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The Reasonability of Reasonable Compensation

The Reasonability of Reasonable Compensation

When performing a business valuation, a factor we consider is the value to attribute to the owners responsible for the operations of the subject company. This is an important piece of the valuation process as there is an inverse relationship between reasonable compensation and value derived for the enterprise. The greater the reasonable compensation – the lower the business value and vice-versa.

The term reasonable compensation is not limited to business valuation, as it can be found in Internal Revenue Code Section 162(a), which provides for a corporation to deduct as a business expense “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The IRS concerns itself with reasonable compensation because it wants to ensure that salaries paid to owners correlate to the services they provide, which is deductible, versus the payment of disguised dividends, which are not. Reasonable compensation is a hypothetical amount intended to represent what a non-owner of a company would be paid if he or she had the same background and the ability to perform the same tasks as the current owner. Reasonable compensation cannot be determined in a vacuum, meaning that the salaries of employees of the company should be analyzed in order to determine if they are performing work that might be represented by the business owner as being their sole responsibility. The business valuation analyst may also wish to compare their preliminary reasonable compensation estimates to compensation being paid to non-owners actively working in the business. On occasion, the analyst may need to justify a reasonable compensation figure that is less than the highest paid employee.

Ten Considerations To Determine Reasonable Compensation

Determining reasonable compensation typically involves consideration of the following ten factors:

  1. Experience;
  2. Age;
  3. Nature of the business;
  4. Hours worked on a daily or periodic basis;
  5. Job title responsibilities;
  6. Duties performed – both primary duties as well as those necessary to maintain the daily operations of the company;
  7. Geographic location of the business;
  8. Current economic conditions and the potential to defer or forego compensation to protect the viability of the company;
  9. Demographics of the company’s target clientele/audience; and
  10. Sustainable revenues of the practice

Of course, each case is different and, therefore, the factors considered and conclusions reached tend to vary. Although mostly found in matrimonial cases, the IRC Code Section 162(a) has also been applied within the tax court. The 1995 tax case Mad Auto Wrecking, Inc. v. Commissioner addressed reasonable compensation requirements for deductibility under Section 162(a).

Mad Auto Wrecking, Inc. was a high-volume wholesale scrap business worked by two equal owners, each working approximately 70 hours per week year round.  After the compensation taken by the owners in one particular year caused the business to generate a small loss, the IRS asserted that less compensation should have been allowed (deductible) and the remainder treated as dividends (non-deductible). The effect of this was to generate taxable income to the Company. Mad Auto, in turn, petitioned the Court to determine if the compensation amount of $2,173,000 paid to its only officers/shareholders from 1989 to 1991 was, in fact, reasonable as compared to the IRS’s claim that the owners’ compensation should have been $1,503,322. The Court stated that there must be convincing evidence that the compensation was paid for actual services rendered by the employees/shareholders as opposed to a distribution of earnings to them that the payer could not deduct.

14 Factors To Determine Reasonable Compensation

The tax court used the following 14 factors to determine reasonable compensation for a shareholder:

  1. Employee’s qualifications;
  2. Nature, extent, and scope of the employee’s work;
  3. Size and complexity of the employer’s business;
  4. Comparison of salaries paid with the employer’s net and gross income;
  5. General economic conditions;
  6. Comparison of salaries with distributions to shareholders and retained earnings;
  7. Prevailing rates of compensation for comparable positions in comparable companies;
  8. Employer’s salary policy as to all employees;
  9. Compensation paid in prior years;
  10. Employer’s past and present financial condition;
  11. Whether employer and employee dealt at arm’s length;
  12. Whether the employee guaranteed the employer’s debt;
  13. Whether the employer offered a pension and/or profit-sharing plan; and
  14. Whether the employee was reimbursed for business expenses.

There are several resources available to assist valuation experts in the determination of reasonable compensation. The most common resources include Economic Research Institute, Salary.com, CareerOneStop, Indeed.com, SimplyHired and SalaryGenius. While these databases are helpful, there are still several questions to consider when utilizing them, including:

  1. Is the data collected regionally or nationally?
  2. Is the data reflecting averages, medians or quartiles?
  3. How reliable is the data and the sources used by the surveys?
  4. Does the data include owners/employees where the compensation amount reported includes business profits as part of compensation?
  5. Is the owner considered a “key person” in the business or a top performer/sales generator within the company?
  6. What are the sampling sizes that relate to the valuation when data relied upon is from business and professional associations?
  7. Industry codes within the Standard Industrial Classification (SIC) and North American Industry Classification System (NAICS) can be broad – how do the particular characteristics of the company compare with the broader range of companies covered within the industry codes?
  8. How are the job titles defined by the databases? Are the actual duties comparable to the duties and hours of the employee/owner?
  9. Are the database surveys fairly representing compensation for people within particular niches such as forensic accounting, matrimonial attorneys, personal injury attorneys, etc.?
  10. Should the valuator include multiple job titles from the various databases to be inclusive of all employee/owner duties?
  11. Are stock options, restricted stock, shadow stock and other perks reflected within the data surveys? Are these perks comparable to what is received by the owner/employee?
  12. Are retirement plans included or not included within the databases?

Since there are times when job titles and job functions do not match, it may be the responsibility of the valuation analyst to allocate job functions based on hours worked. For example, an owner who spends 80% of his or her time generating sales and 20% of his or her time on financial responsibilities may not be best served by a flat dollar amount from one job title. It may be that 80% of a $400,000 annual salary and 20% of a $100,000 annual salary for a different job function may apply. It is important that the valuation expert always clearly understand the job functions of the person whose reasonable compensation they are determining.

When concluding a reasonable compensation figure and the company’s value, ask yourself whether an independent investor would pay the amount of reasonable compensation that you have concluded is reasonable and then ask if you would pay that same amount. If the answer is no, you may need to rethink the reasonable compensation figure concluded.

The information contained herein is not necessarily all-inclusive does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.

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