How the IRS Determines Reasonable Compensation

A Former Insider’s Views on the Subject of Compensation

What is reasonable compensation? In this article, Michael Gregory proposes that while the views of the U.S. Tax Court are well-understood, those of the IRS are not. In this article he underscores the importance of this matter to business valuation professionals.

Over the past few days, the valuation community has heard of two new IRS Job Aids, each with commentary.   Readers of QuickRead will likely know about the IRS Job Aid on the Discount for Lack of Marketability.  That publication was released in 2011 along with the update book regarding that Job Aid.[i]    This Job Aid was obtained after filing a Freedom of Information Act (FOIA) request for these Job Aids with the IRS in the fall of 2014.   As with the other Job Aid released in April 2015, this Job Aid contains commentary from experts working in the area of compensation.

On October 29, 2014, the IRS published an internal white paper entitled “Reasonable Compensation Job Aid for IRS Valuation Professionals”.     This recently obtained IRS white paper presents background on this topic area from the perspective of the IRS.  There are six sections and nine appendices in the Job Aid including detailed Information Document Requests (IDRs) regarding the types of questions the IRS would likely raise when auditing, reviewing, and critiquing the position of a taxpayer in connection with the reasonableness of compensation claimed.   In the publication, I share my thoughts on what constitutes reasonable compensation and what this might mean for business valuation analysts called to determine the reasonableness of compensation.

While the Tax Court has weighed in on the subject matter, the views from the Service are not understood. Several court cases centered on reasonable compensation present a different perspective in relation to how the courts and how the IRS views compensation as “reasonable”.  Reasonable compensation is commonly adjusted when determining the fair market value with privately held firms.  Reasonable compensation is not compensation based on the value of the individual to the firm, but rather according to Regulation 1.162-7(a), “The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.”

In an earlier book of mine, Business Appraisals and the IRS (2013)[ii] I presented a chapter on how to consider reasonable compensation when addressing this issue for federal tax valuation purposes.  I shared that there are many court cases on this issue.  I also point out that these are some of the key court cases that present factors to consider and other key points relative to reasonable compensation:

• Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1247 (9th Cir. 1983), revg. and remanding T.C. Memo 1980-282.

• Hypothetical Independent Investor

• Exacto Spring Corp. v. Comm’r, 196 F.3d 833 (7th Cir. 1999).

• Income to Hypothetical Investor

• Guy Schoenecker, Inc. et al. v. Commissioner, T.C. Memo 1995-539; 70 T.C.M. (CCH) 1303

• Return on Equity Can Be Manipulated Diminishing Value of the Approach

• David C. Watson,  No. 11-1589, February 21, 2012 Appealed to the 8^th Circuit

• 1120S Undervaluation of Reasonable Compensation

•  (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at
  1325 n. 33; R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-51 (1972) at 51;
  Acme Constru. Co. v. Commissioner, T.C. Memo 1995-6; BOCA Constr. Inc. v.
  Commissioner, T.C. Memo 1995-5.)

• Employee Personally Guarantees Debt

• However, in Pulsar Components International, Inc. v. Commissioner, T.C. Memo 1996-129; 71 T.C.M. (CCH) 24; Interest Free Loan Negates Compensation

• Employee Personally Guarantees Debt

Again, since this issue is “gray” in nature, the IRS typically does not pursue it unless the compensation is viewed as egregious.   When discussing this issue with a client, it is important to determine where the firm is within the industry and how that relates to the compensation of key individuals.  When working with a client, it is important to underscore that the critical question is:  What would a third party pay for the service rendered?

There are a host of factors to consider when evaluating reasonable compensation.  The income, market, and cost approaches need to be fully evaluated and considered in each instance.  Key sources of data regarding compensation and industry information are critical in the development of the facts in a case.  Once the facts are gathered and interviews completed, the logic from pertinent court cases needs to be applied to the facts on your case. The market, income, and cost approaches need to be considered and if applicable logically applied when evaluating compensation.

It is important to consider the five common concerns of:

1. Pay of Prior Years Under Compensation
2. Multiple Jobs / Many Hours by  Individual
3. Satisfied “Hypothetical Independent Investor”
4. Employee Personally Guarantees Debt
5. Key Person / Employee Deserves Extraordinary Compensation

Additionally, the question of how to treat loans from shareholders to private corporations needs to be addressed.

If an entity is not-for-profit, this requires special considerations since stock options are not applicable and the entity needs to meet certain requirements to be and remain a not-for-profit entity.  Clearly, in the tax-exempt setting, it is important to retain opinions from sources that are independent and understand the level of compensation paid in the industry.

[i] Michael A. Gregory, Discount for Lack of Marketability and the IRS, (Roseville, Minnesota: Birch Grove Publishing, 2013), 151. www.mikegreg.com

[ii] http://www.mikegreg.com/business-appraisals-and-irs

Michael A. Gregory, MBA, ASA, CVA is Managing Member of Michael Gregory Consulting, LLC. The firm provides management, appraisal, and engineering experience to help clients navigate IRS related issues, review appraisals for quality control or litigation, lead strategic planning sessions, train managers, and mediation services. Michael worked for the Internal Revenue Service for 25 years and he is an Accredited Senior Appraiser with the American Society of Appraisers (ASA), and a Certified Valuation Analyst with the National Association of Certified Valuation Analysts (NACVA). Michael can be reached at mg@mikegregory.com or at (651) 633-5311.

Image courtesy of scottchan/FreeDigitalPhotos.net