What is Reasonable Compensation?

Reasonable compensation is defined as “[T]he amount that would ordinarily be paid for like services by like organizations in like circumstances.”¹ When retained in an engagement that includes an individual who is a business owner of a private or closely held company, determining reasonable compensation is an intensive and sometimes complicated process, particularly if it is to assist in a marital dissolution. In a marital dissolution which includes the value of a business as a component of the marital estate, determining reasonable compensation can affect multiple aspects of the separation. These aspects include, but are not limited to, the amount of support for maintenance purposes and the division of the marital property or assets, including the value of the business or businesses in which the spouse holds an interest. For instance, alimony² could be inadvertently overpaid if it is based on an arbitrarily selected and inflated compensation paid to the business owner at his discretion, which would, in turn, undervalue the business by overstating operating expenses and lowering the business’s income. Therefore, when analyzing reasonable compensation, it is important to understand the actual reported compensation being paid and whether or not that is indicative of reasonable compensation. This concept has two tests per the Internal Revenue Service (“IRS”):³

1. The amount test, which focuses on the reasonableness of the total amount paid; and
2. The purpose test, which examines the services for which the compensation was paid.

When performing these tests, it is essential to consider the following factors:⁴

1. The owner or employee’s role in the company;
2. An external comparison of the owner or employee’s salary and those paid by similar companies for similar services;
3. Character and condition of the company;
4. Any conflict of interest between the employee and the corporation; and
5. Consistency in how company employees are paid.

Reasonable Compensation Issues

When it comes to family-operated or closely held businesses, issues of reasonable compensation arise because the business owner can allocate compensation payments in two ways:⁵

1. Compensation for services performed, which is a deductible business expense; and
2. Compensation for a return on their capital investment, such as dividends and distributions, which is not a deductible business expense.

As such, a business owner can manipulate the business’s income by deducting a stockholder’s compensation rather than classifying it as a dividend. This is a potential issue as compensation is a deductible business expense, while dividends are not — so deducting stockholder compensation permits the business owner to dictate the bottom line income of the closely-held business.

Consequently, reasonable compensation can be a competing force between the business’s value for asset distribution and alimony. Higher reasonable compensation may decrease the value of a business interest for asset distribution but may result in higher alimony payments – the opposite is also true.

Where to Find Guidance

Since reasonable compensation is difficult to quantify, a valuation professional should consider all guidelines, studies, and resources at their disposal to determine a reasonable level of compensation. Some of these resources include the Independent Investor Test promulgated by the IRS, Economic Research Institute (“ERI”)⁶ and Risk Management Association (“RMA”).⁷

The independent investor test “…considers the return on investment indicated by the increase in the value of a corporation’s stock along with dividends paid during the time period in question. It looks at the company’s performance throughout the year to determine if the compensation to key employees is reasonable.”⁸ However, in some cases, a rate of return is difficult to quantify, as presented in Guy Schoenecker, Inc. v. Commissioner.⁹ In this matter, Guy Schoenecker, the business owner, claimed his compensation deduction was reasonable based on his position and the services rendered to the company.¹⁰ The court disagreed with that notion after reviewing similar businesses — including competitors of the subject company — that paid lower levels of compensation.¹¹ The court determined that Guy Schoenecker earned excess compensation in comparison to that of his company’s competitors. Therefore, when considering the independent investor test, “…it is difficult to determine what an independent investor would expect from the risk of his funds in a business…however, it is reasonable to assume that an independent investor would be unwilling for an officer to realize compensation out of line with compensation paid by similar businesses, thus unnecessarily reducing the income produced by the business in which he had invested.”¹²

As outlined above, since the independent investor test is considered more of a guideline, resources such as ERI and RMA can help quantify reasonable compensation levels through their collection and presentation of private and public company data. ERI allows an individual to analyze various levels of compensation based on a person’s geographic location, position or title, size, and the industry in which they operate. Comparably, RMA provides similar services but does not allow the option to select a specific position or title.¹³ These resources assist in the determination of reasonable compensation as it allows for the roles and responsibilities of the business owner to be compared to other employees in similar positions, essentially computing the “amount that would ordinarily be paid for like services by like organizations in like circumstances.”¹⁴

Considering All the Facts

The determination of reasonable compensation may dictate the conclusion of various issues in a marital dissolution. Reasonable compensation is a competing force between the business’s value for asset distribution and alimony, as the selection of reasonable compensation can alter either. Therefore, when quantifying an owner’s compensation, all of their specific facts and circumstances, as well as the appropriate guidelines and resources, should be considered, reviewed, and understood before a fair selection is made.

Sources

1. Per Chapter I, Internal Revenue Service, Department of Treasury. Regulations. § 1.162-7(b)(3)
2. Per the Cornell Law School Legal Information Institute, alimony refers to the financial assistance and monetary support provided by one spouse to another after a marriage ends in divorce. Oftentimes, the receiving spouse must be unable to support themselves without the help of their ex-spouse.
3. Per the Reasonable Compensation Job Aid for Internal Revenue Service (IRS) Valuation Professionals (the Job Aid)Job Aid, page 9, section III: Developing Reasonable Compensation Issues.
4. Per the Job Aid, page 13, section III: Developing Reasonable Compensation Issues.
5. Per the Job Aid, page 4, section II: Identifying a Reasonable Compensation Issue.
6. Per Economic Research Institute, Inc., All Rights Reserved. www.erieri.com.
7. Per the 2023 The Risk Management Association. https:/ementor.rmahq.org.
8. Per the 2023 Economic Research Institute, Inc., website (erieri.com) glossary of commonly used compensation terms and formulas.
9. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner.
10. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Opinion section.
11. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Findings of Fact section.
12. T.C Memo. 1995-539, Guy Schoenecker, Inc. v. Commissioner, Opinion section.
13. Per the 2023 The Risk Management Association. https:/ementor.rmahq.org.
14. Per Chapter I, Internal Revenue Service, Department of Treasury. Regulations. § 1.162-7(b)(3)