Various factors, such as annual earnings, growth rates, risk, assets, and liabilities, are considered when valuing a business. Owners' compensation is a key assumption; without it, you're not getting the true value of the business.
For example, let's say you're considering two different businesses, one with no earnings whatsoever and one with earnings of $300,000. Assuming comparable assets, liabilities, growth rates, and risk, the business with annual earnings of $300,000 looks like the smarter choice, right? But what about owners' compensation? If the owner with no earnings pays himself an annual salary of $500,000 while the other owner takes a modest salary of $70,000, the first business has the higher value.
However, owners' compensation is not always what it seems, making it important to dig deep to fully understand how, and how much, the they are compensated.
For example, when it comes to compensating themselves, business owners can generally pay themselves as they please. After all, they own the business. However, it's not as simple as looking at the owner's salary and factoring that figure into your business valuation.
Why? Depending on the legal structure of the business, owners may be paid a certain way in order to minimize taxes. For example:
Owners of C corporations may have higher than-expected salaries and bonuses in an attempt to minimize corporate taxes. This is because salaries and bonuses are tax deductible while dividends are not.
Owners of S corporations may have lower than-expected salaries with large "distributions" in an attempt to minimize payroll taxes. In this case, salaries are subject to employment taxes whereas distributions are not.
The net income of sole proprietors may appear lower than-expected due to business deductions that aren't necessary to run the business (such as a personal car purchase or golf outings).
Is it Reasonable?
When valuing a business, it's important to determine the reasonableness of owners' compensation. The IRS is aware of tax avoidance schemes and has a long history of challenging owners' compensation issues.
The strategies used in tax court can also be used to determine if owners' compensation is "reasonable."
Direct Test: A direct test compares owners' compensation to market databases which list the compensation ranges paid by title, industry, location, organization size, and other factors. Naturally, some analysis will be needed to conclude the appropriate compensation range because owners typically have many roles and responsibilities. For example, an owner may be simultaneously serving as the CEO, CFO, and sales account manager.
Market Ratio Test: Market ratios can also be used to gauge whether or not owners' compensation is reasonable. By examining the compensation, revenue, and/or earnings of comparable publicly traded companies, it's possible to calculate a compensation range for executives. The assumption here is that the market is comfortable with this range; thus, the compensation is considered reasonable by market standards.
Shareholder Return Test: Next, consider the company's shareholder return under the owner's leadership. Do the earnings generate above-market shareholder returns? Are these returns due to the owner's role in the company? If so, the compensation may be considered reasonable.
What about Family Members?
Moreover, in family-owned businesses, not only should you look at the owner's compensation, but the compensation of family members.
On one extreme, these individuals could have inflated salaries simply because the owner wants to spread the wealth. For instance, an owner might pay an adult child a salary of $150,000 for a basic bookkeeping position that would otherwise pay about $40,000. That extra compensation doesn't reflect the real world and artificially increases the business valuation.
On the other, family members, particularly spouses, often work in the business without pay. A new owner would likely need to pay someone to perform the equivalent work, so a replacement salary for an unpaid family member needs to be factored in.
When it comes to valuing a business, it's crucial to dig deep into owners' compensation so that you can determine an appropriate business valuation.
If it's a C corporation, consider the possibility that the owners might have inflated their salaries in order to limit corporate taxes.
If it's an S corporation, consider the possibility that the owners' salaries might be lower than expected to limit payroll taxes.
If it's a sole proprietorship, carefully examine business expenses to determine if they are necessary to running the business. If not, add their value back in.
Make sure to look at compensation levels for family members, too. Look for both unpaid and overpaid salaries.