Reasonable Compensation

Compensation paid to shareholders who are also executives becomes an issue in valuation when deciding whether an executive is being reasonably paid for his services or instead is being paid because of his shareholding.  Compensation studies may be helpful as to the market for an executive’s services, but more complete analyses appear in tax court cases that determine whether an executive is being paid deductible compensation or non-deductible dividends.

The independent investor analysis asks how much a hypothetical, independent investor would be willing to compensate the employee for being an employee exclusive of any ownership prerogatives.  Application of this test requires consideration of the nature and quality of the executive’s services and effect of those services upon return on equity (ROE).

In Elliotts, Inc. v. Commissioner (716 F.2d 1241 (1983)), the Ninth Circuit of the U.S. Court of Appeals established an independent investor test for reasonable compensation.  Reasonable compensation deals with deductibility: if salary payments are reasonable compensation, they are deductible; if they are dividends, they are not deductible.  According to Internal Revenue Code, deductible compensation must be reasonable and payments must be for services (Treas. Reg. §1.162-7(a)).  In other words, the question is whether the executive is being paid due to the employment relationship or the shareholder relationship.

For Elliotts, five factors were used to assess the reasonableness of compensation, i.e. whether that compensation reflected the employment relationship or the shareholder relationship:

  • Executive’s role in the company (e.g. job functions and time expended)
  • External comparison (what do similar companies pay for those functions?)
  • Character and condition of the company (e.g. the size of the company, its sales, etc.)
  • Conflict of interest (is the employee the sole shareholder and unencumbered in setting his or her own compensation?)
  • Internal consistency (how are other employees paid, and is a formal structure applied consistently to the shareholder’s compensation; how does a longstanding, as opposed to ad hoc, contingent compensation formula affect the ROE an investor would have achieved after paying the shareholder/employee?)

In Owensby & Kritikos, Inc. v. Commissioner (819 F.2d 1315 (1987)), the Fifth Circuit agreed with Elliotts that ROE after compensation expense should satisfy an independent investor as one indicator of reasonable compensation.  Owensby put forth multiple other factors to be considered in aggregate:

  • Shareholders as employees (paying in proportion to shareholding indicates a dividend)
  • Employees, the employer and the economy (what role have employees played in company growth?)
  • Compensation as a percentage of gross and net income (the larger the proportion of net income paid as salary and bonus, the greater the likelihood of it being dividend in part)
  • Dividend practices and return on equity (if ROE after management compensation would satisfy an independent investor, this factor points to compensable services rather than dividends)
  • Employment under work agreements (longer term, fixed and definite agreements with true upside and downside indicate compensation for services as well as appropriate incentives for an arm’s-length manager)
  • Compensation of nonshareholder-employees (disproportion in total compensation to shareholders versus non-shareholders indicates dividends rather than compensable services)
  • Compensation practices of comparable companies (comparisons to other companies must include the non-shareholder employees and consider disproportions in compensation)

Two other cases involving multi-factor tests were Rapco, Inc. v. Commissioner (85 F.3d 950 (2nd Cir. 1996)) and Exacto Spring Corporation v. Commissioner (196 F.3d 833 (7th Cir. 1999)).  Likewise, Menard, Inc. v. Commissioner (No. 08-2125, 7th Cir. 3/10/2009) used a multi-factor approach, but in Menard the Seventh Circuit chose to focus on the precise nature of the shareholder/executive’s work and how the total compensation to that shareholder compared with executives at competitor firms as well as different challenges faced by the executives and the different responsibilities and performance of the executives.  The panel in Menard cited Owensby for the proposition that all employees, including shareholders, may receive proper incentive compensation.