Owners of closely held businesses are often surprised when business valuators add back a portion of owner compensation to reported earnings to adjust for "above-market" compensation. It’s important to understand that above-market compensation for valuation purposes is not the same thing as "excessive compensation" as defined by the IRS.

Owners of C corporations have an incentive to take income out of the business in the form of compensation (which is deductible by the company) rather than dividends. By doing so, they avoid a layer of tax at the corporate level. If the IRS considers compensation to be excessive, it may recharacterize a portion of it as a constructive dividend, which may have significant tax ramifications for the corporation.

In determining whether compensation is excessive, the IRS doesn’t focus on whether the owner’s salary is above the market rate. Rather, it decides whether compensation is so out of line with that paid to similar employees at other companies, that it can only be explained as a tax-avoidance device.A business valuator looks at compensation from a different perspective: that of a hypothetical willing buyer of the company.

A prospective buyer would separate the owner’s compensation into two components. One component is the amount the buyer would have to pay to hire someone to perform similar duties (i.e., the market rate). The second component is the excess over market, which is properly included in the buyer’s return on investment.

This analysis isn’t limited to owners of C corporations. There may be nontax reasons for paying above-market compensation, such as the owner’s personal preference or the company’s ability to pay. And it’s not necessarily limited to owners. A member of the owner’s family, for example, may receive an above-market salary. In valuing the company, a buyer would consider the possibility that these employees could be replaced at a lower cost.

In some cases, it may be necessary to adjust compensation upward. An owner may accept a below-market salary, for example, if the company is struggling financially.

Determining Market Compensation

To determine the appropriate adjustments, business valuators compare compensation paid by the subject company to that paid by other companies to employees with similar duties and skills. There are a number of sources for this data, including the Economic Research Institute’s Executive Compensation Assessor, an impressive database developed by culling through numerous 10K and 10Q documents and private industry databases. The database can be searched by SIC code, industry, market capitalization, or even geographical location.

The benchmarks derived from the Executive Compensation Assessor or other sources may be adjusted to reflect the subject employee’s years of service, knowledge of the market, management skills, and other factors, as well as the type of industry and the value of existing relationships.

In comparing compensation, it’s important to consider all sources of compensation, including salary, stock options, pension plans, bonus plans, fringe benefits, etc.

Purpose of Valuation

The impact of above-market compensation may depend on the purpose of the valuation. When valuing a minority interest, for example, the valuator probably wouldn’t adjust for above-market compensation because the buyer wouldn’t have the power to increase his or her return by eliminating excess compensation.

Similarly, while an adjustment for above-market compensation makes sense when the owner plans to sell the business and retire, it may not be appropriate if the owner plans to continue working indefinitely and the business is being valued in connection with an employee stock ownership plan.