Reasonable compensation is an issue that comes into play in divorce, shareholder disputes and tax cases. It’s also a common financial statement adjustment that valuators make when valuing a business. Although experts are often hired to make the calculations, business owners and attorneys should understand how they do it.

Multiple factors

Valuators weigh a variety of factors when determining reasonable compensation for a specific business owner or executive, including:

Role in the business. Many companies employ multiple executives, but they don’t all fill the same roles. Some are sales rainmakers, while others drive strategic direction or manage the day-to-day operations of the business. A valuator considers the experience and qualifications necessary to fill the individual’s specific job, as opposed to the qualifications the individual currently in the job happens to possess.

Business characteristics. The company’s size, complexity, industry, competitive position, financial condition and history all bear on the reasonableness of compensation. Businesses with long records of stable revenues and profits from loyal customers generally can afford to pay high compensation. But smaller companies might pay a significant salary premium to woo those same employees because of the relatively higher risks faced by small businesses.

Internal consistency. How does the owner’s compensation compare with that of the business’s non-owner employees? If the business consistently pays below-market rates for other employees, an above-market rate for an owner may be unreasonable.

Comparable positions. The compensation received by similarly situated employees at similar companies is often useful. Valuators gather such data from various external sources, including the Bureau of Labor Statistics, the Economic Research Institute and professional associations (such as the Medical Group Management Association).

Location. A technology-based firm located in an urban area will generally have greater access to comparable employees than will a similar company in a rural area. The cost of living is relevant, too. For example, an owner in San Francisco requires more compensation than an owner in Kalamazoo, Mich., does to maintain a similar standard of living.

Case in point

Reasonable compensation was a key issue in a recent U.S. Court of Appeals case (Clary Hood, Inc., CA 4, May 31, 2023). Under tax law, compensation can be deducted by a business only to the extent that it’s reasonable. Any unreasonable portion, if paid to a shareholder, isn’t deductible and may be taxed as a dividend.

The federal appeals court upheld the U.S. Tax Court’s finding that a closely held construction company didn’t establish that the compensation paid to its CEO was reasonable. Therefore, it disallowed part of the corporation’s business deduction for bonuses paid to the CEO in two years.

Factors that indicated overpayment included that the company:

• Paid no dividends even after accumulating significant capital,
• Had no “structured system” for determining compensation, and
• Paid excessive bonuses compared to those paid to employee-shareholders by comparable contractors.

The court agreed with the U.S. Tax Court “that the bonuses were excessive, with the excess amount actually representing a disguised payment of dividends from profits, which could not be deducted.”

Get it right

When an issue is as multifaceted as reasonable compensation, it’s important not to make assumptions or rely on rules of thumb. Whether in the context of litigation, a tax audit or a conflict among shareholders, calculating a defensible estimation of reasonable compensation should be the goal.

(This is Blog Post #1448)