The Tax Cut and Jobs Act (TCJA) contains a provision for reasonable compensation as defined in IRS Code Section 162. Reasonable compensation has always been an important issue in business valuation, but the TCJA has put a much brighter spotlight on the matter, which will be closer scrutinized starting in 2018.
There is a new tax deduction for owners of pass-through entities (PTEs) and reasonable compensation for owner-employees figures into that calculated deduction. Critical to the aforementioned, the new law stipulates rules and limitations regarding reasonable compensation.
Background on S vs. C Entities
Prior to the passage of the TCJA, “S” corporations had a tax advantage over “C” corporations due to the double taxation of C-Corps. S-Corps income passes through to the owners and is taxed at the individual level, while C-Corps income is taxed twice (first at the corporate level and then as dividends to the owners and shareholders).
The New Law
The new law is designed to create parity between C-Corps and PTEs by placing them on substantially the same playing field for tax purposes. Section 199a deduction allows a 20% write-off of “qualified business income” (QBI) for PTEs. Owner’s compensation is one of the key inputs into calculating the limitation to the deduction, so a major focus will be on the determination of reasonable compensation, one of which the IRS is sure to examine closely moving forward.
Note: To be eligible for QBI, the 20% pass-through deduction under TCJA is after a deduction for reasonable compensation.
Sources for Determining Reasonable Compensation
Over the years, there has been increasing resources to help determine and support reasonable compensation. The U.S. Census data in the early years was a source; however, databases such as Economic Research Institute (ERI), Bizminer Industry Financial Reports, Risk Management Associates (RMA), Reasonable Compensation Reports, to name a few, would withstand IRS scrutiny.
IRS Future Tax Payer Challenges
KC Conrad, a partner in our firm, has been an instructor of business valuation courses with the various business valuation societies since the mid-90’s. Oftentimes, the IRS has enrolled service personnel (students) in the classrooms. The IRS is aware of these reasonable compensation resources and how the data should be employed. In the future, if the business owner(s) decides that his or her pay is reasonable without supporting that figure in the calculation of the deduction, there is an increased probability that it will be challenged by the IRS.
How can American Business Appraisers Help?
Business valuations require a significant amount of careful consideration and judgment. Our experienced staff recognizes and quantifies a business’ reasonable compensation. Call us to discuss any specific valuation needs. Every individual situation is different and not everyone requires our certified appraisal services and sometimes just talking with one of our appraisers is all that may be necessary. With our initial consultation, there is no cost or obligation to you. We promise you two things; first, to invest a reasonable amount of time to gain an understanding of your specific requirements, and second, our communication will be kept confidential.