Reasonable Compensation Job Aid for IRS Valuation Professionals

When analyzing a business that is family-operated, closely held or is taxed as an S-corporation, business owners and taxpayers should be especially aware of the issue of reasonable compensation. The Reasonable Compensation Job Aid for Internal Revenue Service (IRS) Valuation Professionals (the Job Aid) is a guide on the reasonable compensation issue in both not-for-profit and for-profit entities.¹ When analyzing reasonable compensation, it’s important to understand the actual reported compensation being paid and whether or not that constitutes reasonable compensation. Reasonable compensation is defined as “[T]he amount that would ordinarily be paid for like services by like organizations in like circumstances.”² This concept has two tests:³

1. The amount test, which focuses on the reasonableness of the total amount paid; and
2. The purpose test, which examines the services for which the compensation was paid.

The reasonable compensation issue is factually intensive and must be determined based on all relevant facts and circumstances. As such, when determining reasonable compensation, consider the following factors:⁴

1. The employee’s role in the company;
2. An external comparison of the employee’s salary and those paid by similar companies for similar services;
3. Character and condition of the company;
4. Any conflict of interest between the employee and the corporation; and
5. Consistency in how company employees are paid.

Where the IRS Finds Reasonable Compensation Issues

When it comes to family-operated businesses, issues of reasonable compensation arise when an employee, who is also a family member, receives higher compensation than a third party to perform the same tasks. The family-operated business might then claim a tax deduction resulting in an inflation the company’s operating expenses by overstating compensation for what could be considered a gift to the family member.⁵ The IRS may classify this as unreasonable compensation.

Similarly, a closely held business can manipulate its income by deducting all of a stockholder’s compensation, rather than classifying it as a dividend. This is an issue because compensation is a deductible business expense, but dividends are not — so deducting stockholder compensation permits the business owner or taxpayer to dictate the tax effect on the closely-held business.

Determining reasonable compensation can also be an issue with respect to an S-corporation because, “[I]f there is more than one owner then tax issues could arise as to the proper party or parties to which a disallowed compensation amount should be allocated. The more likely scenario is that a lesser amount be identified as compensation in order to avoid paying payroll taxes with the remaining amount treated as owner distributions.”⁶

It is the responsibility of a valuation professional engaged in matters in which the IRS has oversight, to perform the necessary due diligence in understanding the Job Aid and considering the applicable methodologies in the analyses of the businesses, the owners and key employees, and their compensation. Before determining reasonable compensation for a business owner or key employee, a valuation professional should review, analyze, and understand the company’s financial performance. They can use that knowledge to spot trends and differences between the subject company and comparable businesses, as well as industry norms.

The Independent Investor Test

The independent investor test is a key component to applying an appropriate level of reasonable compensation under the income approach. This test “…considers the return on investment indicated by the increase in the value of a corporation’s stock along with dividends paid during the time period in question. It looks at the company’s performance throughout the year to determine if the compensation to key employees is reasonable.”⁷

In matters in which the IRS has oversight, the independent investor test is utilized when analyzing a company’s financial performance to determine whether an independent investor would be satisfied with their return on an investment. It involves analyzing the business’s financial performance in conjunction with the subject employee’s level of compensation.⁸ The independent investor test assumes an investor will compensate their employees in exchange for their services and efforts to increase the value of the assets held by the company. Therefore, a high rate of return generally indicates that the value of the assets increased and the employee provided valuable services.⁹ Thus, if investors obtain returns above what they should reasonably expect, then an employee’s salary is presumptively reasonable.¹⁰ However, if the high rate of return on an investment is attributable to events unrelated to the employee’s services, the assumption that their compensation is reasonable is presumed to be invalidated, as the increase is not associated with their role or efforts in the company.

In the independent investor test, dividends, stock appreciation, and corporate earnings are considered in the investor’s total return. That income is then compared to the equity invested in the company to arrive at the annual return on equity.¹¹ When analyzing publicly traded companies, return on equity can be meaningful because the equity is marked to fair market value¹² every day based on the price of the stock. However, for a private or closely-held company, the book value of equity rarely represents the fair market value of the business entity, as the value can include tangible and intangible assets marked to book value rather than their respective fair market value.¹³ In addition, a private or closely-held company may have owners who the IRS presumes to be overpaid based on the relevant facts and circumstances of their job title. In many cases, the business owner or taxpayer may argue that the employee at issue is a key person, without whom the company would either cease to operate or greatly diminish in value.¹⁴ This argument is most common with a highly involved and experienced employee who owns stock in the company, such as the company president or managing partner.

In this circumstance, the business owner or taxpayer can allocate compensation payments to the employee-owners in two ways:

1. Compensation for services performed, which is a deductible business expense; and
2. Compensation for a return on their capital investment, such as dividends and distributions, which is not a deductible business expense.

The valuation professional should be aware of all the potential issues and closely vet the business, employees, and services they perform. In addition, when determining reasonable compensation, a valuation professional should compare the employee-owner’s compensation to that of a comparable employee who is not an owner.¹⁵ Assuming the valuation professional can determine the fair market value of the company, they can calculate a return on equity for any level of compensation and compare it against a required rate of return.¹⁶

However, in some cases, a required rate of return is difficult to quantify, as depicted in Guy Schoenecker, Inc. v. Commissioner.¹⁷ In this matter, Guy Schoenecker, the business owner, claimed his compensation deduction was reasonable based on his position and the services rendered to the company.¹⁸ The court disagreed with that notion after reviewing similar businesses — including competitors of the subject company — that paid lower levels of compensation.¹⁹ It was the court’s determination that Guy Schoenecker earned excess compensation in comparison to that of his company’s competitors. Therefore, when considering the independent investor test, “…it is difficult to determine what an independent investor would expect from the risk of his funds in a business…however, it is reasonable to assume that an independent investor would be unwilling for an officer to realize compensation out of line with compensation paid by similar businesses, thus unnecessarily reducing the income produced by the business in which he had invested.”²⁰

Conclusion

In conclusion, when submitting a company’s financial information to the IRS for any purpose it is important to apply, or at least consider, the Job Aid. The IRS scrutinizes business owners and taxpayers to determine what is reasonable compensation. When quantifying an owner’s or employee’s compensation, a valuation professional should first understand all of their specific facts and circumstances to determine what portion of compensation is reasonable and what is unreasonable. In simple terms, reasonable compensation is the amount of compensation an independent investor would expect to receive in return for their efforts in performing the same duties and obligations as the business owner or employee in question.

Sources

1. Per the Job Aid disclaimer, “the Job Aid is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.”
2. Per Chapter I, Internal Revenue Service, Department of Treasury. Regulations. § 1.162-7(b)(3)
3. Per the Job Aid, page 9, section III: Developing Reasonable Compensation Issues.
4. Per the Job Aid, page 13, section III: Developing Reasonable Compensation Issues.
5. Per the Job Aid, page 3, section II: Identifying a Reasonable Compensation Issue.
6. Ibid.
7. Per the 2023 Economic Research Institute, Inc., website (erieri.com) glossary of commonly used compensation terms and formulas.
8. Per the Job Aid, page 16, section III: Developing Reasonable Compensation Issues, Income Approach.
9. Per the Job Aid, page 16, section III: Developing Reasonable Compensation Issues, Income Approach.
10. Ibid.
11. Return on Equity = annual net income / shareholders’ equity.
12. U.S. Treasury Regulation §25.2512-1, regarding the value of gifts, defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”
13. Per the Job Aid, page 16, section III: Developing Reasonable Compensation Issues, Income Approach.
14. Per the Job Aid, page 16, section IV: Taxpayer Arguments for Reasonable Compensation Issues.
15. Per the Job Aid, page 16, section IV: Taxpayer Arguments for Reasonable Compensation Issues.
16. Per the Corporate Finance Institute (CFI) Education Inc. website, required rate of return, also referred to as a hurdle rate, is the minimum return that an investor is expecting to receive for their investment. Essentially, the required rate is the minimum acceptable compensation for the investment’s level of risk.
17. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner.
18. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Opinion section.
19. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Findings of Fact section.
20. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Opinion section.