An important aspect of virtually every control level valuation of a privately-held company is the determination of reasonable owner’s compensation. This is necessary in order to separate the income the owner receives by working the business from the income the owner receives through owning the business. In economist’s language, the concept of reasonable compensation separates the return on the owner’s labor from the return on the owner’s capital.
The starting point for determining reasonable compensation is to ask the owner how much he or she would have to pay to hire someone qualified to perform the duties of the business owner. This can then be validated by using either a multi-factor test or an independent investor standard.
The multi-factor test of reasonable compensation looks at what others are willing to pay for qualified people with similar skills, industry knowledge, experience, and making similar contributions to their company. This can be determined by researching compensation databases, government statistics, public filings and even job listings. From this one can get a reasonable estimate of the compensation needed to replace the owner’s labor in the business.
The independent investor standard presumes that compensation is reasonable as long as the business owners are receiving their expected rates of return on their investments in the business. It is often used when a business owner possesses unique skills and experience that make finding accurate market compensation data difficult. This approach starts with the income or cash flow of the business and subtracts an expected rate of return to the investment capital of the owner. Once the return to capital has been subtracted, the remaining income is considered reasonable compensation for the owner’s labor. This approach is often useful when the owner is a “rainmaker”, whose personal connections and sales ability are critical to the success of the business.
The concept of reasonable compensation has uses far beyond private company valuation, particularly when we look at the issue of tax policy. Most privately-held companies are S-Corporations, LLCs or partnerships where the income of the business passes directly to the owners, where it is taxed on their personal tax returns at their personal tax rates. So the owner of a privately-held company is getting taxed on two streams of income, the income from his labor and the return to his investment capital.
This gets interesting when we hear calls to “soak the rich”. This is usually put in terms of making the rich “pay their fair share” of taxes, which is fascinating given the Congressional Budget office data below shows that the top 10% of taxpayers paid 55.4% of Federal taxes and the top 1% paid 29.3% in 2006.
Now look carefully at the chart. The above mentioned percentages are of all Federal taxes, when you just look at the income tax the percentage rises to 72.8% for the top 10% and 39.1% for the top 1%. About half the population pays no income tax at all, or even receives money from the government!
So looking at the chart, one might think the rich are thoroughly soaked. Drenched. Downright waterlogged. Yet the advocates for higher taxation often define “rich” as anyone making more than $250,000 per year, so let’s see where that puts the rich in the population:
That would make about 20% of the population rich, but let’s be more precise and see that the top 10% earned an average of $366,400 in 2006. That is not a bad income number for a small business, especially one that is large enough to hire workers other than the owner’s immediate family. I would expect a lot of small to medium size business owners fit in this category.
In my work as a business valuation expert, I have seen several cases in which a reasonable compensation analysis yielded a figure of around $250,000 for the owner. So if the business owner made $366,400, then the remaining $116,400 of that would be the return to the owner’s capital investment. Applying the principle of “soak the rich”, the owner would be relatively lightly taxed on the first $250,000, with the remaining $166,400 taxed at “soak the rich” tax rates of over 50% when Medicare taxes and state income taxes are added to the Federal income tax. What results is a very high tax rate on the returns to investment capital.
This is an excellent policy result if you are a Marxist. The owner’s labor has been rewarded, but the returns to the owner’s capital are largely confiscated by the government for the benefit of the proletariat.
On the other hand, “soak the rich” sucks if you are a small business owner. Why risk your investment capital and work 12 hours days to expand your business if over half the profits are taken by your unlimited partner, Uncle Sam? Wouldn’t it be better to lay off a couple employees, scale back to an eight hour day, take some risk capital out of the business, enjoy some free time and make an easier $250,000? Even if you have Napoleonic dreams of building a vast business empire, expanding your business is a lot tougher when most of the returns on investment capital you planned to use to hire more employees or buy new equipment are taxed away by the government. The negative implications for economic growth and reducing unemployment are obvious. What a reasonable compensation analysis shows is that “soak the rich” really means “heavily tax the returns on the investment capital of small business owners”. This will result in less investment, slower growth and lower valuations for small businesses.
If the gap becomes large enough between high personal tax rates versus corporate and dividend tax rates, we might even see a flight from pass-through entities back to C corporations. The S-Corporation premium that valuation experts consider adding for certain types of valuations might disappear.
ADDITION: Here is an interesting article from the Tax Foundation that supports my analysis: