Reasonable Salary Labor Data

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Among several things, the Tax Court and the IRS will attempt to support a reasonable salary based on your peers and colleagues. They will use an expert who specializes in vocational valuations, and this person might use Risk Management Association (RMA) and Bureau of Labor Statistics (BLS) data, including local and regional data.

Our previous real estate agent benefited from this type of valuation since his S corporation earned significantly more than the average real estate agent’s salary. But what if the opposite was true? So, instead of earning $231,454 and only paying out $100,755 in salary, what if you earned $110,000. Would you have to pay out $100,755 in salary just because you are a real estate agent in an area where other agents earn $100,755?

The answer is a true accountant or lawyer response- it depends. There are several factors that mitigate the calculus. Perhaps you work part time. Perhaps you simply are not as good as your peers. Perhaps you focus on a different type of customer. Review the previous IRS and Tax Court laundry lists, and as you go through each item ask yourself if you could safely use it to justify a lower salary than your peers- we bet you can find several instances.

Statistics attempt to homogenize a population so we may draw correlations and eventual conclusions. Certain professions that appear to be slam dunks are not as they appear. Attorneys and accountants come to mind- we know some attorneys that make $150,000 a year while others make $450,000. It is very tough to jam these two square pegs into the same round hole. Accountants, same thing. IT consultants, same thing. Even physicians doing the same line of work (such as anesthesia) range between $80,000 and $400,000. Same work, at least on paper, yet wildly different incomes!

There is another lesson to be learned here. As your S Corp income increases, the reasonable salaries paid to the shareholders do not necessarily increase on a pro rate basis. In other words, if you peg your salary at $60,000 and that is supported with labor data, your salary does not double just because your net business income (profit) in your S corporation doubles. Your salary is based on you, and the data surrounding you. Yes, the courts look at distributions and net income, and Yes, your salary would probably be increased if your net income doubles, but it is not tethered in a lockstep, $1 for $1 pattern (more on this in a bit).

Salary.com and the like also do a great job of compiling labor data. RMA and BLS is going to be much more authoritative in court, but RMA (as an example) requires an expensive subscription and is usually reserved for valuation experts who rely on their data multiple times to justify the cost.