Reasonable Compensation Review Checklist: What the Reviewer Checks Before Signing

A finished salary figure reads the same whether it's right or wrong. The Study lands on your desk with a number at the bottom, and by the time you sign, that number is headed for payroll and the return. You're the last person in the firm who can still ask how it got there.

That's the job this reasonable compensation review checklist is built for. Review is where the firm's professional judgment actually gets applied, and it deserves better than a skim of the summary page. Your name sits on the conclusion, and your PTIN sits on the return it feeds.

This piece doesn't cover how to build the figure, and it doesn't list what the file should hold. The workpapers a reasonable compensation file should keep covers the file itself. What follows are the questions a Reviewer asks of that file before signing, with what a good answer looks like and what should send the Study back.

What the review step is for

The Study makes a claim: this salary is what like enterprises would ordinarily pay for like services under like circumstances. That's the language of Treas. Reg. §1.162-7, and it's a facts-and-circumstances test. Rev. Rul. 74-44 adds the other side of the problem. When a shareholder-officer takes distributions in place of salary, those payments can be treated as wages for employment tax purposes.

Neither authority produces a number. So the review asks whether the facts, the evidence and the method add up to the figure on the last page.

The IRS "Reasonable Compensation Job Aid for IRS Valuation Professionals" (2014) describes three approaches: cost, market and income. A Study picks one, or weighs more than one. How the figure gets determined walks through each approach in depth. At review, your question is narrower: does the approach chosen fit this business and this shareholder?

For the documents themselves, the reasonable compensation workpaper index lists them in order. Keep it open beside this checklist. Not tax advice.

Duties, time, and occupation mapping

Start with the facts. If the description of the work is wrong, every figure built on it inherits the error.

1. Do the recorded duties describe what the shareholder actually does?

• Good answer: duties captured from the shareholder in their own terms, specific enough that you could picture a week of the work. An officer who performs services is an employee under IRC §3121(d)(1), so the services are the anchor for everything downstream.
• Red flag: a job title standing in for duties. "President" tells you nothing about whether this person runs the crew, keeps the books or sells the contracts.

2. Is the time by function captured from the shareholder, and dated?

• Good answer: hours or a share of the week split across functions, recorded as intake with the date it was taken.
• Red flag: a clean even split that nobody can source. If you can't tell whether the allocation came from the owner or from a preparer's assumption, you can't rely on it.

3. Does each role map to an occupation, with the near misses noted?

• Good answer: each function matched to an occupation, with a sentence on why that match beat its closest neighbors.
• Red flag: a single occupation for an owner who plainly does three jobs, or a mapping with no stated reason. An imperfect match that's explained reads far better than a clean one that isn't.

Wage evidence and geography

This is where "every figure traces to a source" either holds or doesn't.

4. Does every wage figure carry its source, version and period?

• Good answer: the dataset named, the release or version identified, and the reference period stated for each number.
• Red flag: a wage figure with no vintage. Published wage data gets revised, so a number without a version can't be located again in the form the Study used. The guide to using BLS OEWS wage data covers what a clean citation to that source looks like.

5. Could you retrieve the same number from the citation alone?

• Good answer: yes, without asking the preparer anything.
• Red flag: you have to message someone to find out where a figure came from. If you can't retrace it today, nobody will be able to retrace it years from now.

6. Does the geography match where the work is done, and is the choice explained?

• Good answer: the area used for wage data tracks where the shareholder performs the services, with a note when that differs from the entity's address.
• Red flag: national figures used by default for a business that operates in one local market, or a higher-paying area chosen with no stated reason.

Computation and adjustments

The arithmetic is the easiest part to check and the one reviewers most often stop at. Check it, then keep going.

7. Can a colleague reproduce the arithmetic without asking a question?

• Good answer: roles, time and wage figures combine into one salary through steps written out plainly enough to repeat.
• Red flag: a total that only works if you already know the preparer's spreadsheet.

8. Is the chosen approach stated, with a reason?

• Good answer: the Study names whether it relied on the cost, market or income approach from the Job Aid, and says in a sentence or two why that approach fits.
• Red flag: an approach that appears nowhere, or a method borrowed from a template regardless of the business.

9. Does every adjustment show the prior value, the new value, who changed it and why?

• Good answer: each change carries the fact that drove it, not just a restatement that the number moved.
• Red flag: a figure adjusted downward late in the process with no rationale. That pattern can read as working backward from a target.

Prior-year change and contradictions

A single year can look fine on its own. Set against last year and against payroll, gaps show up.

10. If pay moved from last year, is the change explained by changed facts?

• • Good answer: the Study points to what changed: duties, hours, a new location, a shift in who does the work.
  • Red flag: a salary that dropped while the business grew and the owner's role stayed the same.

11. Were contradictions between the interview, payroll and distributions resolved on the record?

• • Good answer: each conflict named, the resolution stated, and the reason given.
  • Red flag: an interview describing part-time work beside a distribution history that describes a full-time operator, with nothing reconciling the two.

Courts have weighed what the shareholder actually did against how the money was paid out. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), Glass Blocks Unlimited v. Commissioner, T.C. Memo 2013-180, Joly v. Commissioner, T.C. Memo 1998-361, and Veterinary Surgical Consultants v. Commissioner, 117 T.C. 141 (2001), payments to shareholder-officers who performed services were treated as wages. IRS Fact Sheet FS-2008-25 sets out the IRS position and lists factors including duties, time devoted and what comparable businesses pay for similar services. Rev. Rul. 59-221 holds that a shareholder's share of S corporation income isn't self-employment income, which is why the wage line has to carry the employment tax on services. How reasonable compensation holds up under exam covers what happens when these questions come from an examiner instead of you. Not tax advice.

The stated conclusion

12. Is the conclusion written in words, with the figure, the approach and the facts it rests on?

• • Good answer: a short paragraph a stranger could read and check against the file. The figure, the approach, the key facts, and anything the Reviewer weighed.
  • Red flag: a number with no sentence attached.

The conclusion also has to match what goes out the door. Officer compensation is reported on Form 1125-E, which the IRS Instructions for Form 1125-E require with Form 1120-S when total receipts are $500,000 or more and the corporation deducts officer compensation. The form reports the figure without testing whether it's reasonable. That test happened here, in your review.

Where the software fits in the review

TracePrep puts the answers to these questions where you can check them. Inside the Firm's own engagement, the Reviewer opens the Study and sees where each figure came from: source, occupation, geography, period. Adjustments carry the prior value, the new value, who changed it and the reason. Contradictory inputs are flagged before review. Then the Reviewer signs off on the record, and the conclusion stays the Reviewer's. The software supports professional judgment; the call is yours.

Conclusion

A reasonable compensation review checklist of twelve questions, asked the same way on every Study, turns review from a glance at the total into a check of the reasoning behind it. For the full picture of the standard these questions test, start with the S-corp reasonable compensation guide.

Every figure traces to a source. The Reviewer signs off on the record.

These are the questions that come up most when firms build a reasonable compensation review checklist.

TracePrep is a software product from TracePrep Inc., not a CPA firm. This content is operator experience for educational purposes; it is not tax advice and has not been reviewed by a licensed CPA. Consult a qualified tax professional for guidance on your specific situation. Source citations in TracePrep workpapers support audit defense but do not guarantee IRS outcomes.