If you work with S Corp clients, you've likely faced the challenge of setting reasonable compensation for owners who play multiple roles. Many tax professionals follow traditional rules of thumb, like a 50/50 or 60/40 split between salary and distributions, to set S Corp owner compensation. However, the IRS expects a fair wage based on the services owners provide, not just their share of profits. When traditional market data doesn’t quite fit, the Cost Approach is a practical method to determine fair pay based on what it would cost to replace the owner’s work. 

What is the Cost Approach?

Instead of only looking at what others are paid in similar roles, the Cost Approach asks, “What would it cost to replace the owner’s unique contributions to the business?” This method focuses on the specific roles and tasks the owner performs. So, if your client wears multiple hats—generating sales, managing people, technical work, and day-to-day administration—the Cost Approach captures each piece and adds it all up. It’s a great option when the usual data sources don’t paint the whole picture.

Key Steps to Apply the Cost Approach

1. List Out the Owner’s Tasks: Start by getting a full picture of the work the owner actually does. Are they overseeing employees, handling client relations, or managing finances? Having these details makes it easier to estimate what an outside hire would cost.

1. Estimate the Cost for Each Role: Now, think about what the business would pay someone else for each responsibility. Here’s how:

   • Look Up Comparable Salaries: Check industry-standard salaries for similar positions, ideally within the same field and location. If they’re performing specialized tasks, those may have higher pay rates. The Bureau of Labor Statistics (BLS) Occupational Employment and Wage Statistics is a great resource for researching salaries and wages across different geographic locations and job types. 

   • Factor in Experience: If the owner’s skills are unique, that replacement cost may be higher. For instance, a technical founder might have skills that are hard to find on the job market. Using the various percentile wages in the BLS data is a great way to adjust for experience. For example, use the 75th or 90th percentile wages to adjust for an S Corp owner that has a higher experience or skill level in a specific area. 

     
     

2. Add It All Up: With replacement costs in hand, calculate a total by considering the time spent on each task. For example, if the owner spends 40% of their time on management, 30% on client services, and 30% on administration, apply those percentages to each role’s estimated salary, then add them together.

3. Adjust for Ownership Value: Since an S Corp owner often brings unique dedication, responsibility, or advanced skills, it may be reasonable to set their compensation slightly higher than what a non-owner might earn in a similar role. However, this adjustment should be realistic and grounded in their contributions. 

Why the Cost Approach Works

The IRS requires S Corp owners to earn a reasonable wage for their work. Unlike simple salary-to-distribution splits, the Cost Approach is a reliable way to calculate fair compensation based on the owners’ unique contributions to the business, lowering the chance of negative findings in the event of an audit.

Who is the Cost Approach Best For?

The Cost Approach is especially useful for S Corp owners who take on specialized or hard-to-replace roles within their businesses. It’s ideal for small business owners in fields like consulting, contracting, healthcare, or tech, where the owner’s work isn’t easily matched by standard market salaries. This approach ensures fair compensation by valuing the unique contributions of owners whose skills and involvement extend beyond typical management.

Quick Example

Picture an S Corp owner who splits time between managing the business, handling client projects, and managing accounting and finances. You’d use the Cost Approach to:

• Find salaries for each. For example, the following roles from the Bureau of Labor Statistics may be appropriate: General and Operations Managers, Project Management Specialists, Bookkeeping, Accounting and Auditing Clerks

• Adjust each salary according to the time the owner spends in each role.

• Sum these amounts to reach a fair, reasonable compensation total.

Using the Cost Approach gives tax advisors a practical way to determine a fair wage for S Corp owners, even when typical salary data doesn’t quite fit.

About the Author

Charles Roscopf is a Texas-based CPA with over 13 years of experience in accounting, finance, and tax services. Charles has worked for both large firms, like Ernst & Young, and small startups, and he recently launched his own consulting firm, Scratch Consulting, LLC (scratchconsultingllc.com). When he’s not advising clients, Charles enjoys spending time with his wife, two children, and two dogs.