What is Reasonable Compensation?

A reasonable compensation study is an analysis conducted to determine an appropriate salary for a shareholder-employee, ensuring it aligns with IRS guidelines and industry standards. The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” This analysis is crucial because it ensures that salaries are neither excessively high (which could invite IRS scrutiny and penalties) nor too low (which might result in underpayment of taxes).

What is an MSO?

A Management Services Organization (MSO) is an entity designed to provide administrative and management services to healthcare providers and other businesses. It allows operating companies to outsource non-core administrative functions such as human resources, IT, and accounting, enabling them to focus on their primary business activities.

An MSO is often structured as a C-corporation to take advantage of the flat 21% corporate tax rate, which can be beneficial compared to higher individual tax rates. This structure also aids in asset protection by separating business operations from administrative functions, mitigating risks, and enhancing operational efficiency.

Structuring MSOs for Tax Savings and Family Wealth Preservation

MSOs offer several benefits for tax savings and family wealth preservation, particularly when structured as C-corporations. Here are the key strategies:

1. **Income Shifting**: By paying a management fee to the MSO, the operating company reduces its taxable income. The MSO, in turn, pays taxes at the lower corporate rate.

2. **Reasonable Compensation**: The MSO can employ family members, ensuring they receive reasonable compensation for their services. This not only provides tax-deductible wages but also helps in wealth distribution among family members.

3. **Asset Protection**: The separation of administrative functions into an MSO protects business assets from liabilities associated with the operating company.

4. **Succession Planning**: MSOs facilitate smoother transitions of business ownership, often utilizing life insurance and other financial instruments to support succession planning and maintain business continuity.

Risks of Not Conducting a Reasonable Compensation Study

For business owners of both S-corporations and C-corporations, failing to conduct a reasonable compensation study poses significant risks:

1. **IRS Scrutiny and Penalties**: The IRS closely monitors compensation levels to ensure they are reasonable. Excessive compensation in C-corporations can be reclassified as dividends, leading to higher tax liabilities. For S-corporations, underpayment can result in unpaid payroll taxes.

2. **Double Taxation**: In C-corporations, profits are taxed at the corporate level and then again as dividends to shareholders. If salaries are deemed unreasonable, the IRS might reclassify them as dividends, leading to double taxation.

3. **Inaccurate Financial Statements**: Overstated or understated salaries can distort a company’s financial health, affecting stakeholder trust and investment decisions.

Stories of Bad Outcomes

1. **David E. Watson, P.C. v. United States**:
   David Watson, a CPA, paid himself $24,000 annually while taking $200,000 in distributions. The IRS reclassified a significant portion of the distributions as wages, resulting in substantial payroll taxes and penalties. The court upheld the IRS’s position, leading to Watson paying over $1.3 million in back taxes, penalties, and interest.

2. **JD & Associates Ltd. v. United States**:
   In this case, a law firm paid its partners minimal salaries and substantial dividends. The IRS reclassified the dividends as wages. The firm faced over $2 million in back taxes, penalties, and interest after the court upheld the IRS’s reclassification.

3. **Watson v. United States**:
   In a similar case, an accountant and sole owner of an S-corporation took a minimal salary and significant distributions. The IRS reclassified the distributions as wages, resulting in additional taxes and penalties. Watson was required to pay over $1 million in back taxes, penalties, and interest for not taking a reasonable salary.

Detailed Methodology of Reasonable Compensation Studies

A Reasonable Compensation (RC) study involves a comprehensive analysis to determine an appropriate salary for a shareholder-employee, ensuring it aligns with IRS guidelines and industry standards. The study typically uses the Market Approach to compare the compensation of the business owner to that of similar positions in comparable companies. The following sections delve into the detailed methodology and data sources used to establish reasonable compensation.

1. **Data Collection and Analysis**:
   – **Interview and Data Gathering**: Information on the business owner’s role, experience, time commitment, and responsibilities is collected. Company-specific data such as industry, size, location, number of employees, and financial performance is gathered. An interview is conducted to understand the depth of the owner’s involvement and contributions to the business.
   – **Market Approach**: The Market Approach compares the business owner’s compensation with similar positions in the same industry. Data is sourced from various reputable databases, including Reasonable Compensation Reports, Inc., Bureau of Labor Statistics (BLS), and U.S. Census data. This approach helps determine what a non-owner would be paid in an arm’s-length employment relationship for similar services.
   – **Stress Testing**: Compensation figures are stress-tested against factors used by the IRS and courts, such as those outlined in the IRS Fact Sheet 2008-25. Factors include the employee’s qualifications, contributions to business success, compensation comparisons with other employees, and industry standards.
   – **Adjustments and Considerations**: Adjustments are made for additional factors such as personal guarantees of debt, the financial condition of the company, and key relationships/contracts held by the owner. The study also considers the salary history and travel requirements of the owner, as well as the distribution history of the company.

2. **Sources of Data**:
   – **Reasonable Compensation Reports, Inc.**: Provides industry-specific compensation data. Utilizes proprietary algorithms and methodologies to analyze compensation figures.
   – **Bureau of Labor Statistics (BLS)**: Offers comprehensive data on employment, wages, and industry standards. Provides statistical data on various occupations, including chief executives and managers.
   – **U.S. Census Data**: Supplies demographic and economic data relevant to different industries and geographic locations. Helps in understanding the broader economic context in which the business operates.

Establishing a Reasonable Compensation of $1.45 Million

To build a case for a CEO with a reasonable compensation of $1.45 million, we need to consider several critical factors, ensuring that the compensation is justifiable based on the role, responsibilities, and unique contributions of the individual. Here’s how the case can be constructed:

1. **Role and Responsibilities**:
   – The CEO is responsible for the overall strategic direction, policy formulation, and operational management of the company.
   – The role involves high-level decision-making, managing subordinate executives, and coordinating operational activities at the highest level.

2. **Personal Guarantees and Financial Risk**:
   – The CEO has personal guarantees on substantial company debt, increasing personal financial risk. This added financial exposure justifies a higher compensation to account for the personal liabilities undertaken, as a replacement would require substantial remuneration to take on this risk.

3. **High Work Hours and Dedication**:
   – The CEO works more than 65 hours per week, demonstrating a high level of dedication and commitment to the business.
   – Extensive working hours often correlate with higher compensation to reflect the time and effort invested in the company’s success.

4. **High Proficiency and Experience**:
   – The CEO has extensive experience and a high proficiency level, significantly contributing to the company’s growth and performance.
   – Qualifications, including formal education, industry certifications, and a proven track record of business success, further support higher compensation.

5. **Industry and Market Comparisons**:
   – Comparable CEOs in the same industry, managing companies of similar size and financial performance, receive compensation in the range of $1.2 million to $1.6 million.
   – Market data from BLS and industry-specific compensation reports validate this range, ensuring that $1.45 million is within the acceptable and reasonable spectrum.

6. **IRS Guidelines and Precedents**:
   – The methodology aligns with IRS guidelines, using factors such as those outlined in the IRS Fact Sheet 2008-25.
   – Past tax court cases have upheld high compensation for CEOs with significant personal risk, high dedication, and substantial contributions to business success.

By thoroughly documenting these factors and ensuring comprehensive data analysis, a reasonable compensation of $1.45 million for the CEO can be robustly justified. This approach not only aligns with IRS standards but also reflects the CEO’s critical role and contributions to the business.

Conclusion

Integrating an MSO structure with a detailed reasonable compensation study provides a robust framework for tax efficiency, asset protection, and wealth preservation. By ensuring compliance with IRS regulations and strategically managing compensation and management fees, business owners can optimize their financial planning and safeguard their legacy for future generations.

Make sure you hire a firm like Guardian Tax Consultants that has the tax attorneys with reasonable compensation expertise on your side.

References

1. [IRS Fact Sheet 2008-25](https://www.irs.gov/newsroom/fact-sheet-2008-25)

2. [Bureau of Labor Statistics (BLS)](https://www.bls.gov/)

3. [U.S. Census Data](https://www.census.gov/)

4. [Reasonable Compensation Reports, Inc.](https://rcreports.biz/)

5. [IRS: Tests for Deducting Pay](https://www.irs.gov/newsroom/tests-for-deducting-pay)

6. [IRS: Treatment of Excessive Compensation](https://www.irs.gov/newsroom/treatment-of-excessive-compensation)

7. [IRS: Instructions for Form 1125-E](https://www.irs.gov/instructions/i1125e)

8. [Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943)](https://supreme.justia.com/cases/federal/us/319/436/)

9. [LabelGraphics, Inc. v. Commissioner, T.C. Memo 1998-343](https://casetext.com/case/label-graphics-inc-v-commissioner)

10. [Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200](https://casetext.com/case/brewer-quality-homes-inc-v-commissioner-of-internal-revenue)

11. [Lender Management, LLC v. Commissioner, T.C. Memo 2017-246](https://www.leagle.com/decision/intco20171218115)

12. [Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983)](https://law.justia.com/cases/federal/appellate-courts/F2/716/1241/134940/)

13. [Midwest Eye Center, S.C. v. Commissioner, T.C. Memo 2015-53](https://www.leagle.com/decision/intco20150406a66)

14. [Watson, P.C. v. U.S., 668 F.3d 1008 (8th Cir. 2012)](https://casetext.com/case/david-e-watson-pc-v-united-states)

15. [Estate of Morrissette v. Commissioner, 146 T.C. No. 11 (April 13, 2016)](https://www.leagle.com/decision/intco20160413h97)