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Home / Expert Opinion / Keeping Your Balance: Reasonable compensation issues in business valuations

Keeping Your Balance: Reasonable compensation issues in business valuations

James Schnell

James Schnell

The IRS periodically publishes “Job Aids for IRS Valuation Professionals.” These resources are helpful for IRS Valuation Engineers, other IRS field personnel and valuation professionals in practice. While these documents are issued with a standard disclaimer stating “This Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position,” they are commonly used for training purposes by all professionals as well as serving as guides in difficult areas subject to wide interpretation in both practice and examination.

One such area is reasonable compensation. From a tax perspective, reasonable compensation issues are governed under Internal Revenue Code 162. In addition, the Treasury Regulations provide two further points of guidance: 1.162-7(a) “The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services” and 1.162-7(b)(3) “The allowance for the compensation paid may not exceed what is reasonable under all of the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”

These issues have been continually adjudicated in tax courts for almost a century now and also continue to arise more frequently in cases rooted in a business valuation report. As any valuation professional may attest, the amount of compensation assigned to an earnings stream will have a profound effect (either way) on the ultimate conclusion of value derived in any specific situation.

The following are examples of how this issue has been approached and handled by the IRS, the tax courts and the valuation profession as a whole:

• In tax court case LabelGraphics, Inc. v. Commissioner, T.C. Memo 1998-343, the court proposed a five-factor test in order to assess reasonable compensation in terms of a tax deduction for employees who are also owners of private, closely held corporations. The five factors were: Employee’s role in the company, a comparison of the compensation paid to similarly situated employees in similar companies, the character and condition of the company, whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation, and whether the compensation was paid pursuant to a structured, formal and consistently applied program.

• In addition, the court utilized a nine factor test in the case Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200. The nine factors were: Employee’s qualifications; the nature, extent and scope of the employee’s work; size and complexity of the company; comparison of the employee’s salary with the company’s gross and net income; prevailing general economic conditions; comparison of salaries with distributions to stockholders; compensation for comparable positions in comparable concern; salary policy of the company as to all employees; and amount of compensation paid to the employee in previous years.

The Independent Investor Test looks at the company’s current dividend payout rate, corporate earnings and return on equity to help determine whether a neutral stockholder would approve the employee’s level of compensation. This test may allow for a more unbiased and quantitative analysis versus one of the above referenced multi-factor tests.

The IRS acknowledges that reasonable compensation issues that may be more prevalent or require more examination are situations involving: family businesses, closely held private companies, subchapter S corporations, foreign corporations, merger and acquisition scenarios, adjustments made in current years for prior years (under) compensation, and situations involving employee or officer loans containing no interest, low interest or potential disguised compensation.

It is common and sound practice for valuation professionals to seek sources in which to benchmark and document the positions taken in a business valuation report. A few examples of these sources are: “Executive Compensation Assessor” from the Economic Research Institute, “American Salaries and Wages Survey” through Gale Research, “America’s Career InfoNet,” through the Department of Labor and “Executive Insight” through Equilar.

In summary, the next time you are involved in a matter requiring or utilizing a business valuation report, don’t hesitate to probe a little deeper into the areas regarding officer compensation. Specifically in terms of how the amounts utilized in the report were derived, what sources may have been used or benchmarked and in general, how it relates to the Independent Investor Test outlined above.

James P. Schnell, CPA/ABV, CVA, is a tax and business valuation partner with Mengel, Metzger, Barr & Co. LLP. He can be reached at (585) 423-1860 or JSchnell@mmb-co.com.

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