Owner Compensation: What's Reasonable
Controlling owners of closely held construction companies are generally free to set their own salaries and bonuses. But, under certain circumstances, the reasonableness of owner compensation can become an issue.
In a 2010 case, Multi-Pak Corp. v. Commissioner, the U.S. Tax Court outlined five factors to consider in determining whether a corporate shareholder/employee compensation is reasonable.
Compensation matters
There are several situations in which the reasonableness of owner compensation might come into play. If a company is a C corporation, for example, the IRS or a state taxing authority might challenge excessive owner salaries as an attempt to disguise nondeductible dividends as deductible wages.
If a company is an S corporation, the government may claim that it set unreasonably low salaries to avoid payroll taxes. S corporation shareholders aren't subject to self-employment taxes (the equivalent of payroll taxes for the self-employed) on their shares of corporate earnings. So there a tax incentive to pay out earnings as distributions rather than salaries.
This isn't an issue for other types of entities, such as partnerships or LLCs. Their owners generally are subject to self-employment taxes on their shares of the entity earnings, whether distributed to them or not.
In a valuation context, it often necessary to normalize owner compensation to a reasonable level to avoid distorting a company true earning power. This may be an issue in divorce or other family law matters involving the value of a spouse business interest.
The issue may also come up in situations requiring valuation of a company stock (such as a merger or acquisition, equity or debt financing, shareholder dispute, or bankruptcy).
The 5 factor test
Courts take different approaches in determining whether a business owner compensation is reasonable. Some have adopted a multifactor approach, considering anywhere from five to 12 factors in light of a company particular facts and circumstances.
Other courts apply an independent investor test. Essentially, this test asks whether a hypothetical independent investor would be willing to pay the amount of compensation at issue.
In Multi-Pak, the Tax Court examined five factors in determining whether compensation paid to the corporation sole shareholder and CEO (more than $2 million in 2002 and 2003) was reasonable:
1. The employee role in the company, including position, duties, hours and general importance to the company success.
2. Comparison of employee compensation to compensation paid by comparable companies for comparable work.
3. The company character and condition, including sales, net income or value, business complexity, and relative success in its industry.
4. Potential conflicts of interest, that is, does the employee relationship with the company enable the business to disguise nondeductible dividends as deductible compensation?
5. Internal consistency of compensation policies and practices.
The Tax Court added an independent investor test to its conflict-of-interest analysis. The court explained that, if the company earnings on equity after payment of the compensation at issue remain at a level that would satisfy a hypothetical independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned out of the company disguised as salary.
Although factors 1, 3 and 5 above favored the company over the IRS, and factor 2 was neutral, the court decision turned almost exclusively on the outcome of the independent investor test. It found that the CEO 2002 compensation was reasonable: The company 2.9 % return on equity (ROE) for that year, though modest, would have satisfied an independent investor in light of the company recent sales growth and its long-term potential.
In 2003, however, the ROE dropped to an unacceptable -15.8%. The court found that reasonable compensation for that year was just under $1.3 million, which was in line with the CEO average compensation in previous years and would produce an ROE of 10%.
Do your own research
To anticipate potential issues with owner compensation, it good to examine these factors when structuring compensation packages. By evaluating the five factors above, researching compensation surveys for your industry and estimating the impact of owner salaries on ROE, you can get a feel for what reasonable and what not.