Reasonable Compensation for Determinations of Business Valuations
Closely held businesses often require valuations for various purposes such as securing loans, estate planning, business acquisitions, and strategic planning. One critical aspect of valuing these businesses is assessing the adequacy of compensation paid to owners.
Normalization Adjustments
Valuing a closely held business begins with “normalization adjustments.” These adjustments address related-party transactions involving owners, such as self-charged rent or owner compensation. Valuators scrutinize these transactions and normalize expenses that appear unreasonable to ensure an accurate business valuation. Unrealistic expenses can distort the calculated business value significantly.
Determining Reasonable Compensation
Valuators face the challenge of determining if compensation paid to owners is reasonable. For instance, an owner who takes all profits in a very profitable year as compensation raises questions: is this reasonable or should some of it be treated as return on investment or dividends? Similarly, shareholders in Sub S corporations often take distributions instead of salaries to reduce tax liabilities.
Methods for Assessing Reasonableness
Valuators employ several methods to evaluate the reasonableness of owner compensation:
- Market Approach: This method benchmarks compensation against similar businesses, assessing how much comparable businesses pay for similar executive services.
- Cost Approach: Here, duties performed by the chief executive are itemized, and benchmarks are established for each duty based on factors like time allocation.
- Income Approach (Independent Investor Test): This approach evaluates whether profits attributable to owners are reasonable returns on investment, considering appreciation and comparing profitability with similar businesses.
Additional Considerations
Other factors influencing the determination of reasonable compensation include deferral of compensation, hours worked, specialized skills, experience, and technical expertise. These factors collectively contribute to a comprehensive assessment by valuators.
Significance for Owners
Understanding these concepts is crucial for owners of closely held businesses, as business valuations can impact various aspects of operations, including tax implications and strategic decision-making.
For more information on business valuations, or to get started on a valuation of your closely held business, please contact the valuation professionals at ShindelRock.