AUTHOR: Rick Evans - CPA, CA, CFF, ABV, CVA, CFE, CPA (CALIFORNIA)
One of the most subjective and discretionary expenses for many small closely held businesses or professional practices is owner compensation. Reasonable compensation is a key assumption in the valuation model as it can have the most impact on the profits of the closely held business. This is due to the fact that compensation recorded in the Company’s books and records and presented in the financial statements is not always at market rates and it is not required to be. For example, owner compensation may have been established for tax planning purposes.
An accepted interpretation of reasonable compensation under the fair market value standard is the salary necessary to hire a non - owner replacement employee of equal experience, education and skill, etc.(1)
Why is Reasonable Compensation Important?
- If owner compensation is above or below market, it can affect the assessment of the subject company’s performance when comparing against industry benchmarks.
- An understatement of reasonable compensation will lead to an overstatement of enterprise value and enterprise goodwill.
- An overstatement of reasonable compensation will lead to an understatement of enterprise value and enterprise goodwill.
- A reasonable compensation analysis can address the concept of personal goodwill. The analysis may show that the owner is being paid above market because he or she is wearing many hats in the company, and is being compensated appropriately. The “above market” compensation translates into the personal goodwill.
- It can affect spousal and /or child support.
Things to Remember When Determining Reasonable Compensation
- Determine what the owner/manager actually does for the Company.
- Find an industry benchmark. A good place to start is by looking at the information available regarding the Company’s industry. There are many sources such as Statistics Canada, industry associations; certain fee based and free databases, human resource specialists, etc.
- Determine how the above industry data is compiled and what their limitations are.
- Does the owner have control over the business or is he/she a minority shareholder?
- Look at the factors that the courts have developed to provide guidance on what is reasonable compensation.
Some Factors to Consider when Determining Reasonable Compensation
The business valuator can look to the US Tax Courts for considerable guidance on reasonable compensation. Some factors to consider are as follows:(2)
- Employee’s qualifications
- Nature, extent, and scope of the employee’s work
- Size and complexity of the employer’s business
- Comparison of salaries paid with the employer’s business gross and net income
- Prevailing general economic conditions
- Comparison of salaries with distributions to shareholders and retained earnings
- Prevailing rates of compensation for comparable positions in comparable companies
- Employers salary policy of the employer to all employees
- Amount paid to employees in previous years
- Employer’s financial condition
- Whether employer and employee dealt at arm’s length
- Whether employee guaranteed employer’s debt
- Whether employer offered a pension plan or profit-sharing plan to employees
- Whether the employee was reimbursed by the employer for business expenses that the employee paid personally
Independent Investor Standard
The courts have also looked at the concept of the Independent Investor Standard. The concept requires an analysis to determine whether an independent investor in the subject business would be considered to be receiving a satisfactory rate of return on his/her investment, at the current level of owner compensation. If the rate of return is considered satisfactory, then the amount of compensation paid to the owner/manager would be considered reasonable.
The purpose of the valuation, the type of valuation report being prepared and the amount of compensation involved will factor into the level of analysis required to determine what constitutes reasonable owner/manager compensation.
(1) Medical Practices: A BV Rx, Journal of Accountancy, November 2005.
(2) Mad Auto Wrecking, Inc. v Commissioner, TC Memo, 1995-153, 69 TCM 2330, April 5, 1995
For more information on reasonable compensation, please contact your McCay Duff advisor.