Reasonable Compensation 101

Today, our guest is Paul Hamann. Paul is the founder and president of RCReports. RCReports is an online application that helps determine reasonable compensation for closely held business owners. I’ve known Paul for quite a few years, and I’m glad that we were able to get this opportunity to record today. 

Paul, I just noticed a month ago or so was listed, and now I’m jealous, but he was listed on the CPA Academy’s top presenter awards for 2022. So he you know, you know, he’s very educational. And I know he bases his firm on education first, which is really cool, because I feel we do that as well. But Paul, welcome to The Unique CPA.

Thank you so much for having me on. Randy. I’ve been looking forward to this.

Yeah, it’s. So this actually came about, like I said, I don’t even know how many years ago you and I first met, it was at a conference. I don’t even know the location of the first conference we were at together might have been like Boston or something, or…

Yeah, in Boston or San Diego. But yeah, it was a while back. 

It was a while back. And honestly, and I hate to admit this, I didn’t really understand what reasonable compensation, what you do with RCReports and reasonable compensation was, and I honestly still don’t. But I was talking to you about it a little bit recently, and you did an awesome job of educating me on this. And I thought, you know what, we need to get this out here. Because if I, if I have all this misinformation in my head about this, I’m thinking a lot of other people do. So real quick, before we get into what’s reasonable comp and all that, why don’t you give us a little background on RCReports and how that came about? And then we’ll go from there.

Absolutely. So my background for the last 25 years has been in and around human resources and compensation. And in the late 2000s, this issue of reasonable compensation just came out of nowhere, and it came out like a freight train. People were getting audited through IRS issues and some others. And so some close connections to me reached out and said, “Hey, we need something called a reasonable compensation study.” And I said, alright, let me take a look, I’ve done a million comp studies, what’s different about this one? And there was some differences. 

And so I got into it, figured it out, and afterward, took a look back after I’d done a few of these, and they were taking me about two days, just so you know, to complete one. And I was probably billing some of their neighborhood of two to three grand again, this is like 10 or 15 years ago now. Right? Probably closer to 15. Which, that’s not a small price tag for anything else, for what you would consider a reasonable comp study. 

And so I just started gathering people around me, I’m pretty relationship based. When I meet people, I tend to know him for a long time. And I said, like, can we make this process easier? We need to figure out reasonable compensation, and we need to do it quickly, like less than two days, and we need to do it accurately, because even back then, some of the studies I don’t think had the best data. And we need to do it at a reasonable price. And so that was our humble beginnings. I just, I did what everybody does when they have this problem, I Googled it. I could not find a solution. So that’s where it came from. We built it.

So today, you would probably ChatGPT it, not Google. It seems like that’s taken over. But yeah, that’s how I do a lot of my research, googling things. 

So let me just jump right into it then. Because I’ll just say that the myth or the misinformation, one of the things I had in my head when it comes to reasonable compensation, and I was a practicing CPA journalist for a long time, in the early 2000s, I was, as well. And so I knew about this, I heard the terms, but I always assumed it was like, okay, everybody’s trying to minimize their W-2 and their S corp, so they can maximize their distributions. And so reasonable comp, in my mind was like, hey, let’s just make sure that it’s a, you know, whatever, we’re covering Social Security taxes, and now the IRS is going to accept our compensation as reasonable and then we can take out a bunch of distributions. That’s not how this works. But after you tell me why don’t you debunk that myth and give us a more definition, what really this is?

Absolutely. And I think a huge part of kind of the way you were thinking about it back in the day, and a lot of the ways current practitioners think about it, was caused because there was this giant void or vacuum on the subject. There really wasn’t anything out there. So what happens when there’s nothing? People start coming up with, with different ways of coming up with it? Because you got to be able to answer the question when your clients ask. 

Right.

So at one point in time, a myth came, became very popular, a lot of people still think it’s true today, which is, well just split your distributions and reasonable compensation 50/50. Others were paid the Social Security maximum, or a percentage of net sales or gross revenue, those types of things. And what that did is it did give you a number to put down, it may keep you from throwing a red flag with the IRS, but it didn’t really meet what the IRS eventually came out as their definition of what reasonable compensation is. And to everybody’s defense out there who’s been practicing for a while, that definition really didn’t come out, and it really wasn’t clarified till about 2008. 

Okay.

But from that point forward, it’s just been trying to debunk the myths because the mister spins have been ingrained for a decade before that. So it’s rough to actually get the actual facts through.

Right. And so can I actually point to a IRS code section that says here, you have to have a reasonable compensation? Or is it based on IRS notices and clarifications or court cases? Where do we get the definition of what reasonable comp is?

Yeah, so the actual definition is in the IRS code, and I’d have to look up the actual number for you—I have it somewhere, don’t have it memorized. But basically, what it reads, let’s see if I can do this from memory is reasonable compensation is the value that would be paid if you worked for an outside employer doing the same thing, under the same circumstances, that’s paraphrasing a little bit. But basically, that’s what it is. And then they provided a significant amount of additional information on top of that over the years. So there’s a fact sheet that expands on that. There’s court cases that also kind of factor into some of that, as well as an Internal job aid that’s now available publicly that all talks more and more about how you actually determined reasonable compensation and what the definitions are. But none of that started coming out until about 2008. 

2008. And you’ve been in business—RCReports, when did that begin?

Well, we began just kicking the idea around, seeing if we could actually do it, in 2010. And we launched our product in 2012. So we had our 10 year anniversary last year.

Well, happy anniversary. 

Thank you. 

Last year was our 15th year, so we’re kind of on that same same schedule. So a two year process of like, kicking around to go live. So in the meantime, were you still doing your day to day studies, or?

I was. The biggest holdup was we didn’t have the data, right? The platform itself that you interact with, that wasn’t a hard build. But the data that pushes everything that we rely on, there wasn’t a complete reliable database out there. So that’s where it really held us up. And so we built it, and we maintain it. And it is by far we put most of our resources. 

Yeah, I would assume that database has to be pretty in depth to figure this out. That was I guess my next question you just said, so how do we then calculate reasonable comp, but I mean, you must have all kinds of statistics and data based on industry and job title and all this. So what goes into determine what a reasonable comp is?

First and foremost, you need to have that back end so that no matter what you do, you can find that number. And then what our software does is it just walks you through a number of different options. There’s different ways of determining reasonable compensation, different approaches that the IRS has formalized in their job aid. But depending on which approach you use, we just ask you some questions. But really, what we want to break down is what do you do for your company? What are the services that you provide? Great, now, what is the market pay for those services? Fantastic, we know that, now we can build you a custom job profile or a custom reasonable comp study.

And then, you know, let’s say your services, what if you were the top in your industry, and so you’re not the same, you know, payment schedule, maybe, that someone else is? Is there like a sliding scale that you can say, hey, you know, this individual just has so much more knowledge that they really should be paid a higher comp, or this is somebody new to this position that probably a lower comp on the scale. How do you determine that? 

So we have skill levels, experience levels, proficiency levels, however you want to describe them, built into that process as well. So as an example, a lot of small business owners do bookkeeping, right? It’s not usually their main piece of what they do, but they do some of that. So when it comes to that section of the interview, we’re like, okay, well first, tell us how much time you spend doing bookkeeping each and every month. And then also let us know, you know, where you rank as far as skill in that, right? We go all the way from low to high, and we’ve got three options in between there, but each one of those will be tied to its own unique wage.

Alright, so this is something I should have said at the beginning and didn’t but I’ll ask, I won’t say it—I think I remember hearing maybe in talking to you that every S corp owner needs this, right? This is not something that’s like, you can decide yes or no, I’m going to do this? If the IRS comes calling, this should be in or needs to be in your packet of documentation?

Absolutely. So being proactive is the insurance in this matter when it comes to compliance. If you pull a number out of thin air, which a lot of small business owners do, or they rely on one of the myths that their tax advisor is still relying on, and the IRS knocks and says, “Hey, where did you come up with that $40,000 figure?” “Oh, well, my CPA said that I just split distributions and wages 50/50.” Okay, well, I don’t know where you got that information. It’s not part of the IRS information. But we think your reasonable cost should be closer to $70,000.” So you need to have this in your background, because it is great documentation and protection against getting that question.

And so what is, I guess going back then to the “why” then—I mean, the “why” is probably multifold. But my mindset was always, let’s not underpay, because the IRS wants their Social Security taxes. But now, when you and I were talking before, it’s like, we can’t also overpay, you know, because there are certain things that come into play if let’s say you’re a highly paid individual, and you’re trying to maximize your QBI. And so to do this, you get to a point where you have to go, you know, half of the wages paid out, or 20% of the net income. And so that’s probably another thing, they want to make sure you’re not just coming up with a number that says, hey, they did this to to maximize QBI. What are the things that they’re trying to avoid when it comes reasonable comp from either the low end or the high end?

Yeah, so we do have reports for a number of different issues, but s corps are our most popular. But traditionally, that was the game so to speak, right, which is the skinny down your reasonable comp for an S corp and save on payroll taxes and the C corps are playing a different game—let’s fatten up reasonable compensation, so that we can avoid double taxation—

Oh, right.

—by paying that. When the Tax Cut and Jobs Act passed, that got a lot more confusing, because we do have 199A now, and corporate income tax went down quite a bit as well. And so there are these scenarios now where as a taxpayer, you might be better off raising your reasonable comp up in an S corp or lowering it in a C Corp. But I use the word “reasonable” incorrectly, what we’re talking about is optimized compensation. And the IRS doesn’t care at all about optimized compensation. They want reasonable compensation, which is what is it going to cost to replace yourself and your company? It’s that hypothetical amount.

Yep. So really reasonable compensation, determining compensation is not an optimization tool, “let’s optimize our tax savings.” That’s not this has to be completely—well, I’ll take that back. It needs to be completely separate from tax planning from let’s say it after the fact. But it can be used in tax planning, probably like, Hey, we are currently a Schedule C, maybe we should be an S corp, let’s determine if there’s tax savings in becoming an S corp, whatever they are, and it may just be the the reduction in Social Security taxes or things. But that has can’t be based on then, us picking a number out of the out of the cloud out of the air, it has to be still reasonable. But then you can use that in the planning opportunity. Hey, we’re deciding if we should be an S corp or not. Let’s see reasonable comp, how’s this gonna play is? Is it used in tools like that, then?

Oh, yeah, absolutely. So using RCReports in one of two places is very popular—tax planning is my favorite, right? That’s when you get to really start to build that relationship with your client, or you already have that relationship with your client. Hey, let’s run a reasonable comp report. Let’s see what your reasonable comp is. Then let’s plug it in to an entity planner, we have one in our system, and take a look at what that looks like for your business over a 10 year timeframe. It may tell you no, from dollar standpoint or a tax savings standpoint, this doesn’t make sense. But it can also show the opposite. 

So now we’re doing tax planning, we’re helping out the client. Reasonable comp is a lifecycle of a business issue, right? It helps you from day one, decide whether you should maybe look at an entity choice. It comes into play if there are life changes during the course of that business. And what I mean by that is typically divorce but also end of business, right? Either you’re passing it on to the next generation, or you’re valuing it to sell it. Reasonable comp plays a role in all of those steps. So if you’re consulting, you do truly have that advisor practice or you’re building toward that advisor practice, reasonable comp, our good friend Dawn talks about it all the time. It’s the building block, you need to know that first before you can have any other meaningful discussion. So that’s my favorite place. 

The flip side of that is compliance, right? We want to keep you out of hot water. If you’re in hot water, we want to try and help you as much as we can.

So you just mentioned Dawn—Dawn Brolin is who—you and I and she were all on a call together just talking about this. And I just got intrigued with that reasonable comp, and, and felt so uninformed, like I didn’t even know that everybody needs this. But let me ask the question on that then. Is it every S corp, every C Corp owner needs this? Or are there other employees that if you’re not an owner, this still needs to come into play? Or is it just the owner that we’re talking about?

Yeah, so it’s typically going to be the S corp or the C Corp owner, right? Because the number they’re using to pay themselves, they need to have some kind of backup for that, rather than pulling it out of thin air, or using, you know, one of the myths that are out there. But there are situations where other people in the firm may need to have a reasonable comp report run on them, typically in valuation or in litigation, but they’re going to be typically senior members, right? They may not be necessarily shareholders of the company, but they could be close family members, etc., where that wage may not have been set at a market rate. So it does happen, it’s just doesn’t happen very often.

Okay, that is great. This is so much great information that everybody needs to know that I didn’t know everybody needs to know. The one thing that you just mentioned when we were talking is kind of alluded to advisory and using this in tax planning, but advisory in general. Advisory is a huge topic, in fact, now I’m gonna brag for a second, I just got another invite today. I’ll be speaking at the accounting today growth conference twice on two different advisory subjects. So I love talking about advisory. So how does this help the preparer become more of an advisor then?

As a preparer, if your market is going to be small and medium sized businesses, knowing what that reasonable compensation figure is going to be a lead into, I don’t know, least a half dozen conversations right off the bat. First and foremost is entity planning, either demonstrating that it does make sense to move maybe to an S corp from a Schedule C, or not. If you are building your practice, and you’re working with somebody who has a Schedule C right now, and it does benefit them to move to an S corp, right? You’ve just built in another 1120s into your practice. Now that S corp needs do payroll, if you’re offering payroll services, then you can offer them payroll services, in addition to this, and you can build all this into that, to that analysis. 

As that business grows with you, which is what I think advisors really love, I think there’s a lot of reward and passion for accountants that move to advisory, to just work with that small business as its as it grows and moves on and it starts to bring other people on, or other shareholders on, and things along those lines, compensation comes up, you can obviously address that. But when those other lifecycle needs start to come up, which they do, and unfortunately, like I said, one can be divorce, right? Reasonable comp comes up in that regularly. 

Or at the end of the rainbow, your successful client is cashing out and selling their company, having read that reasonable compensation figure when the evaluator is doing their thing, having that already set ahead of time, so they don’t have to make big normalization adjustments that just reflect so much more positive on not only the business, but on you as the advisor. So I am very passionate about accountants getting more and more into advisory. It’s really where they can help businesses. I mean, they can make a huge difference.

I agree completely. And, I think it’s just more rewarding too. And compliance is  extremely necessary and extremely needed. And good people in compliance are great. Boy, adding that advisory, like you said, seeing the growth of your client that you’re contributing to and that you’re keeping them, you know, at a point where they can continue keep investing money back into the business. However, you’ve done it through advisory is awesome. 

Let’s switch gears for a second. And I mentioned at the beginning that you were listed as one of the top presenters on CPA Academy this past year. I know education, and I’ve heard you say, is a passion of yours. And want to expand on that—the education aspect of what you do through RCReports.

Absolutely. I educated myself on reasonable compensation back when we started the company. But when we launched the product, what I realized is how much myths were out there and nobody was talking about it—literally nobody, otherwise I’d have taken the course. So we were one of the very first presenters on CPA Academy. I know Scott Zeratt, the owner over there quite well. And we’ve been presenting on that platform and many others for many, many years, but a foundation of our company, and we talked about this regularly—we are an education forward company. Almost everything we do to introduce ourselves to the public comes with education.

Yeah, we do the exact same thing, I feel like, that we are education first. The Unique CPA is basically a secondary brand of Tri-Merit, really, and it’s all about education. And we’re doing it right now. Doing it through webinars, doing it through conferences, doing it through articles. So I, I have my personal, which I’m sure I stole from someone else, but my personal I guess, Milo or something that is share your knowledge. I just figure if you share your knowledge, people are going to come to you and realize you’re the expert. So it seems like we have the same philosophy there.

Oh, absolutely, yeah. Love to be able to get the actual facts out in front of people, and I can’t tell you how many hundreds if not thousands of people have had the same reaction as you had. It’s like I had no idea. I just skipped over it for years. And it is something that we need to talk with our clients about.

Yeah. I’m gonna put you on the spot right now. You don’t have to answer this. But we do a lot of webinars, and I’d love to have you present on our platform at some point on this because you know, we have access to a lot of CPAs. And tax preparers, EAs I got the stuff generically “CPAs,” EAs, tax preparers, tax advisers, tax reporters that would love to do this. So you and I will talk about this after the fact. But that’d be awesome if we could work that out.

Absolutely. I can tell you right now, if I turned you down, you would probably be a first. Somebody gives me the opportunity to educate, I take it. I love doing it. And I love getting the actual information out there. And we’ve built a fantastic stable of different educational topics. Let’s catch up. You let me know what you want me to talk about. I will be there.

Yep. This is awesome. Everybody heard it. It’s official now, it’s on the recording here. Paul’s coming on and educating us. 

Alright. So before we wrap up reasonable comp, because I think you did a great job explaining this. I’m gonna let you wrap that before I go. The final two questions I want to ask you. So give us a wrap up on reasonable comp that is going to help us all.

For a lot of you out there, if you are already up to speed on this, fantastic. If you’re not, it’s an issue that’s been in the background, it’s coming to the forefront. I love it from an advisory role. But just be aware that a recent Forbes article or recent Entrepreneur magazine article, they’re sounding the warning bell, the IRS is coming for this issue. And they’re also got the funding to do it. Just get a piece of paper in your file. Even if it’s not on a piece of paper, put a piece of paper in the file that is reliable that you can pull out to backup reasonable comp for your clients. It’s going to be a lifesaver when you need it.

Yeah. That being said, then, because I think this is important. And you know, we’re normally not like selling products or anything on this. But I think yours is such a unique and important tool that, why don’t you talk about how people work with your product. And it’s a subscription is it every single comp report you pay for, how does it work?

we have a couple of different options. We do have it if you need a single report, you can buy one, right because there are some scenarios like that. But almost all of our clients or customers buy a subscription. And we have a couple of different levels. We have a basic and a premium depending on what different options and features you’d like. They’re all annual, so you can log in anytime over that year, use any of the tools that are built in, run reports as many as you’d like. And we built it to be incredibly affordable, especially when you look at the industry for wage data.

Yes, that was one of my very first impressions. You put your pricing rate on the website and then like does he know he’s got the corner on this market because those prices are really reasonable! At least I assume you have the corner on this market but that’s very fair pricing. And so I would just recommend anybody go there, RCReports.com, pricing is a tab right on the website. So take a look at that because it is important again, I didn’t know this I didn’t know we needed this and boy putting this is getting as much contemporaneous documentation into that file as you can during the tax year is important I know that through different residents and I’m so so same thing with this. 

Alright, final question then. I’m gonna put you on the stand—put you on stand? Yeah, we’re now going to tax court—no, we’re not gonna do that.

Alright, well, I’m gonna I’m gonna have to go with the Chiefs.

That was not the question! But this one, we shall see what happens. People will hear, this will be out after the Super Bowl, and we’ll see if your prediction was correct.

I’m not saying it’s correct. I’m just gonna say that who I’m gonna have to root for, because they’re in our conference.

Alright. Are you a Broncos fan? Is that… wait.

I try to be a Broncos fan but they make it really hard.

Yeah. But you do live in the Denver area, right? 

Yes, I do. 

Alright. Well, here’s the question then. And it may be related to where you live. You know, besides being the guru on reasonable compensation and the educator, when you’re not working and educating, what do you do for fun? What’s your outside of work passions.

My outside of work passion is outside. It is outside under the sky. And there’s two places that I always always want to be. One is right behind me, my wife had that made that’s in any beach on Kauai, which we visit as often as we can, the hiking on that island will knock your socks off if you’re a hiker. If I’m not hiking there than on in the high country of Colorado hiking, I also like to paddle when I can, but I have a chocolate lab. And as much as he likes to swim, he’s not great in boats. So if I’m hiking, he’s usually with me, as is my wife, if a hike is isn’t too extreme.

So my wife and I, you and I were talking before we recorded, my wife and I are on our winter trip, we head out to Chicago for the winter. You know, Denver in the winter, I think, is much better than Chicago in the winter. And so we’ve been up in Arizona and California and hiking is a big part of what we’re doing. So I agree completely with you—hiking is one of my outside of work passions. 

Well, with that being said, we already said the website, RCReports.com. I assume any information they want us they can get there, or would you direct anybody anywhere else?

Absolutely. If you’re interested at all, grab a demo, our demo team is the best, they just are fantastic. We have a phone number on the site. So we nine times out of ten when you dial that number, you will get to talk to a live person.

Alright, I’m gonna call ten times today and see if I get nine out of ten people answering, and then I’ll report back if Paul was accurate with nine times out of ten. 

So don’t be surprised if they keep asking you why you’re calling.

It’s that Randy guy again! What’s he doing? Don’t answer! Don’t answer! Well, we met the requirements of laughing, so I appreciate that, and educating, we met the other requirement. So awesome job today. It was great talking to you. And I really appreciate you being a guest on the show.

Thank you so much for having me on Randy. I do very much appreciate it.