1. The owner’s qualifications and role in the corporation; 2. The corporation’s character and condition; 3. Compensation levels for comparable positions in similar companies; 4. The corporation’s salary policy; and 5. The independent investor standard.
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How to Steer Clear of (T)reasonable Compensation in a Business Valuation — Part 2* by Kevin R. Yeanoplos, CPA/ABV/CFF, ASA In determining the reasonableness of compensation, Tax Courts have considered the owner’s experience and education to be particularly important. The Courts have responded favorably in cases where the taxpayer presented strong evidence of formal education directly related to the business of the company and technical or managerial experience to the company. While there have been a number of relevant cases dealing with reasonable replacement compensation, many consider the definitive case to be Elliots, Inc. v. Commissioner.1 In the 1983 case, the Tax Court set forth a standard consisting of five criteria to determine the reasonableness of compensation for owners of closely held corporations: *Part one of this article was published in the Sept. 2016 issue of AZ CPA.
The fifth criterion was a judicially created analysis that determined how a hypothetical third-party purchaser of the corporation would compensate the executive position at issue. This independent investor standard has received a large amount of attention in other cases as a meaningful way to indirectly measure the propriety of owner/ employee compensation through an analysis of the returns provided at the enterprise investor level. The concept is that if an independent investor in the enterprise receives an arm’s length return on his or her investment, then the amounts paid to the owner/employee(s) must be reasonable in relation to the remaining returns available at the investor level. The Mad Auto Wrecking, Inc. v. Commissioner2 decision indicated that the following factors could be considered in determining reasonable compensation: • The employee’s qualifications; • The nature, extent, and scope of the employee’s work; • The size and complexities of the employer’s business; • Comparison of salaries paid with the employer’s gross and net income; • The prevailing general economic conditions; • A comparison of salaries with distributions to shareholders and retained earnings; • T h e p r e v a i l i n g r a t e s o f compensation for comparable positions in comparable concerns; • The salary policy of the employer as to all employees; • The amount of compensation
NOVEMBER 2016 AZ CPA
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