Reasonable Compensation for Determinations of Business Valuations
Closely held businesses commonly require valuations for many different reasons. They can be required for borrowings from banks, estate and gift planning, buying and selling businesses, and strategic planning. One of the key components in calculating the value of a closely held business is a determination as to the adequacy of compensation paid to owners.
Normalizations
The initial steps in valuing a closely held business are known as ‘normalization adjustments”. When a business is closely held, there may be related-party transactions involving the owners. These transactions can include self-charged rent, i.e., the business owners will rent the premises, as landlords, to the tenant/business. They can also include the amount of compensation paid to the owners or related parties. If necessary, the valuator will adjust (read – ‘normalize’) these expenses if they are unreasonable.
The profits of a business significantly influence the business value. If expenses are unrealistic, the calculated value will be meaningless.
The challenge, for a valuator, is how to determine whether normalizations such as owner compensation are required. A common example could be a business owner who has a very good year. The owner then takes, as compensation, all of these profits. Is this reasonable or is a portion of these profits a return on owner investment, and are, in fact, dividends?
Alternatively, many shareholders of Sub S corporations will work for the business but take little or no salary. Instead, they take the profits as distributions thus avoiding social security taxes on wages.
Valuators use various tools to help measure if the compensation paid to owners of closely held companies is reasonable. These same criteria are also used by the IRS and other taxing agencies for tax-audit purposes. These adjustments, in addition to impacts on valuations, can also result in significant tax costs. A basic understanding of reasonable compensation is essential for owners of closely held businesses.
Determining if Compensation is Reasonable.
There are three methods that valuators will use to calculate whether compensation is reasonable:
- The Market Approach
This approach uses compensation data from similar businesses as benchmarks for the value of services provided by chief executives. How much do similar businesses pay for similar services? - The Cost Approach
For this approach, the various duties performed by the Chief Executive are separated, and the benchmark value for each of these separate services is calculated and allocated based on a measure such as time worked. - The Income Approach
This is also known as the Independent Investor Test. The owner of the business, as an investor, requires profits from a business, over and above any compensation. If these profits are a reasonable return on investment, including appreciation, and the profits are comparable to similar businesses, then the compensation paid is reasonable.
Other factors are also considered – such as deferral of compensation, hours worked, specialized knowledge or skills, experience, and technical ability.
Business Valuations can end up being used for a wide variety of reasons. An owner of a closely held business should have a foundational understanding of these concepts. 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.