Calculating Reasonable Compensation for Business Valuations

Normalization Adjustment Steps and Practice Pointers

Reasonable compensation is among the most common of all normalizing adjustments in valuations of closely held businesses. The dollar amounts involved can be significant, the issues can be complex, and the valuator’s conclusions can be controversial. In preparing to make these adjustments, there are a series of steps that are normally followed. Among the steps are gathering relevant facts and making appropriate assumptions. Other steps include identifying the commonly accepted approaches or methodologies and locating reliable sources of benchmarking data. Then, the more complex steps may be forming defensible conclusions and explaining them in a report. This article discusses the steps and a few practice pointers.

Reasonable compensation is among the most common of all normalizing adjustments in valuations of closely held businesses. The dollar amounts involved can be significant, the issues can be complex, and the valuator’s conclusions can be controversial.

In preparing to make these adjustments, there are a series of steps that are normally followed. Among the steps are gathering relevant facts and making appropriate assumptions. Other steps include identifying the commonly accepted approaches or methodologies and locating reliable sources of benchmarking data. Then, the more complex steps may be forming defensible conclusions and explaining them in a report.

Since business owners can be surprised by the compensation adjustments, we recommend advising clients early in the process that normalizing owner compensation is a normal part of the process. At the same time, it may be wise to ask the client to identify all of the related parties such as family members who were on the payroll. The engagement letter may be the best place to request this information.

The three common approaches that are used for calculating reasonable compensation are somewhat like the three approaches used in business valuations. But there are differences. In the market approach to compensation, pay data from the client’s industry is used for benchmarking. For example, the compensation paid to the Chief Executive of an automobile dealership may be compared to that of other dealership Chief Executives.

The cost approach involves breaking down specific duties and benchmarking each of them separately. This uses compensation data which may be from multiple industries. For example, imagine a business owner’s grandson who spends half of his time in marketing and half of his time in bookkeeping. Since it is not feasible to find survey data for others providing that same mix of services, it is common to benchmark each of the duties separately. An hourly rate can be found for each duty, which would in turn be multiplied by the number of hours devoted to that duty.

Although compensation comparability data is used in both the market and cost approaches, there may be outliers. Those are individuals whose reasonable compensation may be below or above that of their peers due to extenuating circumstances. Perhaps they are not functioning adequately due to health complications or are performing at superstar level due to extraordinarily brilliant ideas. For them, other approaches may be used.

The third approach to determining reasonable compensation is the income approach, which is commonly referred to as the independent investor test. Arriving at compensation adjustments under this approach does not involve multiples of EBITDA. Instead, the independent investor test looks at an owner’s return on equity, which would include appreciation in the value of an ownership interest. If the return on equity was comparable to that of the company’s peers or higher, the independent investor test presumes that the owners were not overpaid.

In each of the three approaches, the individual’s job proficiency should be considered. Their years of experience, their education, and the results they achieve may all be used to help estimate proficiency. 

To learn more about these approaches, see the Reasonable Compensation Job Aid for IRS Valuation Professionals, which can be found at IRS.gov. Federal, state, and local courts often follow these approaches regardless of the purpose of the valuation.

Before finalizing a normalization adjustment, there are a few twists and turns to consider. For example, the cash amount paid to the owner during any one year may have been increased or decreased due to nonqualified deferred compensation. It is especially common among startup companies for owners to defer some of their pay until the company reaches financial stability.

Business owners may also have unusual skills that could justify upward bumps in their compensation. For example, being multilingual, having exceptional knowledge in using technology, or extensive professional goodwill could all warrant upward movement.

Other factors may call for a reduction in cash compensation. One example would be the officer who is provided excessive employee benefits by the company.

The business owner may also be providing special services that justify additional compensation. An example would be personally guaranteeing company debt, credit cards, or leases. Another example could be signing and honoring enforceable covenants.

Due to the size and sensitivity of compensation normalization adjustments, a few words of caution are in order. Before issuing your report, it may be worthwhile to caution your client that the tax authorities could use your report to propose a tax assessment. For example, consider an S corporation that may have underpaid its shareholder. If your report includes an upward adjustment in their compensation, the Internal Revenue Service could use that as evidence that the company underpaid its payroll taxes. Further, if the corporation has multiple shareholders, reclassifying a portion of one shareholder’s distributions to compensation could result in disproportionate distributions among the shareholders. Since S corporation shareholders must have equal rights to distributions, the disproportionate distribution could lead to an inadvertent termination of the company’s S status. Although business valuation reports commonly state that they are intended for only one specific purpose, that may not prevent others from using the report in other venues. A reader could easily argue that the valuator devoted considerable amounts of time to the valuation, had valuable industry experience, was paid a substantial amount for the analyses and conclusions, and had multiple certifications. So, to be the devil’s advocate, how could the report not be reliable evidence?

Large compensation adjustments could also lead lenders to suspect that the financial statements they relied upon were not accurate. Perhaps EBITDA was not as high as the bank believed it was when evaluating credit worthiness. Other shareholders can also become uncomfortable when they see that someone else is being overpaid.

As a separate service, to help clients avoid the difficulties that can come with large normalization adjustments, financial professionals could provide compensation comparability data. By using this data, companies may be able to avoid later issues including tax assessments and shareholder disputes.

Explaining the three approaches and providing comparability data can also be an effective way to get a foot in the door with prospective clients. Offering these services can lead to opportunities to interview key decision makers in order to understand their roles and the company’s operations.

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Stephen Kirkland, CPA, CMC, CFF, is a compensation consultant and expert witness at Atlantic Executive Consulting, LLC. He serves as an expert witness in cases involving potentially unreasonable compensation.

Mr. Kirkland can be contacted at (803) 724-1414 or through ReasonableComp.biz, at Stephen.Kirkland@AECG.biz.

Paul Hamann is the founder and President of RCReports, a leading provider of compensation comparability data. Mr. Hamann, along with other experts in their own fields, founded RCReports in 2010. RCReports cloud software determines reasonable compensation for closely held business owners and is used by CPAs, EAs, tax advisors, valuators, forensic accountants, and attorneys when they need to determine a reasonable compensation figure for a client.

Mr. Hamann can be contacted at (720) 279-8800 or by e-mail to phamann@rcreports.com.