Small businesses that are operating as “flow-through entities” are becoming increasingly common. We see a lot of compensation issues arising from these types of businesses. When such a company comes to you for accounting services, what best practices can you keep in mind?
8 Best Practices for Setting Reasonable Compensation
It’s important to remember that “reasonable compensation” is left open to interpretation. Therefore, no single factor is likely to ever be determinative. However, based on recently litigated cases, these eight best practices have arisen:
- Use the fair market value. In other words, charge what the service is worth based on the current market value of the service being provided to the small business.
- Always put it in writing. A written agreement should always be in place. It should clearly document the services to be provided.
- Consult an objective opinion. It’s dangerous to enter into an agreement drafted solely by the service provider and receiver. Include a non-interested third party when establishing the criteria of the agreement and the service value.
- Document payment. The business should make payments based on the terms and conditions of the agreement. If an adjustment is made when accepting, delaying, or changing a payment, document the reasons and why or how compensation was changed.
- Avoid discounting qualifications. Compensation should always reflect actual qualifications. In other words, someone with many years of industry experience should receive higher compensation than someone who has just entered the job market.
- Properly assessing business conditions. Compensation should match the owner’s or employee’s worked hours, duties, responsibility scope, expectations, and the complexity of the business and conditions. All of this should be established at the time the agreement is reached.
- Measure compensation over time. As time passes and the business grows, compensation should be tracked, measured, and evaluated. How much has it increased as the company has grown larger, accomplished its goals, and increased profits? If it hasn’t, this might alert the IRS to a compensation issue.
- Compare against other metrics. It’s a good idea to compare owner/employee compensation to other metrics within the company, such as gross and net income, shareholder distributions and non-owner employee compensation.
- Compare against other businesses in the industry. You can consult annual studies on your own, or hire an expert to assist. The idea is to gauge company profits versus compensation. For example, if profits are high and compensation low, you may have an issue that will raise a red flag at the IRS.
Explaining reasonable compensation to small business owners can prove to be a challenge. However, if you stand by these eight best practices, you will be promoting a service that safeguards the small business by avoiding an IRS issue with reasonable compensation.
For more practice managements tips, check out the book Accounting Firm Owners: The 7 Secrets You Know To Increase Profits in 2014.
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