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By Jason Watson, CPA
Posted Thursday, November 2, 2023
For several years now, WCG CPAs & Advisors has leveraged RCReports or Reasonable Compensation Reports which is a consulting firm out of Denver, Colorado. They send out a survey to you which asks a bunch of questions about qualifications, time spent on various tasks, regional data, etc. From there, and in their words, “RCReports synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and our EXCLUSIVE database of wages to accurately assess Reasonable Compensation for S Corp, Small & Closely Held Business Owners.” Cool!
You can view a sample here-
If you visit this link and read the report, RCReports does a wonderful job coming up with a number and then putting a bunch of data behind it. The report looks official and uses sources; this is a critical consideration since reasonable compensation is such a squishy thing. In other words, the IRS might challenge your reasonable S Corp salary much like a mall cop with a badge but no gun, and certainly no evidence. When you roll up with a 7-page document that has numbers, data and sources scattered about, it is super hard for the IRS to say No. For lack of better evidence, the IRS would be forced to use your evidence.
Two more considerations with RCReports. They use a typical appraisal approach similar to home appraisals, business valuations, etc. using cost, market and income approaches. This is pretty cool, and lends additional credibility to their work.
Here is a blurb from their website about the approaches-
Cost (AKA Many Hats Approach)
Cost Approach (AKA Many Hats Approach) – The Cost 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 into 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 added 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).
Market (AKA Industry Standard Approach)
Market Approach (AKA Industry Standard 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 non-owner in an arms-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.
Income (AKA Independent Investors Test)
Income Approach (AKA Independent Investors Test) – Seeks to determine whether a hypothetical investor 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 is no comparability data available.
The other consideration is that just because RCReports comes up with a salary does not mean you must pay that salary. There might be circumstances which would drive down a reasonable salary such as rapid growth, unsteady earnings, etc. There might be circumstances, such as 401k and other external reasons, to increase your salary.
Recently WCG CPAs & Advisors had a foot and ankle physician group in Rhode Island complete two different RCReports interviews to determine a reasonable salary for their S Corp, and the results are worthy of further discussion. The first draft yielded a shareholder salary of $193,762 yet the second draft returned $112,728. That is an $81,000 difference!
What changed? Good question. In the updated report, all three components changed-
- 2,080 hours went to 1,820 which is either 35 hours a week or just over 45 weeks per year.
- Time spent went from 80% to 75% when the S Corp shareholders dug a little deeper into their time allocations.
- Proficiency went from above-average to average. This was HUGE! It changed the hourly rate from $104 to $66.
Therefore, think of the pinball bouncing around in your RCReports pinball machine. The first bounce was reducing the hourly rate from $104 to $66. Next, the annual hours went from 2,080 to 1,820 given vacations, golfing, holidays and general screwing-around. Lastly, less time was spent performing doctor tasks (80% to 75%). In other words, the time spent was less valuable and the amount of time spent was reduced. Double dip!
Please keep in mind too that reasonable compensation includes self-employed health insurance and HSA contributions (and health reimbursement arrangements, and long-term care and disability premiums too). Therefore, if RCReports comes up with $80,000 but your self-employed health insurance including dental and vision is $10,000, then your shareholder salary should be $70,000. This alone saves you $1,500 in unnecessary payroll taxes (we had some tables in a previous chapter showing this arbitrage as well).
Sidebar: Health Reimbursement Arrangements (HRAs), Long-Term Care and Disability should be paid by the business. No, they are not income tax deductions. No, your benefits are not taxable should you receive them. However, these payments buttress your reasonable salary calculations. In simple math, you save 15% of these amounts through the reduction of salary which reduces your Social Security and Medicare taxes. We expand on this in a later section.
We can do a reasonable compensation analysis for you. Yeah, we charge you about $400 but it gives you a defensible salary and some peace of mind. Bargain!
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