Articles

Case Shows Power of Buy-Sell Agreements

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A recent court decision demonstrated the power of buy-sell agreements. Photo by Matthew Henry on Burst

A buy-sell provision can help ensure an orderly transaction when one shareholder wishes to leave a business. It can dictate the manner in which an owner’s interest changes hands, as well as the price.

The enforcement of one such provision was the point of contention when the shareholders of a family-owned automotive repair business in Nassau County recently faced off in court.

Tabs Motors of Valley Stream Corp. was owned by four siblings, each of whom held 50 shares of common stock. The siblings signed the shareholders agreement in December 2013, after allowing more than a year for consideration of its terms. The agreement featured a buy-sell provision that, among other things, would be triggered upon the filing of a motion to dissolve the company. 

Buy-sell agreements

Buy-sell provisions spell out the terms under which an owner’s share of a business may be reassigned when they leave the company. They often provide for some combination of redemption, in which the company is required to repurchase the interest, and cross-purchase, in which the remaining owners are permitted to buy it. Such provisions are often intended to prevent ownership from falling into the hands of outside parties. If designed properly, they can reduce the likelihood of controversy when a shareholder decides to leave the company.

Tabs Motors’ shareholders agreement (as cited in the decision) includes a buy-sell provision stating that “if any shareholder files a petition to dissolve the Corporation; … the Corporation firstly, and then the other Shareholders shall have the option to purchase all, but not part of the shares owned by such Shareholder.”

On October 29, 2019, two of the shareholders of Tabs Motors, Michael Louros and the Estate of Connie Collins, filed a petition for dissolution of the corporation. The filing triggered the buy-sell provision in the shareholders agreement. The corporation held a shareholder meeting on December 16, 2019, at which the two nonpetitioning shareholders voted to have the corporation exercise its option to purchase the shares held by the petitioners. The shareholders agreement excluded the petitioning shareholders from voting.

The closing was set for February 11, 2020. The purchase price was set by the shareholders agreement at $5,250 per share, nearly twice the value determined by an appraisal of the company in 2011, two years before the execution of the shareholders agreement.

In response to the petition for dissolution, Tabs Motors filed a counterclaim seeking to enforce the sale of the petitioners’ shares. Supreme Court Justice Robert Reed granted summary judgment in favor of Tabs Motors, ordering the sale of the interests. 

Justice Reed rejected the petitioners’ contention that the shareholders agreement was unconscionable, noting that it applied equally to any shareholder who petitioned for dissolution and that the parties had more than a year to review the agreement and receive counsel prior to signing. He rejected the claim that the valuation provided in the shareholders agreement was stale, pointing out that it was double the 2011 valuation and that it had been affirmed in 2018 in the probate of Connie Collins’ estate.

Finally, Justice Reed rejected the petitioners’ assertion that the other owners had breached their fiduciary duties, noting that even if the claims were legitimate, “they would not invalidate the buy-sell provision. The buy-sell provision is still enforceable.”

Parting thoughts

The ruling in Estate of Connie Collins v. Tabs Motors demonstrates the durability of buy-sell provisions written into owners agreements. That’s why it is vital to give due consideration to the wording of such agreements. For instance, language that calls for an appraisal in the event of a controversy can help ensure equitable treatment of all interests. For more information on buy-sell agreements or other valuation matters, please contact the trusted professionals at Advent.

The case is The Estate of Collins v. Tabs Motors of Valley Stream Corp. You can read the decision here. Read additional Advent blog posts on buy-sell agreements here and here.

Advent Named to Top 10 Emerging Firms List

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Advent Valuation Advisors has been named one of the Top 10 Emerging Valuation Services Companies for 2022 by CFO Tech Outlook magazine. The honorees were unveiled in the March edition of the magazine, which was dedicated to business valuation. The article is available here.

Valuations of Distressed Companies Require Special Treatment

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Valuing a financially troubled company requires special treatment. Photo by Andrea Piacquadio from Pexels

Over the last two years, market conditions — from cost increases and forced shutdowns to shortages of labor and supplies — have taken their toll on many businesses. While owners of distressed businesses may hope to turn things around, some will unfortunately shutter. Valuation is a prophecy of the future, not the past. So, valuing a financially troubled company requires special treatment.

Diagnosing the Situation

Valuing a distressed business is similar in many ways to valuing a healthy one: The valuation professional evaluates financial information and examines the business and its industry to assess the company’s ability to generate earnings. But troubled companies don’t behave in quite the same way as healthy companies, so valuators must approach them a little differently.

One of a valuator’s biggest challenges in valuing a struggling company is normalizing its operating results. Most valuations, even of healthy companies, involve some normalization. The valuator adjusts the company’s operating results to exclude unusual items — such as nonrecurring income or expenses. This allows the valuator to project earnings under “normal” conditions.

Determining the causes of a company’s poor performance is critical. If the company got into trouble because of poor management or excessive debt, it could have a great deal of value to a buyer with a stronger management team or greater access to capital. But if the company is struggling because of reduced demand for its products or services or because its technology has become obsolete, it may be difficult — if not impossible — to restore it to profitability.

Prescribing a Valuation Method

For healthy companies, past performance is often a reliable predictor of future success. But for troubled companies, valuations must be essentially forward-looking. The key is to identify what caused the company’s financial distress, determine whether the problem can be fixed and develop a picture of the company’s future earnings after management has turned operations around.

For this reason, valuation pros usually use income-based methods, such as discounted cash flow analysis, to value troubled companies.

Market-based methods — where valuators apply price-to-earnings multiples or other measures derived from transactions involving comparable companies — are difficult if not impossible to use. Most market data is drawn from transactions involving healthy companies, which can’t be applied to troubled companies without complex (and potentially problematic) adjustments.

The cost approach also may be particularly relevant when valuing a distressed business. While healthy companies are almost always valued as going concerns, a distressed company may be worth more in liquidation. Therefore, the valuator needs to determine its liquidation value for comparison.

Proper Treatment

Distressed companies operate under extraordinary circumstances, so different rules apply. Advent’s business valuation experts have experience working with struggling companies and can help determine what’s appropriate for your case. Contact us for more information.

© 2022, Powered by Thomson Reuters Checkpoint 

Opinions Split on Discounts for Controlling Interests

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Courts and experts often disagree on the applicability of marketability discounts for controlling interests. Photo by Artem Beliaikin from Pexels

In a business valuation context, the term “marketability” refers to the ability to quickly convert property to cash at minimal cost. While publicly traded stocks are readily marketable, interests in private companies typically require substantial time, cost and effort to sell. To the extent that public stock data is used to value private businesses, a discount may be warranted to reflect the lack of marketability. However, an important distinction must be made when applying these discounts to controlling interests.

Minority vs. Controlling Interests

Marketability discounts are well established when valuing minority interests in closely held businesses. Several empirical studies support and quantify these discounts. Restricted stock and pre-IPO studies, for example, demonstrate the spread between prices paid for freely traded shares and identical shares that are less marketable because they’re restricted or not yet publicly traded. Discounts typically average between 30 percent and 45 percent.

Using marketability discounts for controlling interests is controversial, although courts have sometimes accepted them. Most experts agree that the size of marketability discounts shrinks as the level of control increases. But while many argue that some amount of discount is available at all levels of control – even 100 percent – others say it is inappropriate to apply a marketability discount to a controlling interest.

Illiquidity

Marketability discounts applied to controlling interests are sometimes referred to as “illiquidity” discounts to help differentiate them from discounts taken on minority interests. With a controlling interest, it takes time and expense to complete a sale. The discount reflects the uncertainty and risk associated with the timing of the sale and the ultimate price.

The rationale underlying taking a marketability discount on a controlling interest is that fair market value is a cash equivalent concept. In contrast, a future sale of a controlling interest is speculative and expensive. The deal also may include noncash terms, such as employment contracts, restricted stock or installment payments.

For example, in a divorce case, it may seem inequitable for one spouse to receive $1 million of an illiquid business, while the other spouse receives $1 million of cash and real estate, which are considerably more liquid.

When quantifying illiquidity discounts, valuation experts consider the time, costs and risks of selling a business (or a controlling interest within it). Alternatively, they may estimate the costs of going public. No official empirical data exists to support marketability discounts on controlling interests. But all else being equal, most experts agree the discount for a controlling interest should generally be lower than for a minority interest in the same company.

Case in Point

To see how this can play out in court, let’s look at a recent divorce case where the husband’s expert applied a marketability discount on a controlling interest in the husband’s dental practice. (Kakollu v. Vadlamudi, No. 21A-DC-96, Ind. App., July 26, 2021.)

The wife’s valuation expert valued the entire practice at $3 million. The husband’s expert arrived at a value of $1.56 million after taking a 45 percent marketability discount. The lower court rejected the expert’s discount because he admitted that:

  • A discount greater than 35 percent would likely draw IRS attention, if it was taken in a valuation prepared for federal tax purposes,
  • Controlling interests may be easier to sell than minority interests,
  • Dental practices are easily tradeable as they have a ready market of purchasers (new dentists) graduating each year, and
  • The husband had no intention to sell his practice.

Because the marketability discount was the primary reason for the difference between the experts’ values, the trial court accepted the analysis prepared by the wife’s expert. The Indiana Court of Appeals upheld the decision, concluding that there was no requirement for the trial court to apply a marketability discount when determining the value of a business. You can read the decision here: https://adventvalue.com/wp-content/uploads/2022/03/Srinivasulu-Kakollu-v.-Sraina-Sowmya-Vadlamudi.pdf

Contact Us

The application and magnitude of marketability discounts are matters of professional judgment and can vary significantly from one valuation assignment to the next. The professionals at Advent Valuation Advisors can help you support or challenge the use of a marketability discount for a specific case.

What is ‘Known or Knowable’ on Value Date?

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With limited exceptions, events that occur after the valuation date generally are not considered in determining the value of a business interest. Photo by Wyron A on Unsplash.

The value of a business interest is valid as of a specific date. The effective date is a critical cutoff point because events that occur after that date generally are not taken into account when estimating value.

However, there are two key exceptions.

1. When an Event Is Foreseeable

Subsequent events that were reasonably foreseeable on the effective date are usually factored into a valuation. That’s because, under the definition of fair market value, hypothetical willing buyers and sellers are presumed to have reasonable knowledge of relevant facts affecting the value of a business interest. Examples of potentially relevant subsequent events are:

  • An offer to purchase the business,
  • A bankruptcy filing,
  • The emergence of new technology or government regulations,
  • A natural or human-made disaster,
  • A pending legal investigation or lawsuit, and
  • The loss of a key person or major contract.

But not all of these examples would be reasonably foreseeable. For example, you probably can’t predict when your company will be affected by a tornado or a data breach.

This issue has come to the forefront during the COVID-19 pandemic. To determine what was known or knowable about this ongoing crisis on a valuation’s effective date, experts must put themselves in the shoes of hypothetical buyers and sellers on that date and consider how they would have perceived the situation.

Many businesses have been adversely affected by the pandemic; others have taken advantage of opportunities that emerged from the the crisis. The effects also may vary depending on the company’s geographic location or industry, so valuators must evaluate the situation closely to determine what’s appropriate for the specific subject company.

In addition to facts that are publicly available, “reasonable knowledge” includes facts that a buyer would uncover over the course of private negotiations over the property’s purchase price. During normal due diligence procedures, a hypothetical buyer is expected to ask the hypothetical seller for information that’s not publicly available.

2. When a Transaction Provides an Indication of Value

A subsequent event that’s unforeseeable as of the effective date may still be considered if it provides an indication of value. However, it generally must be within a reasonable period and occur at arm’s length.

For example, in a landmark case — Estate of Jung v. Commissioner (101 T.C. 312, 1993) — the U.S. Tax Court ruled that actual sales prices received for property after the effective date may be considered when valuing a business interest, “so long as the sale occurred within a reasonable time … and no intervening events drastically changed the value of the property.” This ruling differentiates subsequent events that affect fair market value from those that provide an indication of fair market value.

Full Disclosure

When you hire a business valuation expert, it’s important to share all information that could potentially be relevant to the value of the business. This includes information about subsequent events that affect value or provide an indication of value. Once the valuation expert is aware of this information, he or she can determine whether an event is appropriate to consider when valuing the business interest.

If you require assistance with a business valuation-related matter, please contact Advent for trusted guidance.

© 2022, Powered by Thomson Reuters Checkpoint 

Divorce Case Spotlights Complexities of Double-Dipping Analysis

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Courts sometimes have difficulty determining an appropriate allocation of assets in a divorce.

The division of assets in a divorce is vital to the financial futures of the spouses. A fair division of assets is required under New York state equitable distribution law. For many couples, a professional practice (think doctor, lawyer or accountant) or a business is a key asset in their divorce. While not a New York case, Oudheusden v. Oudheusden was an interesting read for those of us seeking to better understand this topic. 

In this Connecticut case, the husband defendant, whose marriage had been dissolved, appealed to the Appellate Court a judgment of the trial court. The trial court had awarded his wife $18,000 per month in permanent alimony that could not be modified or changed in duration or amount. The trial court found the husband’s gross annual income of $550,000 was completely derived from his two closely held businesses, which were valued at $904,000.

As part of its financial orders, the court awarded 50 percent of the fair market value of the two businesses to each party, ordering the defendant to pay the plaintiff $452,000. The court awarded 100 percent ownership of both businesses to the husband. 

Income vs. Profit

On appeal to the Connecticut Appellate Court, the husband claimed that the trial court impermissibly double-counted his income by considering it both for the purpose of valuing his businesses and in making its maintenance award.

The Appellate Court reversed in part the trial court’s judgment and remanded the case for a new hearing on all financial issues. The Appellate Court concluded that the trial court had abused its discretion in failing to issue equitable orders and to consider, with respect to its maintenance award, the possibility that the husband, who was 58 years old at the time of the dissolution and had a history of alcohol abuse, could become ill or might want to retire, or that his businesses could fail to prosper through no fault of his own.

The Appellate Court further determined that the trial court had engaged in double-counting. The plaintiff wife then appealed to the Connecticut Supreme Court. 

Double Reversal

The judgment of the Appellate Court was affirmed by the Supreme Court with respect to its determination regarding the trial court’s financial orders but reversed with respect to its determination that the trial court improperly double-counted the value of the defendant’s businesses for purposes of the property division and alimony awards. The case was remanded to the Appellate Court with direction to remand the case to the trial court for a new hearing on all financial issues.

The case is Oudheusden v. Oudheusden, (SC 20330, Connecticut Supreme Court, Apr. 27, 2021). Read the decision here. For additional blog posts on divorce-related topics, click here, here or here.

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If you require assistance with the valuation of a business or determination of reasonable compensation in a matrimonial matter, please contact Advent for trusted guidance.  

Lost Profits: Calculating the Damage

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When a business has been damaged by another party, an expert may be needed to estimate the damages. Photo by Dovis from Pexels

Financial experts are often hired to measure economic damages in contract breach, patent infringement and other tort claims. Here’s an overview of how experts quantify damages, along with some common pitfalls to avoid.

Estimating Lost Profits

Where would the plaintiff be today “but for” the defendant’s alleged wrongdoing? There are three ways experts address that question:

1. Before-and-after method. Here, the expert assumes that, if it hadn’t been for the breach or other tortious act, the company’s operating trends would have continued in pace with past performance. In other words, damages equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the company’s value before and after the alleged tort occurred.

2. Yardstick method. Using this technique, the expert benchmarks a damaged company’s performance to external sources, such as publicly traded comparables or industry guidelines. The presumption is that the company’s performance would have mimicked that of its competitors if not for the tortious act.

3. Sales projection method. Projections or forecasts of the company’s expected cash flow serve as the basis for damages under this method. Damages involving niche players and start-ups often call for the sales projection method, because they have limited operating history and few meaningful comparables.

Experts will consider the specific circumstances of the case to determine the appropriate method (or methods) for the situation.

Discounting Damages

After experts have estimated lost profits, they discount their estimates to present value. Some jurisdictions have prescribed discount rates, but, in many instances, experts subjectively build up the discount rate based on their professional opinions about risk. Small differences in the discount rate can generate large differences in valuators’ final conclusions. As a result, the discount rate is often a contentious issue.

Mitigating Factors

Another key step is to address mitigating factors. In other words, what could the damaged party have done to minimize its loss?

For example:

• A manufacturer that suffers a business interruption should minimize the impact by resuming operations at a temporary location or outsourcing production to another company, if possible.

• A wrongfully terminated employee needs to make a reasonable effort to find another job.

• An antitrust plaintiff prevented from entering a particular market should explore opportunities to invest in alternative markets.

• A plaintiff in a breach-of-contract case should make a reasonable effort to replace the business lost as a result of the defendant’s wrongdoing.

Most jurisdictions hold plaintiffs at least partially responsible for mitigating their own damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.

Avoiding Potential Pitfalls

Some key factors need to be considered to avoid over- or underestimating a plaintiff’s loss. For example, the taxation of damages can have a significant impact on an expert’s conclusion. If the plaintiff must pay taxes, an after-tax assessment wouldn’t be equitable. Also realize that some parts of a damages award, such as return of capital, may be nontaxable and require an after-tax estimate.

Taxes also need to be handled properly when lost profits are discounted to present value. In other words, if damages need to be calculated on a pretax basis, the expert should use pretax discount rates. Mismatching after-tax discount rates to pretax cash flows would overstate damages, all else being equal.

In addition, it’s important to not assume that damages will occur into perpetuity. Economic damages generally occur over a finite period. They have a beginning and an end. Eventually most plaintiffs can overcome the effects of the defendant’s alleged wrongdoing.

For More Information

When calculating economic damages, there isn’t a one-size-fits-all approach. What’s right depends on the facts of your particular case. Contact the experts at Advent Valuation Advisors to develop an estimate that avoids potential pitfalls and can withstand scrutiny in court.

© 2021, Powered by Thomson Reuters Checkpoint 

Tax Treatment Complicates S Corp Valuation

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So-called “pass-through” entities — including partnerships, limited liability companies (LLCs) and S corporations — generally aren’t required to pay entity-level taxes. So, when it comes to valuing a small business structured as a pass-through entity for tax purposes, people often wonder: Would investors pay a premium for an interest in this business compared to an interest in an otherwise identical C corporation? And, if so, how much is this favorable tax treatment worth? This is the crux of the tax-affecting debate.

Much of the litigation regarding this issue comes from the IRS and tax courts. But a recent Tennessee Court of Appeals decision discusses this issue in the context of a shareholder buyout. (Raley v. Brinkman, No. 2018-02002, Tenn. App., July 30, 2020)

Pros and Cons of Pass-Throughs

For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ individual tax returns, and taxes are paid at the personal level. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.

If a pass-through entity distributes just enough of its earnings to cover the owners’ tax liabilities, there may be little potential valuation difference at the investor level between the pass-through entity and a taxable entity, assuming similar tax rates at the entity and the investor levels. If the pass-through entity distributes larger amounts of earnings to the owner, the interest becomes potentially more valuable than an equal interest in a taxable entity, all other things being equal. If the pass-through entity distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable in the hands of the owner.

Court Allows Tax Affecting

The tax-affecting issue took center stage in a recent buyout case involving two equal partners in a restaurant that generated roughly $3.4 million in gross annual income in 2016. When the owners disagreed about how to manage their business, a Tennessee trial court ordered a buyout of one owner’s interest at “fair value” under applicable state law.

The business operated as an LLC that elected to be treated as an S corporation for income tax purposes. The trial court allowed the buyout price to include a hypothetical 38% corporate income tax rate to the restaurant’s earnings. But the seller (plaintiff) appealed, arguing that tax affecting wasn’t appropriate for a pass-through business that wasn’t subject to entity-level tax.

The buyer (defendant) contended that tax affecting was appropriate because the income from an S corporation passes through to the owners’ individual tax returns and is taxed at the owners’ personal tax rates. He also argued that valuation experts commonly use after-tax income values to calculate the capitalization rate under the income approach.

The appellate court explained that the problem with using the income approach to value a pass-through entity is that it’s designed to discount cash flows of C corporations, which are taxed at both the entity and the shareholder level. Income from an S corporation is taxed only at the shareholders’ personal level.

Citing the landmark Delaware Open MRI Radiology Associates case, the appellate court concluded that declining to tax affect an S corporation’s earnings would overvalue it, but charging the full corporate rate would undervalue it by failing to recognize the tax advantages of S status. The court also determined that it was appropriate to use an after-tax earnings stream because the expert’s capitalization rate was based on after-tax values.

Finally, the appellate court cited the Estate of Jones. In this U.S. Tax Court case, the court concluded that the cash flows and discount rate should be treated consistently when valuing a pass-through entity.

IRS Job Aid Provides Insight

The debate over tax affecting pass-through entities has persisted for decades. To help clarify matters, the IRS has published a job aid entitled “Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated As S Corporations for Federal Tax Purposes.” This document helps IRS valuation analysts evaluate appraisals of minority interests in S corporations for federal tax purposes.

However, the job aid provides useful guidance on the issue of tax affecting that may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons. Business valuation experts may use this job aid as a reference tool to help support their decisions to apply tax rates to the earnings of pass-through entities when projecting future cash flows.

No Bright-Line Rules

When it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate — or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.

© 2021, Powered by Thomson Reuters Checkpoint 

Price-to-EBITDA Multiples Decline During First Quarter, According to DealStats

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The median price-to-EBITDA multiple among deals reported to DealStats fell slightly to 3.8 during the first quarter of 2021, down from 3.9 in the fourth quarter of 2020, suggesting transaction prices remain under pressure from the coronavirus pandemic.

According to the latest edition of DealStats Value Index, the four-quarter average EBITDA (earnings before interest, taxes, depreciation and amortization) multiple for the year ending in March 2021 was 3.9, the lowest such average since the period ending in the third quarter of 2016.

EBITDA measured as a percentage of net sales fell to 10 percent in the first quarter of 2020, due at least in part the ongoing economic toll of the pandemic and resulting restrictions. The reduction also reflects a longer-term trend of lower margins. EBITDA margins for transacted businesses have fluctuated between roughly 10.5 percent and 12 percent since late 2018, according to DealStats. From 2015 to 2018, they generally moved between 11 percent and 14.5 percent. DealStats does not indicate if the EBITDA margin metric is a median or an average.

Transaction reporting appears to have slowed with the pandemic. Of 15 sectors tracked by DealStats, just three met the minimum of 10 reported transactions during the first quarter required for the inclusion of sector-specific multiples.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the business being valued.

How Reasonable is Your Owners’ Compensation?

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There are many factors to consider when determining reasonable owners’ compensation. Photo by Matthew Henry from Burst

For most privately held businesses, owners’ compensation is one of the largest expenses on the income statement, especially when all the related perks and hidden costs are calculated. Compensation should accurately reflect what others would receive for similar duties in a similar setting. Reasonable compensation levels are important not only for state and federal tax purposes, but also to get an accurate estimate of the fair market value of the business.  

Total Compensation Package

Before compensation can be assessed as reasonable, all components of the package must be calculated, including:

  • Direct salaries, bonuses and commissions,
  • Stock options and contingent payments,
  • Payouts under golden parachute clauses,
  • Shareholder loans with low (or no) interest and other favorable terms,
  • Company-owned or leased vehicles and vehicle allowances,
  • Moving and relocation expenses,
  • Subsidized housing and educational reimbursements,
  • Excessive life insurance or disability payments, and
  • Other perks, such as cafeteria plans, athletic club dues, vacations and discounted services or products.

In addition, owners’ compensation may be buried in such accounts as management and consulting fees, rent expense and noncompete covenants.

IRS Guidance

The IRS has published a guide titled, “Reasonable Compensation: Job Aid for IRS Professionals.” IRS field agents use this guide when conducting audits to help determine what’s reasonable and how to estimate an owner’s total compensation package.

The IRS is on the lookout for C corporations that pay employee-shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t.

Owner-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay owners’ salaries to minimize state and federal payroll taxes. Rather than pay salaries, S corps are more likely to pay distributions to owners. That’s because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.

The IRS job aid lists several sources of objective data that can be used to support compensation levels, including:

  • General industry surveys by Standard Industry Code (SIC) or North American Industry Classification Systems (NAICS),
  • Salary surveys published by trade groups or industry analysts,
  • Proxy statements and annual reports of public companies, and
  • Private company compensation reports such as data published by Willis Towers Watson, Dun & Bradstreet, the Risk Management Association or the Economic Research Institute.

“Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances,” states the IRS job aid.

Compensation Benchmarks

Beyond IRS audits, the issue of reasonable compensation may become an issue in shareholder disputes, marital dissolutions and other litigation matters. When valuing a business for these purposes, a company’s income statement may need to be adjusted for owners’ compensation that is above or below market rates.

Courts often rely on market data to support owners’ compensation assessments. But it can be a challenge to find comparable companies — and comparable employees within those companies. The five areas that courts consider when evaluating reasonable compensation are:

  1. The individual’s role in the company,
  2. External comparisons of the salary with amounts paid to similar individuals in similar roles,
  3. Character and condition of the company,
  4. Potential conflicts of interest between the individual and the company, and
  5. Internal inconsistency in the way employees are treated within the organization.

Owners can control compensation, and that creates an inherent conflict of interest when estimating what’s reasonable. External comparisons are key to supporting compensation levels. Business valuation experts typically interview owners to get a clearer picture of their experience, duties, knowledge and responsibilities.

Get It Right

For more information about reasonable owners’ compensation, please contact the business valuation professionals at Advent Valuation Advisors. We can help estimate total compensation levels, find objective market data and adjust deductions that are above or below market rates.