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Owners’ Compensation – What’s Reasonable And Why?

Posted in Business Valuation, on Feb 2018, By: Mark S. Gottlieb

Many of you may know that I am an Adjunct Professor at Fordham Law School.  This past weeks lecture included a discussion of normalization adjustments to be considered when utilizing the income approach in a business valuation.  As I was presenting my talking points I remembered a lecturer I gave for the Internal Revenue Service many years ago.  During that lecture on tax issues concerning closely-held businesses, I proudly stated that I could show business owners how to avoid (not evade) corporate income taxes by modifying shareholder-employee compensation before year-end.  As you can imagine, my remarks were not warmly greeted by the IRS representatives in the audience. The IRS and closely-held business owners often disagree about the reasonableness of shareholder-employee compensation.  This disagreement is found in both income tax and business valuation instances.

For income tax purposes, business owners usually prefer to classify payments as tax-deductible wages because it lowers its federal taxable income and corporate taxes. But, if the IRS believes that an owner’s compensation is excessive, it may claim that payments are disguised dividends, which aren’t tax deductible.

The determination and application of reasonable shareholder-employee compensation is also often a contested issue in business valuation.  When shareholder-employee’s compensation is overstated, the available cash flow is often lower and the indicated value (under the income approach) is less.  For this and other reasons, the determination of officer compensation is often a contested adjustment.

Whether this conflict is between the taxing authority or an opposing valuation expert, the case law dictates one thing is certain – reasonable officer compensation is decided on a case-by-case basis.

The Trial and Appellate Courts have often struggled with the issue of reasonable officer’s compensation.  In many instances amounts employed by experts have considered replacement costs, peer group comparisons, compensation studies and employment ads, to name a few.  One or more of these sources may be used and considered an appropriate proxy.

So once one or more references are used what other factors should be considered? There is not definitive answer to this question, however the following factors have been considered by the Court to support the reasonable level of officer-shareholder compensation used.

These factors include, but are not limited to:

  1. The Owners’ Role In The Company.

In this instance the owners’ expertise, management skills, relationships, reputations and personal guarantees of corporate indebtedness are considered.

  1. Compensation Paid By Comparable Companies For Similar Services.

In this instance benchmark companies are identified and utilized for comparison.

  1. The Company’s Character And Condition.

Revenues, profits and asset growth in the periods leading to the valuation date are analyzed.  In addition the shareholder-employees’ contributions to the company’s day-to-day operations are identified.

  1. Internal Consistency Of Compensation Arrangements.

Inquiry is made to determine if salaries and bonuses are paid pursuant to a structured or formal basis, and is this methodology applied equally throughout the company. A determination of disguised compensation in the form of discretionary expenses is also considered.

  1. Independent investor test.

In evaluating the reasonableness of shareholder-employee compensation an examination of potential conflicts of interest from a hypothetical independent investor’s perspective should be considered. In this instance one should consider if an investor would be satisfied by his or her return on equity after the deduction of shareholder-employee compensation.

  1. Venue-specific factors.

Tests for evaluating what level of shareholder-employee compensation is reasonable also varies depending on the case’s venue, as well as the facts and circumstances surrounding a company’s compensation. Each jurisdiction may have its own intricacies.  Therefore one should consider the venue specific factors in the analysis.

There are a number of other factors that should be considered in the determination of shareholder-employee compensation, particularly when the business is run by multi-generation family members.  This post just discusses a few of the items that the Trial and Appellate Courts have expressly considered.

Mark S. Gottlieb CPA/ABV/CFF, CVA, CBA, MS-Tax can be reached by phone or at msgcpa@msgcpa.com. You can also schedule a free phone consultation by using the button on the top of this page.