What documentation do I need for reasonable compensation?

A defensible file should include: a written job description, market data analysis (BLS wages or salary surveys), a methodology memo explaining how compensation was determined, board or management approval documentation, and supporting company financial data.

Documentation Best Practices for Reasonable Compensation

Documentation is the cornerstone of defending reasonable compensation. When the IRS questions shareholder salary, the burden shifts to the taxpayer to demonstrate that the amount was reasonable. Contemporaneous, well-organized documentation carries far more weight than analysis prepared after the fact. This guide outlines what to keep, how to structure it, and how to maintain it over time.

What Documentation to Keep

A defensible reasonable compensation file should include several core elements:

Written job description

A description of the shareholder's duties, responsibilities, hours worked, and scope of authority. It should reflect what the person actually does, not a generic template.

Market data analysis

Bureau of Labor Statistics wage data, industry surveys, or comparable company benchmarks. Include sources, dates, and any adjustments applied (geography, company size, experience).

Methodology memo

A brief memo explaining how the compensation was determined. Which factors were considered? How was the final amount selected from the range? What process was followed?

Board or management approval

Minutes or written approval documenting that the compensation was reviewed and approved. Even in single-shareholder S-corps, a formal resolution or memo creates a record.

Supporting data

Company financials, revenue, and profit levels that provide context. Compensation that aligns with company performance and market rates is easier to defend.

How to Build a Defensible File

Structure the file so an examiner can quickly understand the rationale. A logical flow:

Executive summary

One page summarizing the shareholder's role, the methodology used, and the conclusion (e.g., salary of $X is reasonable based on duties and market data).

Job description

Detailed duties, hours, qualifications, and responsibilities.

Market data

BLS or other sources with clear citations. Show the range of comparable compensation and where the chosen amount falls.

Factor analysis

How each IRC §162 factor (duties, time, experience, comparable pay, company size, etc.) was applied.

Approval and date

When the analysis was performed and who approved the compensation.

Pro tip: Keep it organized

Keep the file in a single location—a dedicated folder or secure portal—so it can be produced quickly if requested. The faster you can respond to an IRS request, the better your position.

The Annual Review Process

Reasonable compensation should be reviewed every year. Duties change, market rates shift, and company circumstances evolve. A repeatable process:

Update the job description

Have the shareholder confirm or update their duties, hours, and responsibilities. Document any changes from last year.

Refresh market data

BLS data is updated annually. Industry surveys may have new editions. Ensure benchmarks reflect current conditions.

Re-run the analysis

Apply the same methodology to the updated inputs. Does the prior year's salary still fall within a reasonable range?

Document the review

Add a one-page memo or checklist to the file: "Annual review completed [date]. No material changes to duties. Market data refreshed. Salary of $X remains reasonable."

Obtain approval

Formalize the result with board minutes or management sign-off.

What Auditors Want to See

IRS examiners and quality reviewers look for several things:

Contemporaneous documentation

Records created at or near the time compensation was set, not produced in response to an audit.

Independent benchmarks

Third-party data (BLS, surveys) rather than self-generated estimates without support.

Consistent methodology

The same approach applied year over year, with changes explained when they occur.

Transparency

A clear, logical path from duties and market data to the chosen salary. No unexplained gaps.

Disorganized records invite skepticism

Documents that are disorganized, unclear, or created long after the fact invite skepticism. A well-structured file signals that the taxpayer took the requirement seriously. Learn more about preparing for an IRS audit.

Common Documentation Gaps

Many clients—and some practices—have incomplete files. Typical gaps:

No written job description

Duties exist only in someone's head. Get them in writing.

No market data

Salary was "estimated" or "based on industry norms" without source documentation. Add BLS or survey data.

No methodology memo

The CPA knows how the number was determined, but it is not documented. Write it down.

No annual review

The same salary has been used for years without review. Implement a yearly process.

Retention and Access

7-year minimum retention

Keep reasonable compensation documentation for at least seven years—longer if the client has a complex history or prior audit. Ensure the file is accessible to the client and their representative. In an audit, the IRS will request documentation; having it ready and organized shortens the process and strengthens the position.

Key Takeaways

Build the file proactively — before it's needed, not in response to an audit
Include five core elements — job description, market data, methodology, approval, and financials
Structure logically — so an examiner can follow your reasoning quickly
Review annually — update duties, refresh market data, re-run analysis, obtain approval
Retain at least 7 years — keep files organized, accessible, and ready to produce