How the IRS Determines Reasonable Compensation with

Job Aid Commentary by the Original IRS Champion

The IRS has a new Job Aid entitled Reasonable Compensation Job Aid for IRS Valuation
Professionals. This Job Aid and a Job Aid on valuing non-controlling interests in S Corps were
acquired via a lengthy Freedom Of Information (FOIA) Request. These Jobs are shared with you in a
new book and a book incorporating the IRS Job Aid regarding valuing non-controlling interests in S
Corps. These Job Aids have not been released to the general public at this time. Michael Gregory was
the original issue champion of these Job Aids at the IRS. In this new book, after providing you in
depth background on reasonable compensation in Part One, Part two presents the entire Job Aid on the
right with side by side commentary on the left tying in Part One commentary and offering you further
insights into the document.
The IRS Job Aid on Reasonable Compensation
The Reasonable Compensation Job Aid presents the IRS perspective on this issue. The Table of
Contents of the 54 page Job Aid are:
TABLE OF CONTENTS
Section I: Purpose, Background and Case Coordination
Section II: Identifying a Reasonable Compensation Issue
Section III: Developing Reasonable Compensation Issues
Section IV: Taxpayer Arguments for Reasonable Compensation Issues
Section V: Consideration of Penalties
Section VI: Focusing Specifically on Not-For-Profits
Appendices:
A. Suggested Readings on Reasonable Compensation
B. Data Sources for Compensation Issues
C. Information Document Requests
D. Financial Analysis - Example
E. Market Approach - Example
F. Income Approach - Example
G. Court Cases Relating To Prior Years Under-Compensation
H. Court Cases Relating To Multiple Jobs
I. Example of a Not-for-Profit Analysis (University Sector)

The Appendices are especially useful containing some excellent information for the appraiser addressing
reasonable compensation.
Some Further Thoughts on Determining Reasonable Compensation
The topic of reasonable compensation is one that, on the surface, seems to be well established in the
realm of privately held firms. A closer look, however, shows that this isnt the case. 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 1.1627(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 Michael Gregorysi book Business Appraisals and the IRS (2013) Mike presents a chapter on how to
consider reasonable compensation when addressing this issue for federal tax valuation purposes. Mike
points out that there are many court cases on this issue. However, he points 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 8th 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

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.
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.
Because of the different complexities involved in determining reasonable compensation, Mike put
together a presentation that was filmed prior to receiving the IRS Job Aid to help participants with this
issue. In the end, each participant will take away tools to use when addressing these issues and be able
to better prepare an analysis going forward.

In Mikes video the most pertinent court cases, the factors to consider, and the most common sources
of market compensation and industry information are presented. Whether you are a beginner in the
field or the most seasoned expert, you will find the content of the video interesting and insightful when
considering the issue with your clients. Access to this video, which also offers 2.0 hours of CPE credit, is
available through the Kansas Society of CPAs.

Michael Gregory worked for the IRS for 28 years as a specialist through executive level. In 2011 he founded
Michael Gregory Consulting, LLC. His web page is www.mikegreg.com offering his 13 videos and 9 books. He can
be reached at 651-633-5311 and at mg@mikegreg.com. Michael Gregory Consulting 2015