Although the issue of reasonable owners’ compensation often comes up in federal tax inquiries, it may also be an issue in shareholder disputes and divorce cases.
For example, minority shareholders or the spouses of a controlling shareholder may claim that an owner is taking an excessive amount of salary, thereby impairing the value of the business. Alternatively, if an owner-spouse is trying to minimize the base on which alimony and child support payments will be calculated, the nonowner-spouse may claim that a salary is too low. A valuation expert can help you support, or defend against, these types of claims. Here’s how:
Consider These Factors
What’s considered reasonable in shareholder disputes or divorces may vary based on state law or legal precedent. Generally, looking outside the company at geographic location and external market conditions is the way to start a reasonable compensation assessment. Then, the analysis turns to internal factors, such as the company’s size, financial performance and compensation programs. Finally, the individual’s contributions to the company, including his or her responsibilities, experience, skills and reputation, are factored into the analysis, along with any personal guarantees from the owner.
Sometimes an owner may warrant a salary that’s lower or higher than what nonowner-employees receive for similar positions. For example, the Tax Court recently upheld a combined annual salary of more than $7.3 million for two owners of a large Arizona concrete contractor. That may seem like a lot of money, but the court ruled that the company’s investors still received a reasonable return on investment after owners’ salaries were paid. This type of analysis is known as the independent investor test.
Another type of analysis hinges on comparable salaries paid in arm’s length compensation arrangements. There are several private and public salary surveys where you can find reliable compensation data for a particular industry or geographic market. These surveys include:
- The Conference Board’s annual executive compensation reports,
- Dun & Bradstreet’s Key Business Ratios on the Web,
- Economic Research Institute’s quarterly salary surveys,
- MicroBilt’s Integra industry reports,
- The Risk Management Association’s Annual Statement Studies®, and
- Willis Towers Watson’s executive salary surveys.
Additional location- or industry-specific data can be obtained from salary surveys that break down the data by industry, market or size; industry trade associations and publications; and executive headhunters.
Seek Outside Expertise
Making a decision on what’s considered a reasonable owner salary can be subjective and sensitive. Valuation professionals provide objective insight by researching comparable market data and using it to estimate how much a nonowner-employee would receive for performing similar services, based on the individual, characteristics of the company and market.