This isn’t the first time I’ve posted about the useful resources offered by RCReports — but as it turns out, it’s been a while. Apparently I take it for granted that everyone knows about Reasonable Compensation requirements all too often, and then I regularly discover that it’s just not true.

Note: I am a loyal paid subscriber to RCReports, and receive no compensation or discounts for promoting their service or resources. I just think they’re great.

In any case, recently I was asked by a colleague to train her on the basics of Reasonable Compensation and walk through my process. I asked her to do these three pieces of homework first:

1. Read this article about stress-testing the RC amount – How to Stress Test a Reasonable Compensation Figure – RCReports
2. Watch this 2-hour RC Reports training session – Reasonable Compensation for S Corps on Vimeo
   (tip for professionals – this class is sometimes offered on CPAacademy for free, with CPE credit included).
3. Watch this 1-hour RC Reports demo – RCReports Product Demo – RCReports

I know most non-accountants won’t bother with the 2-hour training session that walks through court cases and the history of Reasonable Compensation audits and challenges. And certainly folks who are not in the business of performing these calculations aren’t likely to bother with the 1-hour demo.

But anyone running their own corporation, and those considering electing S-corp status, will want to read about stress-testing. This is something you can do regardless of the calculation process, or how you got to the salary amount in the first place. A helpful excerpt (edited) from the article:

There are six main factors or tests (the IRS lists even more), but “applying just the first three will usually tell you whether a compensation is reasonable or not. In other words – three strikes and you’re out.”

1) Training and experience: Does $X/year seem like enough compensation for somebody who has this level of training and experience?
2) Duties and responsibilities: Does $X/year seem like enough compensation for someone with these duties and responsibilities?
3) Time and effort devoted to the business: Does $X/year seem like enough compensation for someone who worked this many hours/week?

But what if the company can’t afford to pay reasonable compensation? I hear that question a lot, as you might imagine. That’s a common situation, and a simple answer — you’re not required to pay yourself the entire amount of salary… it just means that you can’t issue distributions until it has been paid. “The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.” And no fair holding off on paying salary for years while building up retained earnings and then issuing a huge distribution in the first year you pay yourself salary. The IRS knows that trick as well. RCReports writes more about the issue in this article — check out Example 4 in particular for information about the look-back period.

There are different methods of determining Reasonable Compensation — yes, I’m referencing yet additional RCReports articles for details — the cost approach, market approach, and income approach. The Cost Approach generally works best for small businesses where the business owner provides multiple services for the business (wears many hats).

The key with all of these resources is to get shareholder-employees to take a closer look at their own salaries and make sure they are following IRS guidelines. Stress-testing is a great place to start, but for a more thorough approach to calculating Reasonable Compensation, I recommend contacting a CPA with background in this area who can walk you through an RC interview and help you support the amount you ultimately choose.

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