Owner compensation is always of interest to valuation advisors. When assessing a company’s value, advisors look at labor costs as a factor in operating earnings. If the owner is paid an unreasonable salary — too high or too low — the advisor “normalizes” it to reflect the amount a non-owner would be paid to do the same job.
Advisors 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 advisors a starting point in compensation assessment.
Advisors 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 advisor 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% 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% of overall business income taken in W-2 wages for the owner. (Consult with us 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 advisors must produce numbers based on reliable data and document their findings thoroughly. For this reason, it’s imperative to work with advisors experienced in reasonable compensation.