Most compliance questions require guessing what the government will do. Reasonable compensation is unusual: the IRS published its playbook. The “Reasonable Compensation Job Aid for IRS Valuation Professionals” (Oct. 29, 2014) is the internal training document for the specialists who build the government’s position in these cases. It carries its own caveat, which should be taken at face value: it “may not be used or cited as authority.” It is not law. But it is a candid description of how the examining side approaches the problem, and any owner or advisor building a compensation position should know what is in it.
Three valuation approaches
The job aid frames reasonable compensation as a valuation exercise with three recognized approaches, the same triad used across valuation practice:
- The market approach. What do comparable businesses pay for similar services? This tracks the Treasury regulation’s definition of the standard, compensation “ordinarily paid for like services by like enterprises under like circumstances” (Treas. Reg. § 1.162-7(b)(3)), and in practice runs on occupational wage data and comparability evidence.
- The cost approach. Decompose what the owner actually does into its component functions (management, sales, bookkeeping, production, administration), price each function at market, and build the total from the parts. This is where duties-and-hours documentation carries the load.
- The income approach. The job aid’s own words:
The income approach is based on an “Independent Investor Test,” which seeks to determine whether an independent investor would be satisfied with his/her return on investment when looking at the financial performance of the taxpayer's business in conjunction with the subject employee's level of compensation.
A position that has been checked against all three approaches, rather than resting on one, is speaking the examiner’s language before the examination starts.
The factors come from case law
The multi-factor tests that dominate this area were not invented by the IRS. The job aid says so itself, tracing its factor list to the courts:
These factors are suggested by the provisions of the statute and the associated regulations and have been fleshed out over the years in numerous court decisions. See Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir.1949), See also Owensby & Kritikos, Inc., v. Commissioner, 819 F.2d 1315 (5th Cir. 1987).
Mayson (1949) is the origin of the nine-factor test; Owensby (1987) is its leading application, including the rule that no single factor is decisive. The practical consequence: the government’s factor analysis and the courts’ factor analysis are the same analysis. Documentation organized around those factors serves both audiences at once.
Why the S corp officer is exposed by default
Two authorities do most of the work in the typical S corp examination. First, employment status is automatic for officers: the statute defines “employee” to include “any officer of a corporation” (26 U.S.C. § 3121(d)(1)). Second, the recharacterization consequence has been on the books since 1974: distributions received in lieu of reasonable compensation are wages, on which the corporation owes FICA, FUTA, and income tax withholding (Rev. Rul. 74-44, 1974-1 C.B. 287). When wages are recharacterized, the corporation faces the back employment taxes, and interest and penalties are computed on top of them.
The Tax Court’s Glass Blocks decision shows how short the path can be when the salary is zero and the services are real:
Because Mr. Blodgett was petitioner's employee for the periods at issue and performed substantial services for it yet it did not pay him a salary, its distributions to him are deemed wages and thus are subject to Federal employment taxes.
One further Glass Blocks lesson is procedural. The owner argued his withdrawals were repayments of loans he had made to the company, but the transfers were undocumented, and the court found them to be capital contributions, not loans. Positions without paper lose twice: once on the law, once on the burden of proof.
What this means for preparation
The examining framework is public, stable, and traceable to primary authority. That is unusually good news for anyone willing to prepare. It means the questions are known in advance: what are the duties, what are the hours, what do like enterprises pay for like services, how does the compensation compare to distributions, and would an independent investor accept the arrangement. A compensation file that answers those questions, with market data and pinpoint citations, at the time compensation is set, is doing before the examination what the government’s specialists are trained to do during it.