From The Lawyer’s Business Valuation Handbook, Chapter 11
Often one of the largest adjustments in a business valuation is reasonable compensation. Reasonable compensation is a normalizing adjustment taken when a key employee or officer is found to be underpaid or overpaid. Some situations where the issue of reasonable compensation may be critical are when the key person is also a shareholder, when there is a family relationship between the payor and payee, and when personal versus enterprise goodwill is a concern.
Reasonable compensation adjustments are most frequently taken when a controlling interest is being valued. The underlying idea behind the adjustment is that a controlling owner would be able to adjust the owner’s compensation to reflect current market rates. In the valuation of a noncontrolling position, an adjustment sometimes is not taken because the shareholder would not have the ability to correct any excess compensation unless otherwise stated as part of the equity position. An example where an adjustment might take place in a noncontrolling valuation is if the issue being litigated deals with shareholder oppression of the controlling shareholder over the minority shareholder.
When reasonable compensation is a key issue in a business valuation, a compensation expert often is consulted. More often, however, the business appraiser is responsible for deciding any reasonable compensation adjustments.
Determining Reasonable Compensation
When determining reasonable compensation, the business appraiser must identify the total compensation being paid to the employee in question and compare that to the compensation needed to attract an employee (or in some cases employees) of similar skill. For example, if a company has a bookkeeper who is also the sister of the company’s owner and is receiving a wage that appears to be reasonable for a full-time employee, the appraiser should inquire as to whether this employee is actually a full-time bookkeeper. If during interviews it is determined that the employee works only 10 hours per week, an adjustment to the employee’s wages to that of a part-time bookkeeper should be made. If the appraiser fails to identify this adjustment, it may be detrimental to the viability of the valuation.
The business appraiser should keep in mind that he or she is not giving an opinion about whether the specific person is overcompensated or undercompensated based on how well the person performs his or her duties. The question the appraiser should ask is What would it cost the company for a hypothetical replacement for the position in question? The adjustment is based on the principle of substitution, not on whether the specific individual is worth more or less.
When determining adjustments to compensation, the professional appraiser must identify the following:
• The job position (including all duties performed by the executive and location)
- The total compensation being paid to the executive (including stock option plans, bonuses, pensions, etc.)
- Sources of salary information for the identified job position
- Relevancy of the data
- The shortcomings of the compensation data utilized
Sources of Information
To verify the compensation needed to attract an executive of similar skills, many valuators will consult a database or a trade association survey. The availability of faultless data is scarce; therefore, the business appraiser needs to use common sense and logic when deciding on the information he or she will use. When the data are available, the business appraiser should examine more than one source of data and use his or her best judgment to determine the reasonableness of the data for the position in question. ValuationResources.com provides a comprehensive list of compensation data resources. The following is a list of broad sources often consulted:
- Executive Compensation Assessor, Economic Research Institute (ERI)
- American Salaries and Wages Survey, Gale Research
- America’s Career InfoNet, sponsored by the U.S. Department of Labor
- Executive Insight, Equilar
Many of the above sources provide data by company size, industry, and location. While it is easy to simply use a number given by one of the above sources, it is critical that the business appraiser be aware of the assumptions and limitations of the data and, thus, the defensibility of the number utilized. The appraiser should know that he or she is looking at a job position that is equivalent and that all compensation is accounted for so that the adjustment he or she takes is not understated or overstated. Exhibit 1 is a checklist of 12 points that valuators should know about the compensation data they utilize.
12-Point Checklist for Valuation Appraisers
- Is the data collected on a national or regional basis?
- Does the data include owner/employees where the amount of compensation reported may also include business profits as compensation (i.e., partners in professions and businesses)?
- Concerning data from business and professional associations, what are the sampling sizes that relate to the subject valuation?
- When using SIC codes in identifying comparables, how do the particular characteristics of the subject company compare with the broader range of companies covered by the SIC code?
- How does the data use/define the job titles, and are the actual duties comparable to the duties/hours of the subject owner/employee?
- Does the data survey reflect averages? Medians? Quartiles?
- Does the survey fairly reflect compensation for people with particular niches and sub-specialties; i.e., matrimonial attorneys, forensic accountants, lobbyists, etc.?
- Does the valuator need to include multiple job titles from the survey data to cover the owner/employee’s duties?
- What is the reliability of the statistics and sources that the survey uses?
- Where applicable, are stock options, restricted stock, shadow stock compensation as well as other perks reflected in the data survey, and comparable to the owner/employee in question?
- Were all companies in the database consistent in having/not having retirement plans separate from salary?
- Is the owner a ‘key person’ in the business or a top performer/sales generator?
Source: “Reasonable Compensation: Can Your Opinion Survive This 12-point Checklist?” Business Valuation Update, July, 2006, 8-10.
Tax Court and Reasonable Compensation
As reasonable compensation has become more of an issue, some guidance has come out of the Tax Court. There are two main tests that the Tax Court has used to determine reasonable compensation: the Multifactor Test and the Hypothetical Independent Investor Test.
The Multifactor Test is essentially a list of factors the Tax Court examines. That analysis produces a conclusion about the reasonableness of the employee’s compensation. While the factors looked at are not consistent among courts or cases, many of them follow some of the same underlying ideas. The factors considered in two different Tax Court cases dealing with closely held corporations are shown in Exhibit 2. It is not the purpose of this chapter to go into detailed analysis of tax cases. For a thorough examination of these and other cases dealing with reasonable compensation, please see Shannon P. Pratt, Valuing a Business, 5th Ed., 771–92.
Tax Court’s Examples of the Factor Test
In LabelGraphics, Inc. v. Commissioner,* the Tax Court used a five-factor test for assessing the reasonableness of the executive compensation income tax deduction related to employees/owners of closely held corporations.
The Tax Court’s Five-Factor Test
The Tax Court’s Five-Factor Test is composed of the following factors:
Factor One: The employee’s role in the company.
Factor Two: A comparison of the compensation paid to similarly situated employees in similar companies.
Factor Three: The character and condition of the company.
Factor Four: Whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.
Factor Five: Whether the compensation was paid pursuant to a (1) structured, (2) formal, and (3) consistently applied program.
* LabelGraphics, Inc. v. Commissioner, T.C. Memo 1998-343 (Sept. 28, 1998), aff’d 221 F.3d 1091 (9th Cir. 2000).
In Brewer Quality Homes, Inc. v. Commissioner,** the Tax Court weighed a nine-factor test as set forth in Owensby & Kritikos, Inc. v. Commissioner in determining whether compensation was reasonable and therefore deductible.
The Tax Court’s Nine-Factor Test
The Tax Court’s Nine-Factor Test is composed of the following factors:
Factor One: The employee’s qualifications.
Factor Two: The nature, extent, and scope of the employee’s work.
Factor Three: Size and complexity of the company.
Factor Four: Comparison of the employee’s salary with the company’s gross and net income.
Factor Five: Prevailing general economic conditions.
Factor Six: Comparison of salaries with distributions to stockholders.
Factor Seven: Compensation for comparable positions in comparable concern.
Factor Eight: Salary policy of the company as to all employees.
Factor Nine: Amount of compensation paid to the employee in previous years.
** Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200 (July 10, 2003).Tax Court’s Examples of the Factor Test
Source: Shannon P. Pratt with Alina V. Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies. New York: McGraw-Hill, 2007, 771-92.
Criticism concerning the Multifactor Test has led to an increase in the use of the hypothetical Independent Investor Test. The Independent Investor Test looks at whether, given the company’s current dividends and return on equity, a neutral stockholder would approve the employee’s level of compensation. This test allows for a more unbiased and quantitative analysis versus the Multifactor Test. Often a Tax Court will use both tests to reach a decision on reasonable compensation.
Reasonable compensation adjustments sometimes can dramatically impact a valuation. The appraiser should have a thorough understanding of any reasonable compensation adjustments taken in a business valuation. By understanding and identifying key personnel and job responsibilities, the appraiser can determine whether a compensation adjustment is necessary and to what degree. If a compensation adjustment is necessary, the appraiser needs to conduct comprehensive research of relevant data sources for the particular industry and job responsibilities. Knowledge of both the pros and cons of the data utilized will assist in justification of the adjustment.
Fannon, Nancy. “Rates of Return: Don’t Ignore Public Market or Transactional Data.” In Business Valuation Update, September 2007, available online at BVResources.com.
Fishman, Jay, et al. 2008. “Business Valuation Discounts and Premia Databases.” In PPC’s Guide to Business Valuations. Fort Worth, Texas: Practitioners Publishing Co., 8–43.
Hitchner, James R. 2006. “Valuation Discounts and Premiums.” In Financial Valuation: Applications and Models, 2d Ed., Chap. 8.
Ostermueller, Ralph E. “Reasonable Executive Compensation.” In AICPA National Business Valuation Conference, December 3, 2006.
Pratt, Shannon P., and Alina V. Niculita. 2008. “Gathering Company Data.” In Valuing a Business, 5th Ed., Chap. 4. New York: McGraw-Hill.
Trugman, Gary. 2002. “Data Analysis.” In Understanding Business Valuation, 2d Ed., Chap. 5.