What is Reasonable? Owners’ Compensation Draws Scrutiny in Determining Business Value.

There is a strong tax incentive for profitable, closely held C corporations, to distribute most, if not all, of their earnings to their owners. The Internal Revenue Service will frequently challenge what it considers to be unreasonably large shareholder salaries and to recharacterize some of the executive compensation as a nondeductible, disguised dividend. Conversely, many S corporations will pay their owners a fairly low salary, in an effort to reduce both the employee and employer share of the FICA and Medicare tax.

In a business valuation environment, the valuation analyst must determine what constitutes reasonable compensation in order to properly measure the normalized cash flows generated by the business. The adjustment for owner compensation is often one of the largest normalization adjustments made by the valuation analyst.

An owner’s compensation may consist of many components. The most obvious elements are the base salary, bonus, dividends and/or withdrawals that the business pays to its owner. Other perquisites may also include retirement plans, life insurance, disability insurance, health club memberships, country club dues and other similar items that are provided to the owner. Entertainment expenses may be an owner’s perquisite if the expense is not a reasonable and ordinary business-related expenditure as compared with industry norms. Likewise, automobile expenses, including those related to automobile leases, insurance, repairs and gasoline, may also be considered additional owner’s compensation if such expenses are not specifically related to business operations.

The typical normalization adjustment substitutes the actual compensation paid to the owner or family member with a provision for replacement compensation, at a level that would ordinarily be paid in the marketplace to a non-related individual who would perform similar duties.

In Multi-Pak Corp., T.C. Memo 2010-139, the U.S. Tax Court articulated five factors that it considered in its determination of the reasonableness of a C corporation sole shareholder’s compensation. These same factors are often referenced by valuation analysts in considering owner compensation adjustments. They are as follows:

1.) The employee’s role in the subject corporation
2.) An external comparison of compensation with other comparable companies
3.) The character and condition of the subject corporation
4.) Any potential conflicts of interest
5.) The internal consistency of executive compensation practices within the subject corporation.

In the Multi-Pak decision, the Tax Court gave considerable weight to the fourth factor, from the perspective of a “hypothetical independent investor test”. In explaining it judicial reasoning, the Tax court quoted the Ninth Circuit analysis of the reasonableness of compensation in the Elliotts, Inc. decision (Elliotts, Inc. v. Commissioner, 716 F2.d at 1246) as follows; “if the company’s earnings on equity after payment of the compensation in question remains at a level that would satisfy a hypothetical independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned our of the company disguised as salary”.

There are several private databases that contain information on compensation levels for various positions within several industries. In addition, trade associations, employment agencies, and other human resource organizations often have resources available related to compensation levels. The valuation analyst will normally perform various quantitative analyses based on published compensation studies, comparison to industry, as well as the independent investor test, to arrive at a conclusion on the reasonableness of owner compensation.

If you need assistance on assessing the reasonableness of your compensation plan, let us know. We can help.

John M. Byrne, CPA/ABV
Mallah Furman, Certified Public Accountants
954-475-3199