September 01, 2010

The compensation paid to a business owner constitutes a related-party transaction which may not transact on an arm’s length basis. Such an arrangement may impact marital dissolution matters in four pivotal areas. First, given the magnitude of owner’s compensation relative to overall expenses, the valuation of a business may be significantly influenced. Second, the reasonableness of compensation vis-à-vis a particular owner’s specific contribution to revenue enhancement or cost savings may drive the value of personal goodwill incorporated within a business. Third, compensation, either actual or implied, factors into determining maintenance (alimony) and child support. Finally, compensation received or withheld from a business assists in determining the appropriate compensation to the marital estate. All of these key matters are impacted by the determination of reasonable compensation.

Illustrating the Effect of the Reasonable Compensation Determination

These issues, and their interconnectivity, can best be illustrated with a hypothetical example. John Smith wholly owns Build-It Company (“Build-It”), a distributor of building materials. In Mr. Smith’s marital dissolution proceeding, the Court-appointed valuation expert determines the following facts and assumptions:

Given this relatively simple fact pattern and analysis, assumptions regarding Mr. Smith’s compensation can drastically alter the property settlement and maintenance determination. For example, the differences resulting from an assumption about reasonable compensation of $3 million versus $6 million can be graphically illustrated as follows:

From this illustration, it is readily apparent that increasing the assumed reasonable compensation from $3 to $6 million will double the annual maintenance payment. However, in so doing, the property settlement (due to the change in equity value of Build-It Company from $23 million to $5 million), would decrease substantially from over $8.6 million to less than $2 million, after deducting the assumed non-marital portion.

This illustration focuses on potential changes to property settlements and maintenance from different determinations of reasonable compensation. Equally complex, but less easily illustrated, are the effects of different reasonable compensation determinations on personal goodwill which, within many state jurisdictions, affects property allocation. For example, even if a business owner receives compensation over and above that which is considered reasonable for a peer, such compensation to this particular owner may be appropriate given his/her unique abilities which contribute to the profitability of the business.1 These unique abilities may be found in the business owner’s relationships, skill, knowledge, and reputation.2

Finally, to the extent it is determined that compensation has been unreasonably high or low, the marital estate may be, respectively, overcompensated or undercompensated. These situations take on added complexity when the business is outside of the marital estate. In such situations where the marital estate has been undercompensated, arguments may be made that the owner’s company (or assets within the corporate umbrella) has been transmuted into marital property.3

Given the repercussions of reasonable compensation in both materiality and the sheer number of marital dissolution issues impacted by the same, what guidance does case law provide in determining reasonable compensation?

Case Law Guidance

Many businesses, due to their corporate structure as C corporations, may be incentivized to pay compensation above that of an arm’s length transaction in order to minimize taxes incurred at the corporate level. As a preventative measure, Internal Revenue Code Section 162(a)(1) requires that, to be recognized as a business expense, compensation must be reasonable in amount and must be paid “for personal services actually rendered.” In contrast, pass-through entities such as S corporations, all else equal, will be motivated to pay reduced compensation to owners and instead make distributions to owners to avoid payroll taxes. Due to the influence of the tax code on compensation, the Internal Revenue Service has a long history of dealing with reasonable compensation issues in Tax Court and on appeal. As such, tax cases can provide some guidance in reviewing the reasonableness of compensation. Included among the most notable and insightful are Elliotts, Inc. v. Commissioner and Mad Auto Wrecking v. Commissioner.4

Both cases employed multi-factor tests in determining the reasonableness of compensation. That is, both cases enumerated various qualitative attributes of the business and its owner. The factors noted by Elliotts were:

  • Role in the company (position, hours worked, duties performed, etc.)

  • External comparison (comparison to “similar companies for similar services”)

  • Character and condition of the company (size and complexity of the business)

  • Conflict of interest (degree of control by the owner over the business)

  • Internal consistency (in application of compensation plans over time)

Likewise, Mad Auto Wrecking detailed the following (partially repetitive with Elliotts) fourteen factors:

  • Employee’s qualifications

  • Nature, extent, and scope of the employee’s work

  • Size and complexity of the employer’s business

  • Comparison of salaries paid with the employer’s business gross and net income

  • Prevailing general economic conditions

  • Comparison of salaries with distributions to shareholders and retained earnings

  • Prevailing rates of compensation for comparable positions in comparable companies

  • Employers salary policy of the employer to all employees

  • Amount paid to employees in previous years

  • Employer’s financial condition

  • Whether employer and employee dealt at arm’s length

  • Whether employee guaranteed employer’s debt

  • Whether employer offered a pension plan or profit-sharing plan to employees

  • Whether the employee was reimbursed by the employer for business expenses that the employee paid personally

Similar to the above in Alpha Medical, Inc. v. Commissioner5, (as guided by the relevant factors stated in Mayson Mfg. Co. v. Commissioner6), the Sixth Circuit Court of Appeals endorsed the consideration of the following nine factors in applying the multi-factor approach to determine the reasonableness of compensation paid to a shareholder/employee of a privately held corporation:

  • Employee’s qualifications

  • Nature, extent and scope of the employee’s work

  • Size and complexities of the business

  • Comparison of salaries paid with gross income and net income

  • Prevailing general economic conditions

  • Comparison of salaries with distributions to stockholders

  • Prevailing rates of compensation for comparable positions in comparable concerns

  • Amount of compensation paid to the employee in previous years

  • Salary policy of the taxpayer as to all employees.

In Eberl’s Claim Service, Inc. v. Commissioner7, the Tenth Circuit Court of Appeals sanctioned the use of twelve factors in applying the multi-factor approach. The additional factors considered included:

  • The company’s current financial condition

  • Whether the employee ever guaranteed the debt of the company

  • Whether the employee and employer dealt at arm’s length, and if not, whether an independent investor would have approved the compensation.

As with any qualitative assessment, an element of imprecision and vagueness inherently exists. Practitioners and courts struggled with such issues as determining which factors may be more relevant than others and how to handle inconsistent conclusions among the various factors (e.g., an employee’s qualifications argue for higher compensation while prevailing economic conditions suggest a lower compensation is appropriate).

Partially in response to such issues, the Seventh Circuit, in Exacto Spring Corporation v. Commissioner, embraced a seemingly more quantitative approach known as the independent or hypothetical investor test.8 This test was summarized by the Court as follows:

A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner’s investment. The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid, for it will be implausible that if he quit if his salary was cut, and he was replaced by a lower-paid manager, the owner would be better off; it would be killing the goose that lays the golden egg.

In short, if investors expect a high rate of return given the risk of the investment, and expect an even higher rate of return to be delivered by management, seemingly exorbitant compensation may still be reasonable.

Although this case was not the first to embrace the independent investor test, the Court did break with precedent in viewing this test as distinct from the multi-factor test. In describing the distinctiveness of the new test, the Court claimed “the new test dissolves the old and returns the inquiry to basics.”

However, the independent investor test still inherently involves opinions as to appropriate expected rates of return, the degree of return attributable to management, and the appropriate compensation to be paid management for its contribution. To illustrate the last point, if investors expect a 13% return and management, solely through their efforts, generates a 20% return, how much of the incremental return should be paid to shareholders versus that of management? The utilization of math, while useful, cannot mask judgment.

Still, the independent investor test has, at a minimum, appropriately noted that compensation in order to align interests in maximizing returns can be significant. The theory exists in practice with many public corporations which compensate upper management handsomely in conjunction with stock price performance.

Both tests require empirical evidence in making assessments and comparisons. What evidence exists, and what is its accuracy and reliability?

Determining Reasonable Compensation

Numerous compensation databases and surveys, deriving from both public and private information, exist. Such information is often produced by a variety of sources such as for-profit companies, trade associations, and government agencies. Utilizing such information requires an understanding of the sources of data, its timeliness, and ultimately the applicability to the matter at hand. Such factors as the size of the company, the duties associated with a title, geographic location, and company industry may each, independently and collectively, impact the concept of reasonableness. For these reasons, it is oftentimes wise to review multiple databases and surveys.

In addition to compensation databases and surveys, compensation information from public companies should be utilized when applicable. To the extent the valuation of a company includes pricing information from comparable public companies, such companies could provide relevant compensation data.

However, in seeking external compensation data, one should not overlook viable indications of arm’s length transactions within the owner’s company. Such internal evidence can be provided both in form and substance.

The form of compensation refers to both the procedural structures in place and the context of the compensation. Robust procedural structures, such as the existence and consistent involvement of an independent “compensation committee” in determining compensation, may suggest reasonability of compensation. Likewise predetermined, formulaic forms of compensation (e.g., 10% of gross profit generated through originated sales) may also suggest reasonable compensation. Context, mostly in the consideration of return to shareholders as noted by the independent investor test, is equally important in determining form.

Substance refers to the actual amounts paid to employees. Such evidence may derive from comparisons between employees. For example, in reviewing the compensation paid to an owner who operates as the company’s Chief Financial Officer, a comparison to the compensation paid the company’s Controller may provide useful information. Such comparisons can often be performed with direct reports. Comparisons to other employees, regardless as to position, may also be informative. For example, if a company’s owner is the fifth-highest paid employee, and the four higher-paid employees are not owners, the contention that the owner’s compensation is reasonable will be bolstered. Reviewing compensation from past years, both for the owner and for other employees, may also prove insightful. Did the owner’s compensation increase concomitant with the increased performance of the company? Did the
owner’s compensation increase with the assumption of additional duties or responsibilities? Reviewing such historical trends may prove helpful.

Two caveats must be noted in assessing the reasonableness of compensation. First, and especially with positions held by owners, responsibilities may transcend traditional duties associated with a title. For example, the Chief Executive Officer may also perform significant sales duties. Owners “wearing multiple hats” may complicate compensation assessments.

Second, care must always be taken to consider non-traditional forms of compensation in determining reasonableness. For example, many private companies now offer stock options and other equity derivatives in compensating employees. Such instruments, even if they are perceived worthless (e.g., call options with strike prices above that of the current market price), may indeed possess substantial value and should be considered in reviewing total compensation. Perquisites, in the form of interest-free mortgages for housing or personal use of a company jet, may also be considered.

Conclusion

Despite the significant repercussions the reasonableness of compensation bears on issues such as business valuation, personal goodwill, maintenance, and compensation to the marital estate, the issue is often overlooked in marital dissolutions. However, this issue should be considered wherever and whenever controlling shareholders perform personal services for their companies. The prevalence and materiality of this issue was recently highlighted by the Seventh Circuit’s decision in Menard, Inc. v. Commissioner in which it reversed a Tax Court decision rejecting $13 million out of $20 million in compensation as unreasonable.9

1 For a discussion on the “compensation-for-contribution” method and its impact upon business valuation and property division, the article “Compensation-for-Contribution: An Alternative Method for Handling Personal Goodwill in Divorce Matters” by Justin L. Cherfoli, CPA/ABV, CFF and Brian R. Potter, CFA, CFE available at www.srr.com.

2 A discussion on personal goodwill and its relationship to the attributes of relationships, skill, knowledge, and reputation is contained in the article “What Creates Personal Goodwill?” by Christopher P. Casey, CPA, CFA, ASA and Brian R. Potter, CFA, CFE which is available at www.srr.com.

3 A trio of Illinois decisions have recently dealt with this issue. See In re Marriage of Joynt, 375 Ill. App. 3d 817 at 821 (2007), In re Marriage of Schmitt, 391 Ill.App.3d 1010 (2d Dist. 2009), and In re Marriage of Lundahl, IL App. 1st District, 5th Division, November 2009.

4 Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Circuit 1983). Mad Auto Wrecking, Inc. v. Commissioner, 69 T.C.M. (CCH) 2330, 2338, 1995 WL 149132 (1995). Also see Alpha Medical, Inc. v. Commissioner, 172 F.3d 942 (1999).

5 Alpha Medical, Inc. v. Commissioner 172 F.3d 942 (1999).

6 Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (1949).

7 Eberl’s Claim Service, Inc. v. Commissioner, 249 F.3d 994 (2001).

8 Exacto Spring Corporation v. Commissioner, 196 F. 3d 833 (7th Circuit 1999).

9 Menard, Inc. v. CIR, 560 F. 3d 620 - Court of Appeals, 7th Circuit 2009.