(Reading time: Under 2 minutes)
In an episode of the critically acclaimed sitcom, Arrested Development, aspiring magician and underachieving employee of the Bluth family business, G.O.B Bluth, tells his brother, Michael, “I figured out a way to make money while I’m working.” Michael, the work-oriented and responsible Bluth brother, replies, “But that is what we call working.”
G.O.B. rarely performs work that adds to the value of the business, but, as a member of the Bluth family and officer of the Bluth Company, he is on the company payroll. His salary is an example of a discretionary expense that can affect the understanding of the company’s value.
Business owners typically have a fair amount of flexibility to choose how they compensate themselves and their officers. The IRS mandates that the officers of a corporation, including the CEO, president, vice president, and any other shareholder employees, must be paid a “reasonable compensation” for their labor, but what qualifies as “reasonable” is left unclear.
Depending on the nature of the business in question, there could be many factors that affect the level of compensation chosen for the business’s shareholders, including the following:
- When possible, companies tend to pay their officers wages that reduce taxes.
For example, a C corporation might increase their shareholder’s compensation, and eliminate dividends, to avoid double taxation, while an S corporation might decrease their shareholder’s compensation in order to reduce payroll taxes.
- The shareholders may be receiving deferred compensation that was earned in previous years when the company was not able to pay them immediately.
When performing a business valuation, the valuator must use adjustments to normalize officer compensation and other discretionary expenses in order to exhibit an accurate income stream for a potential buyer of the company. Essentially, officer compensation adjustments restate the economic income of the company to demonstrate a level of compensation that would be given to an officer if there was not flexibility in choosing officer compensation.
To do this, the valuator assesses the officer’s worth to the company. This is done by examining factors including and related to the following:
- Employee’s education, experience, and other qualifications,
- The nature and extent of the employee’s duties,
- Size of the business,
- The state of the market, and
- Comparison to the salaries of people in the same position at similar companies.
If normalizing adjustments are not made to officer compensation and other discretionary expenses, the business in question could be over or undervalued. For example, let’s say G.O.B. is receiving an annual compensation of $100,000 from the Bluth company but does not contribute to the company’s operation. On paper, this $100,000 salary takes away $100,000 of value from the company’s profits. Because a potential future business owner would not be obligated to pay G.O.B.’s salary, this discretionary expense would be eliminated during the valuation process and a more accurate understanding of the company’s value would be reached.