Michael B. Lehner, CPA/ABV, CFE, ASA
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Adjusting owners’ compensation in business valuation

Business valuation experts “normalize” owners’ compensation adjust reasonable level.

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It’s common for owners of privately held businesses to over- or underpay themselves for a variety of reasons. When valuing a controlling interest under either scenario, it may be necessary to adjust (or “normalize”) owners’ compensation to reflect the amount that an unrelated third party would receive for performing similar duties. Here are some factors that valuation experts consider when making this adjustment.

How much are the owners’ contributions worth?

A common approach to estimating replacement compensation is to start at a micro-level and work up from there. At the most basic level, the expert writes up an accurate job description, keeping in mind that many existing job descriptions are inaccurate or outdated. He or she should also list the educational and work history prerequisites a replacement candidate should possess. If the owner has advanced education or other qualifications that are unrelated to his or her responsibilities (such as an architect with a law degree), the additional qualifications typically aren’t factored into the estimate of replacement compensation.

Next, the expert considers the company’s characteristics. Healthy companies — those with high growth and profits — tend to pay employees more than financially distressed entities. The expert will also consider the company’s size in terms of sales and market share. Although larger companies tend to pay more than their smaller counterparts, some smaller companies must pay a premium to persuade key employees to leave competitors (and to retain them once they leave).

No estimate of replacement compensation would be complete without an evaluation of the industry’s trends. Industry research can help an expert understand how much competition exists and its typical methods of compensation, including base salaries, bonuses, commissions, benefits and stock options. If the industry is cyclical, he or she needs to find out whether it’s currently at a peak, a trough, or somewhere in between. When evaluating the industry, it’s important to research external compensation studies and to interview recruiters.

Finally, the expert must consider the state of the economy. He or she starts with local economic conditions, such as the cost of living at the company’s location. A replacement would be paid less if the company were located in Manhattan, Montana, than if it were located in Manhattan, New York. The national economy is also important. For instance, people are generally paid less in a recession — when profits are down, cash is tight and jobs are hard to come by — than when the economy is booming.

When do compensation issues arise?

The term “reasonable compensation” is rooted in tax law. Why? Historically, some C corporation owners have tried to pay themselves exorbitant salaries — in lieu of dividends — to get cash out while simultaneously lowering the company’s tax bill. So, the IRS often audits companies with high owners’ salaries and doles out penalties on any salary in excess of what the IRS deems reasonable.

This issue also crops up in divorce cases. But, rather than overpay their salaries, business owner spouses have the opposite agenda: To reduce maintenance payments to their spouses, business owner spouses may try to understate compensation. Therefore, the U.S. Tax Court cases involving reasonable compensation may not be particularly helpful in divorce cases.

Likewise, the owner of a start-up or a struggling business might take a minimal salary to preserve a cash flow. Conversely, some owners treat the corporate bank account as their personal piggy bank. Other business owners overpay themselves, because they have unrealistic opinions of their day-to-day contributions to their companies.

Regardless of whether the expert adjusts compensation up or down, it’s important to remember to adjust the company’s income stream for compensation-related items, such as payroll tax expense, benefits and other perks.

A word of caution

Virtually every business owner who’s under oath will say that his or her compensation is “reasonable.” But reasonableness is in the eye of the beholder. So, when broaching the subject, many valuation experts prefer to use the term “replacement compensation,” which is likely to trigger fewer emotional responses and unwanted attention from the IRS.

Michael Lehner

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.