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Reasonable Compensation Guidance

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Adjustments for reasonable or replacement compensation – whether in corporate practice or when conducting a business valuation can be one of the most difficult adjustments to quantify. There are numerous factors that should be considered when adjusting compensation levels.

Oftentimes, American Business Appraisers find an individual’s, whether they are the owner or principle within the organization who work abnormal hours (greater or lesser) than the normal 40 hour work week or 2,080 hours per year. When this situation presents itself, typically an adjustment is warranted for reasonable compensation to present a truer earnings picture of the business.

The following discussion involves two landmark court cases. Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983). This case articulated the “independent investor” standard and remains the leading authority in the Ninth Circuit (U.S. Court of Appeals). Federal courts still apply the Elliott’s five-factor analysis to determine reasonable compensation to owners/employees of small to mid-size closely-held companies. These five factors are:

1.      Employee’s role in the taxpaying company.

2.      Comparison of the salary to those for similar companies that pay for similar services.

3.      Character and condition of the company (size, complexity, general financial condition).

4.      Any existing conflicts of interest.

5.      Internal consistency of the company’s payments to employees.

Another case Mad Auto Wreaking v. Commissioner, Tax Court 1995-153 (1995), enumerated the following factors to judge the reasonableness of shareholder compensation.

1.      Employee’s qualifications.

2.      Nature, extent and scope of the employee’s work.

3.      Size and complexity of the employer’s business.

4.      Comparison of salaries paid with the employer’s net and gross income.

5.      General economic conditions

6.      Comparison of salaries with distribution to shareholders and retained earnings.

7.      Prevailing rates of compensation for comparable positions in comparable companies.

8.      Employer’s salary policy as to all employees.

9.      Compensation paid in prior years.

10.  Employers past and present financial condition.

11.  Whether employer and employee dealt at arm’s length.

12.  Whether the employee guaranteed the employer’s debt.

13.  Whether the employer offered the employee a pension and/or profit-sharing plan.

14.  Whether the employee received business expenses reimbursement.

American Business Appraisers use a model that is fairly straight forward, in as much as we rely heavily on the individual’s role in the business. Our first step is to obtain the percentage of time or job duties allocated to their position. For each duty we select a reasonable compensation based on several salary databases. The following table illustrates the model we most commonly use in a tabular format.

Name Hours Worked Position % of Time Allocated Market Annual Salary Normalized Salary
John Doe        2,080 Manage Sales Staff 60%  $      52,000  $        31,200
Salesperson 30%  $      85,000  $        25,500
Handling A/P and A/R 10%  $      32,000  $           3,200
Reasonable Compensation for Duties Performed 100%  $        59,900

Typically, we find professionals reviewing the various salary studies and selecting a single position (i.e., CEO, President, etc) and applying that figure as a proxy for reasonable compensation for actual duties performed, when in reality this figure may over-state or under-state their actual compensation figure.

Ask yourself this question, could there be excessive compensation that could be added-back to earnings, which typically increases value, or could the opposite occur, by reducing earnings for under compensation amounts, thus reducing the value.

At American Business Appraisers we would be pleased to answer any questions relating to business valuation issues or to discuss a specific valuation requirement.

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