Understanding and Winning Reasonable Compensation Issues
You Need to Know! The practice of family law arguably requires more skill sets of the family law practitioner than any other area of specialty. Business valuation is replete with an unusual combination of technical and subjective analyses proffered by the expert. Rightfully so, business valuation is viewed as part science and part art. To be a successful practitioner, you need to be mindful and conversant in the issues. Although it is natural to simply rely upon your expert on a “need to know basis,” that will invariably result in missed issues, failed discovery, and a tortured courtroom experience. When it comes to smaller business appraisals, perhaps the issue most affecting the valuation opinion, particularly in professional practices, is the determination of reasonable compensation applicable to the business owner(s).
Where Do Reasonable Compensation Issues Arise in Family Law Matters? The application of reasonable compensation crosses over various areas and is not limited solely to business valuation. In an equitable apportionment argument, a Van Camp analysis requires the determination of reasonable compensation during the marriage. That application is carried forward after separation when a Van Camp analysis is applied in reverse.1 Finally, reasonable compensation can be an issue during the post-separation and post-judgment management and control of a community property business interest.
The Reasonable Compensation Dilemma! In reality, the biggest problem in making a determination of reasonable compensation is assessing a rational apportionment of available profits of the company before reasonable compensation, between a return on investment to the owner and compensation that is payable for the market value of services rendered by that owner. This is an issue largely ignored by experts and attorneys alike. While distributions by a company to the owner generally reflect a “return on investment” to the owners, wage compensation to the owner (and discretionary expenses paid on behalf of the owner) is in exchange of services provided to that entity by the owner. Exacerbating the difficulty of the analysis is that the analysis is made as a hypothetical analysis as if the owner and the company were acting at arms’ length to one another. In most family law cases that is not the case. In fact, in the majority of family law cases, the parties typically own all, or the vast majority, of the business interest. This concept is further addressed later in this article.
So, What is Reasonable Compensation? In closely held entities, owners control their own amount and form of compensation. Personal agendas and the company’s ability to pay compensation are overriding factors in the amount of compensation paid rather than the market value of the services performed by the owners. As a result, “reported” business earnings are usually not reflective of true or “economic” profits.2 According to Dr. Shannon Pratt (a widely respected authority on business valuation issues), “the compensation adjustment is to substitute for the compensation actually paid the cost of hiring a non-owner outsider to perform the same function…for performing similar services.” 3 This principle is also well ensconced in California family law. Family Code section 4058 (a)(2) states, in pertinent part, that income from a business is determined after consideration of “… expenditures required [italics added] for the operation of the business.” This language is a mirror image of Treasury Regulation § 162(a)(1),4 which addresses reasonable compensation issues. As such, compensation that is paid merely based upon the self-interest of the owner is not necessarily reflective of a “required” expenditure of the business. If owner compensation is too low or too high relative to what would be paid in the labor marketplace for similar services, then the business income will not reflect an arms’-length depiction of the entity’s income.
Business owners’ behavior is dictated by outside factors. As such, a reasonable compensation adjustment is made to reflect the “Principle of Substitution.” The Principle of Substitution in economic and appraisal theory stands for the notion that a rational or prudent person would pay no more for an item than the cost of acquiring an equally desirable substitute good or service available in the marketplace. That concept is similarly viewed by the IRS, and U.S. Treasury Regulations look at the appropriateness of the paid owner compensation from a tax viewpoint. Treasury Regulation § 1.162-7(b) sets the baseline and states that “the compensation paid [to the owner] may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances [italics added].”
The inclusion of the phrase “under all the circumstances” infers that reasonable compensation analysis is a fact-based endeavor. That is, to truly understand whether compensation paid to an owner of a business is “reasonable” requires gathering substantial information from a variety of sources. Even after gathering all of the available information and a detailed understanding of the owner’s job duties and responsibilities, it may be difficult, if not impossible, to arrive at a definitive “point estimate” of that compensation in any given period. This is an area requiring a significant amount of subjectivity and available data to narrow the opinion, which may be less than optimal. According to the IRS publication IRS Job Aid for IRS Valuation Professionals, October 29, 2014,5 “[w]hat amount constitutes Reasonable Compensation might best be viewed as a range because of the interpretive nature of the issue.” Although family law practitioners working with any of the issues noted above will ultimately require a “point estimate,” it is helpful to understand that reasonable compensation may be measured by a range of values. As such, understanding those factors that are relevant in establishing the potential range and supporting the conclusion of value is important in prevailing on the issue in settlement discussions or at trial.
Different Facts, Different Motivations! Not surprisingly, owners are often motivated by tax considerations when considering the amount and form of compensation they choose to pay themselves. These motivations are often diametrically opposed to positions taken by the IRS on reasonable compensation issues. On the one hand, regular corporations (often referred to as “C” corporations) are tax-paying entities. In C corporations, the income that is retained after owner’s compensation and business expenses are taxed at corporate rates. In order to distribute those retained profits in the future, they are typically paid as dividends and subject to a second tax at the shareholder level. Therefore, it is not unusual for owners of C corporations to be motivated to minimize corporate income through the payment of owner wages (or payment of discretionary personal expenses) that eliminates corporate income and avoids the double taxation issue. On the other hand, owners of Subchapter S corporations,6 may have an opposite motivation to the shareholders of C corporations. In S corporations, owners are motivated to minimize “wage compensation” in order to reduce business payroll contributions paid for FICA, Medicare, and Affordable Care Act taxes.
How Important is the Issue in Your Case? The extent to which a client’s resources are dedicated to this issue depends, in part, upon how important the issue is to the overall valuation conclusion or how important reasonable compensation is to the attendant family law issue at hand. Obviously, if reasonable compensation represents the single largest influencer of value, as it often may, particularly in smaller professional practice valuations, it may be appropriate to consider the retention of a reasonable compensation expert to evaluate the issues rather than have your forensic accountant complete the analysis. However, if this is just one of many issues at hand, reliance upon your forensic accountant and available industry data, may be appropriate and cost effective.
However, whether the issue is relevant may also depend upon an often-overlooked principle. When considering a reasonable compensation adjustment, it must first be determined if the parties in the matter retain a controlling interest in the company being valued. If they have the ability to change the owner compensation, then it is appropriate to consider such adjustments. If they do not have such power, the issue is likely moot. Very often such distinction of control is blurred by other factors and the analysis is necessary and part of a larger legal issue.7
Authoritative Guidance to the Reasonable Compensation Issues Is Out There! Family law and tax court cases provide authoritative guidance that is often not utilized as often as it can or should be. There are a few key principles to be mindful of in the body of case law and tax court rulings.
What is the “Standard of Value” as to Owner’s(s’) Wages? Perhaps the seminal case on the issue is In re Marriage of Garrity & Bishton, 226 Cal. Rptr. 485, 490 (1986). In Bishton, the court established the value of the company by adjusting owner’s compensation to the “salary of the average salaried person.” As it pertains to reasonable compensation, In re Marriage of Rosen, 130 Cal. Rptr. 2d 1 (2002) and In re Marriage of Iredale & Cates, 16 Cal. Rptr. 3d 505 (2004), established a “standard of value” other than the “average salaried person.” In particular, as it relates to professional practices, Iredale addressed a further definition to adjust owner’s compensation. In Iredale, the court reiterated the findings in Marriage of Rosen, 130 Cal. Rptr. 2d 1(2002), that the “average salaried person” standard was not the only basis from which a compensation adjustment may be made. In Iredale, the court further developed the notion of a “similarly situated professional” standard that relied upon comparative compensation, not as quantified by an “averaged salaried” worker, but based upon metrics measured by a similarly skilled person, in a similar industry, in a proximate geographic location, exerting similar efforts. This newly defined standard would relate particularly to professional practices (medical, legal, architecture, financial advisors, accounting, etc.). In general, the “peer group” which forms the comparative data should be one of non-owner professionals8 who are comparable in terms of all factors excluding ownership. However, many experts may still use comparative compensation data from owner-practitioners in making a final determination of reasonable compensation. The basis of that reliance and the assumptions made in such reliance, if any, should be explored.
Mining Data! As with any technical analysis, finding relevant data is a challenge. In Marriage of Ackerman, 52 Cal. Rptr. 3d 744 (2006), the appellate court noted that “[a]lthough not binding, professional compensation surveys may be used by experts and trial courts as guidelines for determining reasonable compensation of a practitioner’s peers. To be relevant, however, the surveys must account for similarly-situated professional practices and practitioners.” The appellate court in Ackerman also did not exclude the use of “private surveys.”
However, caution must be used as to whether such privately prepared surveys are statistically accurate, replicable, and supportable. Since the trial court is the “gatekeeper” of evidence9 and may easily keep out such surveys, use of private surveys should be used with caution and by no means in isolation. Since market compensation surveys are essentially a “market approach” in determining reasonable compensation, care must also be taken to demonstrate that the market compensation information is truly comparable and meaningful under the circumstances. In Marriage of Rosen, 130 Cal. Rptr. 2d 1 (2002), the court specifically cautioned experts on the use of surveys that provided little value to the issues before the court and that were not supported by a detailed understanding of the job description, duties, hours, and tasks of the owner in question. Therefore, it is important to understand the fundamental issues pertaining to the determination of the compensation. For a further understanding and discussion on the admissibility and use of market surveys and whether surveys in general are dispositive, see B&D Foundations v. Commissioner, T.C.M., 2001-262.
What Factors Supplement the Market Surveys? What the precedent cases discussed above make clear is that the fundamental issues surrounding the compensation issue are the true drivers of a reasonable compensation conclusion. In further development of these factors, in the B&D Foundations case, the tax court established a multiple-factor test to develop a basis for determination of a supportable reasonable compensation opinion. The factors that should be developed and considered include:
- The employee/owner’s qualifications. In this regard, job experience, education, and training;
- The nature, extent, and scope of the employee’s/owner’s work. In this regard, consideration to the type of work, the number of hours/efforts exerted, responsibilities, and complexity of the positions;
- The size and complexity of the business. In this regard, if all things are equal, there is an assumption that reasonable compensation will be higher in larger businesses10 that are more complex;
- A comparison of salaries paid as measured against various levels of business income. In this regard, this may measure if there is an adequate rate of return on investment available to the owners after payment of the concluded reasonable compensation (more on this in the next section);
- The prevailing economic conditions. In this regard, considerations include the state of the economy (robust or depressed, for example), and its impact on the performance of the company, as well as reflecting the true performance of the employee/owner and the determination of compensation;
- A summary and comparison of the salary paid to the owner and the distributions (as applicable) paid to the owner by the company. In this regard, this will also address whether the company is generating an adequate return on investment to its owners after payment of the owner salary;
- A comparison of salaries paid to others in the marketplace. In this regard, this would include use of private and public surveys, market information, and a range of potential compensation;
- The salary of the employee/owner as compared to compensation paid to all other employees. In this regard, this may address the reasonableness of the owner compensation vis-à-vis the compensation and contributions of key non-owner employees;
- Compensation paid to the employee/owner in the years in questions relative to compensation paid in prior years. In this regard, this may test the reasonableness of the compensation based upon known changes in compensation vis-à-vis historical payments and performance.
In Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), additional guidance is offered to family law practitioners as this case provides a further understanding of the fundamental issues driving reasonable compensation conclusions. Those factors and sub-factors as relevant to family law are as follows:
- The hours worked;
- Duties performed;
- Compensation paid by similar companies for similar services;
- The size and complexity of the company;
- Whether payments to the owner are internally consistent with compensation paid to non-owners given consideration to the other factors.
As to the last factor, the IRS specifically looks at this metric. In its Job Aid for IRS Valuation Professionals, the IRS notes that “subordinates” comparative pay for the “second in command” where compensation is independently set is typically about “50% to 80% of the CEO’s total compensation.” The IRS notes that if the compensation ratio of the subordinates is materially lower than this, “an issue may exist on the CEO’s compensation.” This “acid” test might be viewed in each family law case as a starting point for a test of reasonableness of any compensation conclusions.
The Missing Link! In Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 834 (7th Cir. 1999), perhaps the most overlooked factor is addressed. This is one of the most important cases as to reasonable compensation as it established an objective test for the appropriateness of the reasonable compensation conclusion. In Exacto, the court held that although having a multiple-prong or factor test is, in and of itself, not inappropriate, such analysis is too vague, subject to bias, and is still too narrow as it ignores the imposition of an adequate rate of return to the shareholders or owners based upon the compensation paid to the company’s owner. So, the court in Exacto imposed an “independent investor test.”
The independent investor test is viewed as a simple and dispositive test that may limit reasonable compensation to an amount that results in an adequate return on investment to the investors/owners of the company. Such an analysis allows for higher reasonable compensation in case of superior financial performance and may limit reasonable compensation when the company or professional practice is a poor financial performer. The omission of this analysis in family law cases seems to be a common flaw where conclusions often result in no, or negative, adjusted business income of the company, with no further support or explanation. The required rate of return to the shareholders may be measured by profits, a return on revenue, return on assets, or a return on owner’s equity. The former measure of returns is of particular importance in the determination of reasonable compensation in professional practices since professional practices are not generally capital intensive.
A defensible reasonable compensation analysis will address all of the relevant factors as noted herein. It is de rigueur that such analysis includes a detailed interview of the owner and relevant officers of the business. The attorney should consider special interrogatories, request for admissions, and depositions, as needed, to insure that the expert has appropriate information to evaluate compensation in light of the owner’s role and the operations of the business. The expert and the attorney must use a broad base of information, including market and industry compensation data/surveys and detailed internal business compensation data. Making a determination as to the appropriate measure of compensation (“average salaried worker” or “similarly situated professional”) must be assessed as neither is precluded from presentation to the trier-of-fact.
At the end of the day, the conclusion as to the reasonable compensation data must be reconciled and supported by the resulting return on investment then inuring to the shareholder/owners after the payment of the reasonable compensation under an “independent investor test.” If the return on investment to the owners is unusually low or high vis-à-vis industry information, the expert needs to be in a position to defend their opinion. Like valuation assignments, the analysis of reasonable compensation involves a substantial amount of analysis and subjective determinations. When this issue is material to the issues in your case, preparation is the only pathway to successful resolution.
1 See, e.g., In re Marriage of Imperato,119 Cal. Rptr. 590 (1975)
2 Economic profits here refer to reported revenue less the necessary costs to generate those revenues.
3 Shannon P. Pratt, Valuing Small Businesses and Professional Practices 59 (1986).
4 § 162(a)(1) states, in pertinent part, that the taxpayer may deduct “all the ordinary and necessary expenses paid or incurred during the taxable years in carrying on any trade or business.”
5 This publication is noted to be non-authoritative.
6 Subchapter S elections allow corporations to pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes.
7 Such as a continued need in a Van Camp analysis.
8 In Marriage of Rosen, the California Society of Certified Public Accountants amicus brief explained that reasonable compensation can be measured by “the cost of hiring a nonowner outsider…” (italics added).
9 Sargon Enterprises, Inc. v. USC, 55 Cal. 4th 747 (2012).
10 Size can be measured in terms of revenue, assets, employees, etc.