Whether a company is being valued for a shareholder or an equitable distribution dispute, one of the most common normalization adjustments to a subject company’s income stream is owner compensation. Both the Court and the IRS tend to closely scrutinize this issue, with the IRS in frequent disagreement as to the reasonableness of shareholder-employee compensation.
For income tax purposes, business owners typically prefer to classify payments as tax-deductible wages. This allocation reduces both their corporate taxes and their federal taxable income. As one might imagine, the IRS is correspondingly meticulous in its examination of these classifications. If it believes that owner compensation is excessive, it may claim that non-deductible dividends have been disguised as compensation.
As they pertain to business valuation, the determination and application of reasonable shareholder-employee compensation are similarly contentious. The correlative relationship between owner compensation and cash flow means that when compensation is inflated, the available cash flow is reduced. Correspondingly, the indicated value under the income approach will be likewise reduced.
But whether challenges to owner compensation emanate from taxing authorities or a rival valuation expert, the case law in this area strongly indicates that there is no global rule of thumb – reasonable officer compensation is determined according to the particular circumstances of an individual case.
It is for this reason that Trial and Appellate Courts often struggle to resolve questions regarding reasonable officer compensation. For non-valuation professionals, this confusion is perhaps attributable to the number and diversity of sources used to ascertain reasonableness. In the course of their analyses, business valuation experts may consider replacement costs, peer group comparisons, compensation studies, and employment ads. Ultimately, one or more of these sources may be deemed an appropriate proxy.
But whilst we may be certain that determinations of reasonable officer compensation are typified solely by their individualism, it is nevertheless pertinent to inquire whether there are any broadly relevant sources that both jurists and valuation professionals should consider when approaching this issue.
When ascertaining reasonableness, we recommend considerations of the following:
The Owner’s Role in the Company – This includes a consideration of the owners’ expertise, management skills, relationships, reputations, and personal guarantees of corporate indebtedness.
Compensation Paid by Comparable Companies for Similar Services – This includes a consideration of benchmark companies and their relevant characteristics.
The Company’s Character and Condition – This includes a consideration of revenues, profits, and asset growth in the periods leading to the valuation date. It likewise encompasses the identification and analysis of the shareholder and employees’ contributions to the company’s daily operations.
Internal Consistency of Compensation Arrangements – This encompasses inquires as to whether salaries and bonuses are paid according to a structured or formal basis, and whether this methodology is applied uniformly to all areas of the company. It likewise includes a determination as to whether disguised compensation in the form of discretionary expenses is present.
Independent Investor Test – This includes examinations as to both the reasonableness of shareholder-employee compensation and potential conflicts of interest from a hypothetical independent investor’s perspective. In so doing, one should consider whether an investor would be satisfied by their return on equity after the deduction of shareholder-employee compensation.
Venue-Specific Factors – This includes considerations of the subject’s venue, as well as the facts and circumstances surrounding its members’ compensation. Each jurisdiction may have its own intricacies. Therefore, one should consider how venue-specific factors may impact the total analysis.
Several other factors should be considered in determining shareholder-employee compensation, particularly when multi-generation family members run the business. The items discussed in this blog post are just a few highlighted by the Trial and Appellate Courts. In addition, the Internal Revenue Service has published a Fact Sheet specifically for S-Corporations.
If you have questions about this or any other valuation issues feel free to contact me at the above phone numbers. I can also be reached via email at msgcpa@msgcpa.com