September 01, 2011

Many business owners are motivated to deviate from an arm’s-length compensation level for owners in order to minimize taxes paid either at the corporate or individual level. For example, owners of businesses organized as C corporations may be incentivized to pay owners’ compensation above that of an arm’s-length amount in order to minimize taxes incurred at the corporate level. In contrast, owners of pass-through entities, such as S corporations, may be motivated to pay reduced compensation to owners and instead make distributions to owners in order to avoid payroll taxes.1 Given these strategies, the Internal Revenue Service (the “IRS”) requires that, to be recognized as a business expense based on §162(a)(1) of the Internal Revenue Code (the “Code”), compensation must be reasonable in amount and must be paid “for personal services actually rendered.” Moreover, shareholders of private businesses have the burden of proof when evaluating what is reasonable as it pertains to owners’ compensation. Treas. Reg. §1.162-7(b)(3) defines “reasonable” compensation as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances.” For any closely held business that has either significant reasonable or actual owners’ compensation relative to overall earnings, the adjustment to that of an arm’s-length transaction may have a profound impact on the concluded value.

Guidance from Case Law

Due to the influence of the Code on compensation, the IRS has a long history of dealing with reasonable compensation issues in Tax Court and on appeal. As such, Tax Court cases can provide guidance in reviewing the reasonableness of compensation for executives who are also owners.

An example of an IRS challenge to reasonable compensation is Menard, Inc. and John R. Menard, Jr. vs. Commissioner, which reached the Seventh Circuit Court of Appeals (the “Seventh Circuit”). In 1998, the tax year at issue, Menard, Inc. (commonly referred to as Menards), was the third largest retail home improvement chain in the U.S., behind only The Home Depot, Inc. (“Home Depot”) and Lowe’s Home Centers, Inc. (“Lowe’s”).

John R. Menard, Jr. founded the company in 1962 and served as the chief executive officer in 1998. He worked approximately 12 to 16 hours per day and six to seven days per week. He was involved in every aspect of the company’s management and took minimal vacations every year. During his tenure as CEO between 1991 and 1998, the company’s revenue increased from $788 million to $3.4 billion, as taxable income increased from $59 million to $315 million. In addition, in 1998 the company generated an 18.8% return on equity (higher than both Home Depot and Lowe’s during the same year). Mr. Menard, who owned all of the company’s voting shares and approximately 56% of the nonvoting shares, paid himself a modest base salary but participated in the company’s bonus program and profit sharing plan. The IRS challenged his compensation, arguing that his profit sharing compensation was more like a dividend than compensation, which allowed the company to deduct a greater amount of salary expense, while allegedly escaping the corporate-level tax.

The Tax Court considered whether the following factors were present with respect to the structure of the compensation plan for Mr. Menard in determining reasonable compensation:

  • Bonuses were paid in exact proportion to the officers’ shareholdings
  • Payments were made in lump sums rather than as the services were rendered
  • Formal dividend distributions were absent even as the company was expanding
  • Bonus systems were unstructured or lacked relation to services performed
  • The company consistently had negligible taxable corporate income
  • Bonus payments were made only to the officer-shareholders

Additionally, the IRS considered the compensation of executives at comparable home improvement retail companies, such as Home Depot and Lowe’s, as a basis for its argument. Effectively, the IRS employed a multi-factor test in determining reasonable compensation. That is, it utilized various qualitative factors in comparing the compensation of Mr. Menard vis-à-vis peers at comparable companies. The Tax Court agreed and opined that Mr. Menard’s compensation was largely a disguised distribution.

In its review of the Tax Court opinion, the Seventh Circuit commented that the following factors, often included in a
multi-factor test, were “semantic vapors,” and wholly subjective:

  • Type and extent of the services rendered
  • Scarcity of qualified employees
  • Qualifications of the employee
  • Employee’s contributions to the business venture
  • Peculiar characteristics of the employer’s business

In its review, the Seventh Circuit commented on the long hours Mr. Menard worked as well as the size, growth, and profitability of the company. Additionally, the Seventh Circuit commented that Mr. Menard’s bonus program, which entitled him to receive 5.0% of the company’s earnings before income taxes, was neither excessive nor a scheme to avoid paying certain taxes because:

1 | the company generated a return on equity in excess of its peers even after consideration of the bonus

2 | the bonus was conditional on the company generating income

3 I the bonus was paid as a percentage of income

Dividends are generally paid as a specific dollar amount, with the intention that the investor receives a more predictable cash flow. A bonus, like the one offered to Mr. Menard, was riskier in nature and was offered to a manager to align his incentive to that of the firm, even if the manager was also a shareholder. The Seventh Circuit additionally commented that for compensation purposes, the shareholder-employee should be treated like all other employees. As such, a shareholder-employee should be treated as two distinct individuals for tax purposes (i.e., an independent investor and an employee), especially as it relates to compensation structure. Effectively, the Seventh Circuit advocated an independent investor test in assessing the reasonableness of owners’ compensation.

An example of the independent investor test was previously applied in Exacto Spring Corporation v. Commissioner, which was summarized by the Seventh Circuit 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, seemingly exorbitant compensation may still be reasonable if management outperforms and delivers the high rate of return investors expect given the risk of the investment.

Although this case was not the first to embrace the independent investor test, the Seventh Circuit did break with precedent in viewing this test as distinct from the multi-factor test. In describing the distinctiveness of the new test, the Seventh Circuit 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 to management for its contribution. 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 test exists in practice by many public corporations that compensate upper management handsomely in conjunction with stock price performance. Both tests require empirical evidence in making assessments and comparisons.

Determining Reasonable Compensation

When valuation professionals need to assess owners’ compensation, case law suggests three separate analyses that may be considered.

1 Direct Test (Market Databases)

Compensation databases and surveys report the ranges of market compensation paid for numerous job titles based on industry, organization size, and geographic location. Accordingly, these surveys provide analysts with empirical data regarding the market wages of executives. To properly utilize this information, however, an analyst must have a detailed understanding of the sources of the data, its timeliness, and its applicability to the subject company.

A key issue in determining reasonable compensation is identifying the appropriate roles and responsibilities of the individual in question. Many of the highest paid employees of privately held companies have roles and responsibilities that cannot easily be condensed into a single job title, even if their given title may directly match one found in the database. In other words, while the subject individual in a reasonable compensation case may have the title of chief executive officer or president, a detailed understanding of his/her actual duties is necessary to ensure that the scope of his/her corporate responsibilities does not exceed (or fall short of) the assumed responsibilities ascribed to the corresponding title in the database. Oftentimes, valuation professionals may need to analyze the compensation data for several job titles in order to appropriately determine the market compensation level for the individual at hand. Given that many business owners wear numerous hats within their company (e.g., CEO, director of corporate development, lead salesperson, etc.), it is critical to match the value being provided by the owner to the value being provided by the employees referenced in the studies.

After gaining a thorough understanding of the subject individual’s roles and responsibilities and conducting a careful search for the associated titles in the compensation databases, a valuation professional may conclude on a reasonable range of compensation for the individual in question.

2 Market Ratio Test (Comparable Public Companies)

Valuation professionals may also consider using market ratios to determine reasonable compensation. Publicly traded companies are required to disclose the compensation of certain corporate officers. By analyzing total executive compensation (i.e., both cash-based and share-based) of comparable publicly traded companies, a valuation professional may develop a range of compensation (as a ratio of revenue and/or earnings) that the market deems reasonable for that particular industry.

Because macroeconomic trends and industry fluctuations can result in significant variability in compensation ratios, a detailed understanding of the market in general and the industry in particular is required to fully utilize this methodology. Additionally, the significance of this analysis can be limited by the comparability of the subject company to publicly traded companies and the amount and quality of information related to executive compensation disclosed by the selected companies. Nonetheless, the market ratio test can provide a valuation professional with a range of ratios with which to assess the reasonableness of owners’ compensation.

3 Shareholder Return Test (Management Value Creation)

A third method of assessing the reasonableness of an individual’s compensation is the application of the shareholder return test. As the Menards and Exacto Springs judgments show, the shareholder return generated by a company under an executive’s leadership must be considered when assessing the reasonableness of compensation. Comparing a subject company’s equity appreciation over the period of time in question to the appreciation of comparable publicly traded companies yields valuable insights into the relative performance of the company and the associated returns achieved by shareholders.

If a company’s earnings (after consideration of the actual executive compensation) generate shareholder returns that are at or above market levels, an independent investor may accept the owners’ compensation as reasonable. While this quantitative analysis should be supplemented with qualitative evidence that the excess returns are attributable to the individual in question, the shareholder return test can provide valuation professionals with evidence that the company is able to satisfy the independent investor test while sustaining the current level of executive compensation.

Conclusion

When used in conjunction with one another, the three tests discussed above allow valuation professionals to develop supportable estimates of reasonable compensation. The conclusions developed from the use of these methods will be based on empirical data, supported by public capital markets, and, most important, will meet the standards of reasonable compensation put forth by the Tax Court. Given the potential tax repercussions resulting from inaccurate assessments of owners’ compensation, the issue of reasonable compensation should be carefully considered by owners and their advisors.

 

Also contributing to this article:

Mark G. Haddad

 

1 The benefits of each respective scenario could be more or less lucrative given the ownership interest held by an executive and the differences between the ordinary income tax rate and dividend tax rate.