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What’s Reasonable in Reasonable Compensation?

Mueller Prost

April 27, 2020

Owner compensation is always of interest to valuation analysts. When assessing a company’s value, analysts look at labor costs as a factor in operating earnings. If the owner is paid an unreasonable salary — too high or too low — the analyst “normalizes” it to reflect the amount a non-owner would be paid to do the same job.

Analysts must determine “reasonable” compensation to reflect true personnel costs. But arriving at what’s reasonable is not as straightforward as it seems.

What’s the Job Worth?

Valuation professionals typically use several methods to determine what’s reasonable:

Job description and title: What skills are required to do the owner’s job? What are the owner’s tasks? How about education, experience, specialized knowledge, responsibilities, and time required to run the business? Answers to these questions give analysts a starting point in compensation assessment.

Compensation data: Analysts may use industry benchmarks and salary surveys, as well as specialized compensation databases, including some that incorporate cost-of-living figures for various locations.

Human resources studies: In cases where data isn’t available or relevant, the valuation analyst might hire an independent expert to conduct a compensation study to provide highly targeted research related to the company’s specific profiles and unique circumstances.

How Does QBI Figure In?

IRC Section 199A and the QBI have impacted the way some owners compensate themselves. The 2017 Tax Cuts and Jobs Act (TCJA) allowed a 20 percent QBI deduction under Section 199A for certain types of pass-through businesses. The code also dictated that, for S corps, QBI does not include “reasonable compensation paid to the taxpayer” for services rendered to the business.

Prior to the TCJA, S corp owners were motivated to report as little income as possible as W-2 wages. Now, with the TCJA, lower W-2 wages mean a lower QBI deduction. To take full advantage of the QBI, it makes sense to keep wages both high enough to maximize the QBI deduction and closer to market levels.

In fact, the TCJA has created a compensation “sweet spot” for S corp owners who want to take full advantage of their QBI deduction. Tax experts calculate this sweet spot at about 28 percent of overall business income taken in W-2 wages for the owner. (Consult your tax advisor regarding this compensation issue, especially if you operate more than one related pass-through entity.)

This increased focus on the QBI deduction may influence S corp owner compensation going forward—and may move compensation in a more reasonable direction overall for S corp owners.

Defensible in Court

In terms of the bigger valuation picture, remember that valuations are often performed in the context of litigation, so analysts must produce numbers based on reliable data and document their findings thoroughly. For this reason, it’s imperative to work with analysts experienced in reasonable compensation.

Our team can assist you. For more information on this issue, please contact Chris Volz, Partner and Director of Business Valuation and Litigation Services.

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