The IRS valuers identified reasonable compensation as one of the top issues for audit. Differences of opinion by valuers in the private sector and IRS valuers could lead to conflict and disputes on examination, leading to Appeals, and potentially to litigation. This commentary defines reasonable compensation, introduces the IRS Job Aid and Appendix, provides links to some recent IRS papers related to reasonable compensation, introduces how various levels at the IRS look at the issue, provides links to relevant court cases and key factors for consideration from those court cases, and provides a source for contemporary commentary on this topic.
What is reasonable compensation and how is it determined?
Reasonable compensation for federal tax purposes is defined in Treasury Regulation Section 1.167-7(b)(3)
“as the amount that would ordinarily be paid for like services by like organizations in like circumstances…” That is, what would a third party pay someone to carry out the activities.
To that end there is a two prong test to look at both the amount of compensation and the activities carried out by the individual. This is expanded upon in the IRS Job Aid.
The IRS Job Aid and Appendix on Reasonable Compensation
It was my pleasure to champion the IRS Reasonable Compensation Job Aid and the associated Reasonable Compensation Appendix at the IRS. They were released to the public on October 29, 2014 following a freedom on information request by this author. IRS valuers wrote them to assist other IRS valuers and employees working this issue and to provide a consistent approach across the IRS. The Job Aid provides background related to the issue, factors to consider, the three approaches of market, income, and cost, five considerations, loan insights, and a not for profit section. The Appendix provides suggested readings, data sources, what types of information and how to request it, examples of the market, income, and cost approaches, pertinent cases up to the date of writing, and an example associated with a not for profit.
Other IRS papers related to reasonable compensation
On examination today the IRS has Issue Practice Networks (IPN) that specialize in various technical topics including reasonable compensation. Two more recent Large Business and International (LB&I) division papers on specialized areas associated with compensation are: cost sharing agreements with stock based compensation and deferred compensation received by nonresidential alien individuals. Examples of two older but still relevant papers shared with the public are: sourcing of multiyear compensation arrangements including stock options for FTC limitation and sourcing of salary and compensation.
Reasonable compensation approaches at Examination, Appeals, and Litigation
On examination the goal of the IRS is to resolve the issue based on the facts. Clearly well-developed facts on the five key factors identified in the job aid need to be addressed. The five key factors to address factually from the courts and Job Aid are:
- Employee's role in the company.
- External comparison of the employee's salary with those paid by similar companies for similar services.
- Character and condition of the company.
- Conflict of interest in relationship of the employee to the corporation.
- Internal consistency in the company’s treatment of payments to employees.
Should the case be unagreed the case may proceed to Appeals. Here there is a shift in thinking. At Appeals the issue may be settled based on the hazards of litigation. If the case is not settled at Appeals the case may proceed to litigation. The taxpayer can proceed to U.S. Tax Court (approximately 90%) or pay the tax, file a claim, and proceed to either U.S. District Court or the U.S. Court of Federal Claims (approximately 10% elect this option).
How has the IRS faired in court?
Exploring the Job Aid, you will see that the IRS does not proceed to court all that often, but when they do, they overall have a rather good track record. The IRS should have a good track record since they decide which cases to take to court. The job aid identifies key court cases that address issues such as intent, what factors the courts considered, and the employee’s value. Check out Appendix G and H in the Appendices of the Job Aid for court cases related to prior years under compensation and multiple jobs.
In looking at three cases since 2010 these three commentaries from the David E. Watson, Sean McAlory Ltd., Inc. and , and Glass Block Unlimited as pulled together by RC Reports with links to the actual court cases provide insights. These three most recent cases were all wins for the IRS.
So why aren’t there even more cases? With the IRS taking more egregious cases forward taxpayers realize that it may not be worth the effort given the facts in their case or the time and expense of litigation simply do not justify going forward with the case.
Is the Job Aid still relevant?
The American Society of Appraisers must think so because Chris Rosenthal, ASA, is speaking on the topic “Determining Compensation in Disputes using the IRS Reasonable Compensation Job Aid” at the 85th Annual ASA International Conference in Tampa on September 12, 2022.
Personally, I would encourage anyone working the issue to download both the IRS Reasonable Compensation Job Aid and the associated Appendix. Together they provide real insight into the issue and how the IRS approaches the issue.
Conclusion on this issue
The technical term for reasonable compensation as an audit issue at the IRS was that it is a “squishy” issue. Yes, that sounds funny. The reality is that two reasonable people can analyze the objective information, apply subjective judgment, and produce different concluding numbers. Unlike many valuation issues where the IRS may make an adjustment if the differences are off more than 10%, with reasonable compensation the range was clearly wider. Egregious aggressive taxpayers may have differences from 150% to 1,000%. The extremes would clearly raise IRS eyebrows. The key is to keep the number reasonable. That is, what would a third party pay someone to do the same task?
As a mediator on valuation issues, I have found that reasonable people can determine reasonable compensation even when starting positions have significant differences. As an example of one case the IRS started at $300,000 and the taxpayer started at $2.4 million. The case was resolved on examination through a negotiation at approximately $1.5 million
About the author
Mike Gregory is a professional speaker, an author, and a mediator. You may contact Mike directly at email@example.com and at (651) 633-5311. Mike has written 12 books (and co-authored two others) including his latest book, The Collaboration Effect: Overcoming Your Conflicts, and The Servant Manager, Business Valuations and the IRS, and Peaceful Resolutions that you may find helpful. [Michael Gregory, ASA, CVA, NSA, MBA, Qualified Mediator with the Minnesota Supreme Court]