Normalizing Owners’ Compensation in Business Valuation

Recently released and on parole, Tyco’s former CEO Dennis Kozlowski was the epitome of excess compensation in the beginning of the millennium. Despite the fact he transformed a small enterprise into a billion-dollar giant, he was convicted of fraud for using Tyco as his “personal piggy bank.” This and other white-collar crimes have led to the creation of better monitoring parameters and resources to help define employees’ salaries, especially those of top executives.

Often, owners of closely-held businesses can easily manipulate their business’s profitability by paying themselves more or less than reasonable compensation. Business valuation experts can serve as a reliable professional resource whose contribution goes beyond tests and industry-specific statistics.

IRS Guidelines and Parameters

Section 162(m)(4)(C) and Section 162(m)(4)(E) of the Internal Revenue Code are both used as guidelines in tracking performance-based compensation. From describing the roles of the board of directors in determining compensation, to establishing further forms of compensation, such as bonuses, these two codes give an outline for investigating an executive or owner’s proper compensation.

In addition to the Revenue Code, the IRS’s Fringe Benefits Audit Technique Guide assists by listing the benefits commonly provided to executives, potential issues, and also provides steps to help examine same.

Both bonuses and benefits received by owners can be complex and ambiguous depending on the case. Bonuses can be clearly recorded, or simply rely on a handshake. Benefits, similarly, can often not be taxed to the recipient, but rather recorded within the operating expenses of the business. This concept is not lost on those who are held with the task of analyzing and estimating the value of closely-held businesses. A forensic accountant has knowledge of these bonuses and benefit packages which equip them to analyze these issues.

Approaches to Examination

The complexity of excess compensation and benefits has also been illustrated in many other high-profile court cases. As a result, four tests have emerged as a primer for determining reasonable compensation.

  • The Direct or Market Database Test calls for an evaluation of databases and surveys that indicate the market range of compensation for different jobs in various industries.
  • The Market Ratio Test between comparable public companies involves looking at and comparing the compensation numbers of publicly traded companies, and developing a range of reasonable compensation estimated as a ratio of revenue and earnings.
  • The Shareholder Return Test deals with the creation of management value. The shareholder return created by the executive must be taken into consideration to evaluate the reasonableness of compensation.
  • The Independent Investor Approach depends upon a measure of performance based on return on equity (hereafter, “ROE”). The question this test attempts to answer is whether or not an independent investor would be satisfied with the company’s rate of return.

In utilizing one or more of these four tests, one may also employ a variety of research tools that can help facilitate this process. These tools collect comprehensive salary surveys that compile current and unbiased data as well as profile samples.

In fact, many industry-specific studies are published annually to provide this information. For instance, reasonable compensation for legal professionals can be extrapolated from the Annual Survey of Law Firm Economics by ALM Legal Intelligence. Accounting and finance compensation is sometimes measured using the annual Salary Guide published by Robert Half. Additionally, the U.S. Bureau of Labor Statistics also collects data and reports salaries for numerous occupations and regions.

Realizing that adjustments to owners’ compensation are an integral part of determining the normalized income stream of a closely-held business, the utilization of institutional recommendations, resources, and the like is justified when estimating its value.

Other than the normalization of operating expenses that may be found during a typical business valuation engagement, the adjustment of officers’ salaries is often the most significant modification to transpose the historical income stream of a closely-held business to the normalized cash flow used as a proxy for value.

We have discussed in depth this normalization process in our whitepaper: “Normalizing Owners’ Compensation in Business Valuation.”

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