There are three generally accepted methods for determining Reasonable Compensation for the owner of a closely-held business. It is important to match each method with the business’s size and the business owner’s job duties.
- The Cost approach, aka many hats, approach: Generally works best for small businesses where the owner wears multiple hats.
- The Market approach, aka the industry comparison approach: Generally works best for Closely-held SMB’s where the owner performs predominantly managerial tasks.
- The Income approach, aka the independent investors’ test: Generally works best for outliers.
This month we explore the Income approach for determining Reasonable Compensation for a closely-held business owner. The Income approach seeks to determine whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.
Frequently, the approaches for determining reasonable compensation for a business owner are compared to the approaches used to value real estate. The Income approach for appraising real estate is how a commercial real estate investor might value a property based on the properties ROI or CAP rate. The investor is interested in knowing how much money they will make as a return on their investment.
The Income approach (aka the Independent Investors Test) for determining Reasonable Compensation for closely held SMB’s is very similar. In order to determine the Reasonable Compensation using the Income approach, you need three pieces of information.
- Fair Market Value (FMV) of the business at the beginning of the year.
- Increase in FMV by the end of the year before owner compensation
- Target return of the Independent Investor
Plug these three values into an Income approach calculator to determine Reasonable Compensation using the Independent Investors test.
Of the three methods discussed the Income approach is the only method that does not rely on comparability data but instead draws a conclusion for what Reasonable Compensation should be based on the financial performance of the business. This approach generally works best for outliers.
Outliers are business owners whose achievements are so great that they deserve compensation above that of their peers (sometimes referred to as a superior/key employee), or perform a unique occupation, skill, or duty where no comparability data exists. In these cases, the Income approach would be an appropriate choice.
Now that we have an approach for different size SMB’s and owner profiles we will explore (in next month’s article) the three key areas in every accounting practice where Reasonable Compensation plays a fundamental role with your SMB clients: Planning, Compliance, and Normalization