Reasonable owners’ compensation is a concept that often arises in federal tax inquiries, shareholder disputes, and divorce cases.
Minority shareholders or spouses of controlling shareholders may claim that the owner of the business they’re connected to is adversely affecting the value of that business by taking an overly-healthy salary, for example. Conversely, in a divorce proceeding, a nonowner-spouse may claim that the owner-spouse is purposely taking a salary that’s too meager in his or her attempt to minimize the base on which alimony and child support payments will be calculated.
Factors that Determine Reasonable Owners’ Compensation
What’s considered reasonable in shareholder disputes or divorces may vary based on state law or legal precedent. A reasonable compensation assessment generally starts by looking outside the company at external market conditions and geographic location. The analysis then examines internal factors such as the company’s size, financial performance, and compensation structure. Finally, the individual’s contributions to the company – including his or her responsibilities, skills, reputation and experience –are factored into the analysis, along with any personal guarantees from the owner.
An owner may sometimes warrant a salary that’s higher or lower than what non-owner employees receive for similar positions. One type of analysis conducted to determine whether or not a particular salary is justified is called the independent investor test. The independent investor test was employed in a U.S. Tax Court case which recently upheld a combined annual salary of more than $7.3 million for two owners of a large Arizona concrete contractor. Because the court ruled that the company’s investors still received a reasonable return on investment after the owners’ salaries were paid, the salaries were deemed to be warranted.
Consulting Compensation Resources
Another type of analysis hinges on comparable salaries paid in arm’s length compensation arrangements. Reliable compensation data for a particular industry or geographic market can be found in several public and private salary surveys which experts consult to make the appropriate salary determinations.
Additional industry- or location-specific data can be obtained from salary surveys that break down the data by industry, market, or size; industry trade associations and publications; and executive headhunters.
Outside Expertise is Essential
Deciding what’s reasonable for a business owner to receive as compensation can be subjective and sensitive. Because financial analysts are trained in how to make these determinations and which analyses to use and resources to consult, it’s essential that you locate and include such an expert if you’re under fire from the IRS or in the midst of a shareholder dispute or divorce case that’s calling reasonable owners’ compensation into question.
If you have questions about reasonable owners’ compensation, contact your Untracht Early advisor.