One of the most important adjustments in valuing a privately held business is normalizing owner and officer compensation. Whether valuing a business for a sale, shareholder dispute, estate and gift tax purposes, or other engagements, determining reasonable compensation is essential to developing an accurate and defensible conclusion of value.
Owner compensation in privately held companies often differs significantly from market rates. Owners may pay themselves above-market salaries to distribute profits or below-market salaries to maximize reported earnings. In either case, business valuators must determine what it would cost to replace the owner’s services with a qualified professional performing comparable duties. These adjustments can materially affect normalized earnings and, ultimately, the value of the business.
Establishing reasonable compensation requires more than industry averages or rules of thumb. Valuation professionals need reliable, objective compensation data that considers factors such as job responsibilities, company size, industry, and geographic location. This is particularly important when valuing businesses with physician owners or non-physician executives, where compensation structures and market benchmarks can vary substantially.
For valuation professionals and firms that also provide tax services, reasonable compensation analysis serves an additional purpose. It can help support compensation decisions for tax compliance, including scrutiny of excessive or inadequate shareholder-employee compensation. A well-supported analysis provides valuable documentation for both valuation conclusions and tax positions.
Beyond its importance in business valuation, compensation analysis can create opportunities to provide additional advisory services to existing clients and establish relationships with prospective clients. By helping business owners understand how their compensation compares with market rates, valuation professionals can deliver meaningful insights while strengthening their role as trusted advisors.
Methodologies
Consultants and courts rely on three primary methodologies to determine whether an owner’s pay is reasonable. These methodologies are somewhat similar to the three approaches used to value a business.
- Multi-Factors: Evaluates a combination of qualitative and quantitative company and individual performance metrics.
- Comparability Data (Market Benchmarking): Directly compares an individual’s pay to market survey data for similar roles within comparable companies. While often integrated into a multi-factor analysis, market benchmarking can be seen as an independent stand-alone method. Peer-to-peer benchmarking is similar to the market approach in valuing a business. However, when one individual handles multiple jobs, think of a cost approach being used to compile pro rata pay amounts for the various positions.
- The Hypothetical Independent Investor Test: Evaluates whether an unassociated, hypothetical shareholder receives an adequate return on his or her investment after the compensation has been paid. If so, the presumption is that the amount paid is reasonable. Similar to the income approach in valuing a business, this test focuses on financial metrics such as net income, EBITDA, and return on investment as measures of value creation.
The strongest conclusions may use multiple approaches and reconcile any discrepancies between them.
Judicial Foundations and Jurisdiction
The multi-factor framework is heavily dictated by judicial precedents that vary by court jurisdiction. Two key Tax Court decisions are:
- Mayson Manufacturing Co. v. Commissioner (6th Cir. 1949): Established nine foundational factors for evaluating executive pay.
- Elliotts, Inc. v. Commissioner (9th Cir. 1983): Streamlined the analysis into five primary factors viewed specifically through the lens of a hypothetical independent investor.
Since the applicable standards depend on the judicial circuit governing the company, consider tailoring your analysis for local jurisdictional standards while building the analysis as if it could eventually end up in court.
Evaluating Key Qualitative and Quantitative Factors
There is a wide range of core operational and financial variables to consider when determining what amounts are justified.
Factors That May Support High Compensation:
- Individual Performance and Scope: Extraordinary hours worked, specialized technical or managerial skills, long executive tenure, or leading a documented corporate turnaround.
- Company Growth and Superior Returns: Above-average profitability or revenue growth attributable to the executive’s personal efforts, key industry relationships, or specialized skills.
- Pre-Existing Formulaic Agreements: An arms-length bonus or compensation formula established before the employee became a controlling shareholder or negotiated at arm’s length can serve as strong evidence of reasonableness.
- Market Evidence: Documented higher-paying offers from third parties help establish the market value of an employee’s services.
Red Flags Potentially Signaling Excessive Pay
- Divergence from Peer Group: Paying compensation far above market peers while consistently failing to distribute corporate dividends may be a sign of profit extraction.
- Inconsistent or Discretionary Formulas: Compensation formulas modified after profits are known, especially for discretionary year-end bonuses, invite heavy scrutiny as disguised dividend distributions.
- Non-Independent Governance: Lack of independent board members or advisors leaves the door open for self-dealing.
Factors Excluded by Law
Although the multi-factors are critical, there are certain factors that are not considered. Under federal anti-discrimination legislation, factors such as gender, race, religion, national origin, disability, genetic information, pregnancy, and age (40 and over) must be excluded. Incorporating these characteristics may damage your professional credibility, harm employee morale, and lead to severe legal liability. Check with legal counsel.
Market Benchmarking and Total Compensation Testing
Using market data is not as easy as it sounds for multiple reasons.
- Job Duties versus Job Titles: Benchmarking should focus on the actual scope of an executive duties, responsibilities, and performance rather than simply relying on any titles shown on business cards.
- Organizational Fit: When appropriate, consider matches that align by industry sector, geographical location, years of experience, and/or company size.
- Data Source Credibility: Sources of compensation comparability data include RCReports, Economic Research Institute (ERI), Candid (for non-profits), and SEC public filings. Many other sources of compensation data are available online, but analysts should scrutinize their underlying methodologies and know where these sources obtain their data. IRS statistical tables can be helpful, but the data is old. ProSight has very limited data for executive compensation, while general job posting sites may have random data without quality control procedures in place.
- Cherry-Picking: Be careful when using multiple databases.
- Complexity: The qualifications, duties, and performance of each executive are unique, and no source of industry data is perfect, so be thorough in your analysis and use the best industry data available.
Evaluating Benefits
Benchmarking may evaluate total compensation, including base salary, bonuses, and employee benefit packages. Datasets like the Bureau of Labor Statistics (BLS) Employer Costs for Employee Compensation series (www.bls.gov/ecec/) and Employee Benefits Survey (www.bls.gov/ebs/) can help measure benefit costs as a percentage of overall pay for various positions.
Normalizing Adjustments
In a business valuation, a normalization adjustment for owner compensation may call for some specialized disclosure. For example, when using comparability data to normalize compensation, an analyst may be relying on the market approach. However, if the business valuation report states that some other approach is being used for the overall company valuation, disclose why the market approach is being used for the compensation adjustment.
The Intent Test and Contemporaneous Documentation
Under Treasury Regulation § 1.162-7(a), compensation is deductible only if payments represent reasonable allowances intended purely as payment for personal services actually rendered. The phrase “intended purely as payment for personal services” is interpreted to mean that an amount must be paid with the intent to compensate in order to be treated as compensation for federal income tax purposes.
- Evidentiary Proof of Intent: Intent to compensate can be evidenced by W-2 reporting, payroll tax returns, withholding, financial statement classifications, and contemporaneous formal corporate records.
- A Cautionary Precedent: In Paula Construction Co. v. Commissioner (58 T.C. 1055, 1972), the Tax Court examined distributions from a company that had inadvertently terminated its S status. The court denied deductions for distributions paid to owner-employees who had performed valuable services because the corporate minutes and books contained no contemporaneous reference to salaries. The court concluded that performing valuable services proves that owners could have been paid, but it does not prove that payments were intended as compensation.
Catch-Up Pay
When compensating an executive for prior under-compensation, a written agreement executed before or while the services were rendered is recommended. To provide a valuable service, advise clients that corporate records should include a clear business rationale for deferring that pay, and to label catch-up pay as such rather than simply rolling it into current bonuses.
Also, for federal income tax purposes, be sure to comply with Internal Revenue Code Section 409A’s deferred compensation requirements.
Personal Guarantee Fees
Owners who personally guarantee corporate debts, leases, or other obligations may deserve guarantee fees. However, for federal income tax purposes, such fees should be demanded in advance and priced at arm’s-length market rates based on actual risk and guarantor solvency. If accounted for separately from salary, such fees may not be subject to payroll taxes.
Distinguishing Pay, Distributions, and Fraud
Poor record-keeping can lead to severe issues and allegations. And small business owners do not always segregate personal credit card expenses, personal asset use (automobiles, boats, vacation properties), and excessive pay to family members.
Loans to shareholders should exhibit bona fide debt characteristics – written promissory notes, commercial interest rates, defined repayment terms, collateral, and documented intent to enforce repayment. Unsubstantiated loans risk reclassification as constructive dividends, or perhaps fraud.
Conclusion
Establishing defensible executive compensation involves a proactive plan backed by market benchmarking and contemporaneous corporate records. Your clients need help with aligning multi-factor analyses, independent investor checks, and total pay comparisons before payments occur.
