann and Jack Salewski originally wrote and posted this on the RCReports blog page on Nov. 1, 2018. Their full blog page can be found here.

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 occasional clients who just don’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 determine reasonable compensation are:

  1. The cost approach, aka "many hats" approach: Generally works best for small businesses where the owner wears multiple hats;
  2. The market approach, aka the industry comparison approach: Generally works best for medium-sized businesses where the owner performs predominantly managerial tasks; and
  3. The income approach, aka the independent investor 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 on 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 adds them 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 nonowner in an arm's-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 investor test)—Seeks to determine whether hypothetical investors 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 are no comparability data available.

Choosing the approach that best fits the facts and circumstances of your clients and their business enables you to help them accurately determine a defensible reasonable compensation figure.

For more information on the IRS job aid on reasonable compensation, click here. To view a case study of all three approaches, click here.

Situations like this can be a major headache for business owners and valuators. Make sure you have all the information you need for your reasonable compensation calculations with an RCReports subscription.