HearthRC Sample Reasonable Compensation Report
Thank you for entrusting this Reasonable Compensation analysis to your firm, with professional delivery by Hearth. This report provides a reasonable estimate of the value of services rendered to your S Corporation based on the duties and responsibilities that you perform annually. Reasonable Compensation is defined by the IRS as “The value that would ordinarily be paid for like services by like enterprises under like circumstances.”
A combined analysis using three independent methodologies—Cost Approach, Market Approach, and Income Approach—was performed to determine a defensible Reasonable Compensation figure. The reconciled recommendation of $195,869 reflects the Market Approach result, weighted by methodology appropriateness and cross-approach consistency.
Hearth recommends completing a Reasonable Compensation report annually.
Client & Entity Profile
| Calculated For | Scott Stone |
| Company | Stone Concrete, Inc. |
| Entity Type | S Corporation |
| Report Year | 20XX |
| NAICS Industry | Specialty Trade Contractors |
| MSA Location | Chicago-Naperville-Elgin, IL-IN |
| State | Illinois |
| Occupation | Chief Executives* |
| Employees (FTE) | 25–75 |
| Adjusted Gross Profit | $1M–$5M |
| Performance vs. Peers | Average |
| Experience Level | Average |
| Time Dedicated | Full Time |
| Hours Worked | 2,080 |
| Interview Completed | 20XX-12-08 |
| Report Finalized | 20XX-03-05 |
* Chief Executives — Determine and formulate policies and provide overall direction of companies or private and public sector organizations within guidelines set up by a board of directors or similar governing body. Plan, direct, or coordinate operational activities at the highest level of management.
** Adjusted Gross Profit is gross revenue less the direct cost of producing this income.
Task-Based Compensation Analysis
The Cost Approach breaks down the time spent by the owner into the various tasks performed; wage levels are assigned for each task based on proficiency, then added together to obtain a hypothetical Replacement Cost. Also referred to as the Many Hats Approach.
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Marketing
10% of total hours • 208.00 hours per year • 7.52% of total compensation
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| Task | Proficiency | % of Category | Hours/Year | Hourly Wage | Annual Wage |
|---|---|---|---|---|---|
| Sales Representative | Average | 100% | 208.00 | $33.17 | $6,899 |
|
Finance
10% of total hours • 208.00 hours per year • 5.76% of total compensation
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| Task | Proficiency | % of Category | Hours/Year | Hourly Wage | Annual Wage |
|---|---|---|---|---|---|
| Bookkeeper | Average | 100% | 208.00 | $25.42 | $5,287 |
|
Inventory
5% of total hours • 104.00 hours per year • 2.59% of total compensation
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| Task | Proficiency | % of Category | Hours/Year | Hourly Wage | Annual Wage |
|---|---|---|---|---|---|
| Purchasing Clerk | Average | 100% | 104.00 | $22.83 | $2,374 |
|
Management
15% of total hours • 312.00 hours per year • 18.49% of total compensation
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| Task | Proficiency | % of Category | Hours/Year | Hourly Wage | Annual Wage |
|---|---|---|---|---|---|
| General and Operations Manager | Average | 100% | 312.00 | $54.39 | $16,970 |
|
My Business
60% of total hours • 1,248.00 hours per year • 65.64% of total compensation
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| Task | Proficiency | % of Category | Hours/Year | Hourly Wage | Annual Wage |
|---|---|---|---|---|---|
| Concrete Finisher | High | 50% | 624.00 | $55.52 | $34,644 |
| Maintenance Mechanic | High | 50% | 624.00 | $41.03 | $25,603 |
| Total Annual Reasonable Compensation (Cost Approach) | 2,080.00 | $91,778 |
Industry Comparison Analysis
The Market Approach compares the business owner’s compensation to compensation within the industry for the specific position being analyzed. The question to be answered is: How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship at a similar company?
Your suggested salary range: $141,520 to $224,179 with a suggested salary of $195,869 was determined to be Reasonable Compensation based on your role in the company, industry, size of the business, time devoted to the business, your experience and location. Any wage selected within the suggested range or expanded geographical area(s) is acceptable and within a 90% confidence interval.
| Low | High | Suggested | |
|---|---|---|---|
| Chicago-Naperville-Elgin, IL-IN | $178,448 | $224,179 | $195,869 |
| Illinois | $174,726 | $219,503 | $191,784 |
| National | $141,520 | $177,787 | $155,336 |
Independent Investor Test
The Income Approach determines whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner. Also known as the Independent Investor Test.
| Fair Market Value (Start) | $6,000,000 |
| FMV Increase | $1,750,000 |
| Target Return on Equity | 20% |
| Return on Equity (after Comp) | $1,200,000 |
Increase in FMV over the year before Reasonable Compensation
− (Target Return × FMV at the beginning of the year)
= Reasonable Compensation
$1,750,000 − (20% × $6,000,000) = $1,750,000 − $1,200,000 = $550,000
The income approach can only be correctly applied when the Fair Market Value (FMV) of the company is available for each year that compensation is being examined. A high rate of return indicates that the assets’ value increased and that the employee provided valuable services. If investors obtain returns above what they should reasonably expect, an employee’s salary is presumptively reasonable.
Multi-Approach Comparison
Three independent methodologies were applied to determine Reasonable Compensation. The reconciliation below evaluates each approach’s result, considers methodology appropriateness, and recommends a defensible compensation figure.
The Market Approach result is recommended as the primary determination. Stone Concrete, Inc. is a medium-sized business where the owner’s primary function is executive management — the Market Approach is most accurate for businesses where the owner provides a single primary function. The Cost Approach result of $91,778 is lower because it reflects the composite of individual task-level wages rather than executive-level comparable compensation. The Income Approach result of $550,000 is an upper-bound indicator confirming the business can support the recommended compensation level.
S Corporation Tax Savings Projection
This projection compares S Corps to other pass-through entities (Schedule C, LLC, and Partnerships) where all net profit is subject to Social Security and Medicare taxes. Based on an expected 20% annual change in profit and 15% annual change in compensation.
| Year | Projected Profit | Entity | Projected Comp | FICA | Medicare | Med. Surtax | FUTA/SUTA | Corp Tax Prep | Payroll Prep | Annual Total | Cumulative |
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2025 | $275,000 | Other Pass-Through | $275,000 | $21,836 | $7,975 | $675 | $600 | $3,200 | $2,400 | $30,486 | $30,486 |
| S Corporation | $91,778 | $11,380 | $2,662 | — | $600 | $3,200 | $2,400 | $24,242 | $24,242 | ||
| 2026 | $330,000 | Other Pass-Through | $330,000 | $22,655 | $9,570 | $1,170 | $600 | $3,200 | $2,400 | $33,395 | $63,881 |
| S Corporation | $105,545 | $13,088 | $3,061 | — | $600 | $3,200 | $2,400 | $23,849 | $48,091 | ||
| 2027 | $396,000 | Other Pass-Through | $396,000 | $23,473 | $11,484 | $1,764 | $600 | $3,200 | $2,400 | $36,721 | $100,602 |
| S Corporation | $121,376 | $15,051 | $3,520 | — | $600 | $3,200 | $2,400 | $26,271 | $74,362 | ||
| 2028 | $475,200 | Other Pass-Through | $475,200 | $24,403 | $13,781 | $2,477 | $600 | $3,200 | $2,400 | $40,661 | $141,263 |
| S Corporation | $139,583 | $17,308 | $4,048 | — | $600 | $3,200 | $2,400 | $29,056 | $103,418 | ||
| 2029 | $570,240 | Other Pass-Through | $570,240 | $25,445 | $16,537 | $3,332 | $600 | $3,200 | $2,400 | $45,314 | $186,577 |
| S Corporation | $160,520 | $19,905 | $4,655 | — | $600 | $3,200 | $2,400 | $32,260 | $135,678 | ||
| 2030 | $684,288 | Other Pass-Through | $684,288 | $26,635 | $19,844 | $4,359 | $600 | $3,200 | $2,400 | $50,838 | $237,415 |
| S Corporation | $184,598 | $22,890 | $5,353 | — | $600 | $3,200 | $2,400 | $35,943 | $171,621 | ||
| 2031 | $821,146 | Other Pass-Through | $821,146 | $27,788 | $23,813 | $5,590 | $600 | $3,200 | $2,400 | $57,191 | $294,606 |
| S Corporation | $212,288 | $26,324 | $6,156 | $111 | $600 | $3,200 | $2,400 | $40,291 | $211,912 | ||
| 2032 | $985,375 | Other Pass-Through | $985,375 | $29,016 | $28,576 | $7,068 | $600 | $3,200 | $2,400 | $64,660 | $359,266 |
| S Corporation | $244,131 | $29,016 | $7,080 | $397 | $600 | $3,200 | $2,400 | $44,193 | $256,105 | ||
| 2033 | $1,182,450 | Other Pass-Through | $1,182,450 | $30,281 | $34,291 | $8,842 | $600 | $3,200 | $2,400 | $73,414 | $432,680 |
| S Corporation | $280,751 | $30,281 | $8,142 | $727 | $600 | $3,200 | $2,400 | $46,850 | $302,955 | ||
| 2034 | $1,418,940 | Other Pass-Through | $1,418,940 | $31,620 | $41,149 | $10,970 | $600 | $3,200 | $2,400 | $83,739 | $516,419 |
| S Corporation | $322,864 | $31,620 | $9,363 | $1,106 | $600 | $3,200 | $2,400 | $49,789 | $352,744 |
How Was My Reasonable Compensation Calculated?
Hearth relies on data provided by Reasonable Compensation Reports, Inc., Bureau of Labor Statistics and U.S. Census data to calculate a concise, independent, unbiased Reasonable Compensation figure.
Cost Approach
The Cost Approach takes into consideration all the tasks a business owner provides to their company, such as administration, accounting, marketing, purchasing, etc. (also referred to as the Many Hats Approach).
The Cost Approach breaks down the time spent by the owner into the various tasks performed; wage levels are assigned for each task based on the owner’s proficiency, and then added back together to obtain a hypothetical Replacement Cost for the owner.
The Cost approach is most accurate when used to determine Reasonable Compensation for owners of a closely-held business where the owner performs multiple job duties (wears many hats).
Market Approach
The Market Approach compares the business owner’s compensation to compensation within the industry. The market approach focuses as much as possible on the owner’s business and the specific position being analyzed (often the CEO or General Manager who also owns the business).
The question to be answered is: How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship at a similar company?
The Market Approach generally works best for medium and large businesses where the business owner provides only one duty: management of the business.
Income Approach
The Income Approach determines whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.
The rationale behind the Independent Investor Test is that investors pay employees to increase the value of the assets entrusted to their management. A high rate of return indicates that the assets’ value increased and that the employee provided valuable services.
The Income approach generally works best when there is no comparability data available.
Data Sources
Your annual salary or Reasonable Compensation represents an estimate of the amount it would cost to “replace” you, based on:
- Your answers to our interview / intake questionnaire
- Bureau of Labor Statistics data
- Census data
- Reasonable Compensation Reports, Inc. database of wages
Reasonable Compensation figures include taxable Medicare wages and flexible spending accounts. Reasonable Compensation figures do not include non-taxable fringe benefits such as health insurance, vehicle or vehicle allowance, stock options, company loans and other items not reported on a W-2 as Medicare wages.
Other Considerations
For the majority of shareholder-employees, the Reasonable Compensation figure calculated in this report should not require adjustments. However, the following factors may need to be taken into consideration before recommending a final figure.
- Compensation of Non-Owner Employees
- Salary History
- Travel Requirements
- Personal Guarantee of Debt
- Key Relationships and/or Contracts
- Financial Condition of Company
- Distribution History
Court Factor Tests
The courts have used a variety of factors to “Stress Test” Reasonable Compensation figures. Four well recognized lists of factors are referenced below.
- The IRS Nine Factors Considered by Tax Courts: IRS Fact Sheet 2008-25
- The Tax Court’s Five–Factor Test: LabelGraphics, Inc. v. Commissioner, T.C. Memo 1998–343 (Sept. 28, 1998)
- The Tax Court’s Ten–Factor Test: Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200 (July 10, 2003)
- Summary of Court Factors used to “Stress Test” Reasonable Compensation Figures
Additional IRS Resources
- IRS: S Corporation Compensation and Medical Insurance Issues
- IRS: S Corporation Employees, Shareholders and Corporate Officers
- IRS Fact Sheet 2008-25: Wage Compensation for S Corporation Officers
- Job Aid for IRS Valuation Professionals
- Reasonable Compensation: Application and Analysis for Appraisal, Tax and Management Purposes by Ronald L. Seigneur and Kevin R. Yeanoplos
Sample Language for Your Corporate Minutes
Hearth recommends incorporating the results of this report into the Corporate Minutes of your S Corporation. Here is a sample document for that purpose.
The undersigned, being all of the directors of Stone Concrete, Inc. (the “Company”), waive any rights to notice, and consent to the following action, taken on , 20:
RESOLVED, that the Company adopt the report of Hearth Tax & Advisory, a copy of which is attached and, in reliance on such report, pay to Scott Stone the sum of $195,869 per year as salary for the duties set forth in such report.
This document is being provided merely as a sample of the type of language that the S Corporation may consider using in connection with minutes of the board of directors adopting the amounts determined by Hearth Tax & Advisory as Reasonable Compensation for its employees.
Hearth Tax & Advisory does not provide legal services, and does not represent that this sample will comply with state laws regarding the procedure for actions of the S Corporation’s board of directors or the form or content of the minutes memorializing such actions.
Hearth Tax & Advisory recommends that the S Corporation consult its attorney for legal advice regarding such matters.
Descriptions of Tasks Selected
Sell goods for wholesalers or manufacturers to businesses or groups of individuals. Work requires substantial knowledge of items sold.
Compute, classify, and record numerical data to keep financial records complete. Perform any combination of routine calculating, posting, and verifying duties to obtain primary financial data for use in maintaining accounting records. May also check the accuracy of figures, calculations, and postings pertaining to business transactions recorded by other workers.
Compile information and records to draw up purchase orders for procurement of materials and services.
Plan, direct, or coordinate the operations of public or private sector organizations. Duties and responsibilities include formulating policies, managing daily operations, and planning the use of materials and human resources, but are too diverse and general in nature to be classified in any one functional area of management or administration such as personnel, purchasing, or administrative services. May include moderate travel.
Smooth and finish surfaces of poured concrete, such as floors, walks, sidewalks, roads, or curbs using a variety of hand and power tools. Align forms for sidewalks, curbs, or gutters; patch voids; and use saws to cut expansion joints.
Perform work involving the skills of two or more maintenance or craft occupations to keep machines, mechanical equipment, or the structure of a building in repair. Duties may involve pipe fitting; HVAC maintenance; insulating; welding; machining; carpentry; repairing electrical or mechanical equipment; installing, aligning, and balancing new equipment; and repairing buildings, floors, or stairs.