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The Relationship Between Reasonable Compensation and Business Valuation

By Jack Salewski, CPA, CGMA & Paul S. Hamann

A common question in public practice is, “how much is my business worth?” This question comes up for a variety of reasons. It could be a business merger, sale of the business, divorce, death or even idle curiosity.

There are a lot of different factors that go into a business valuation. It is an oversimplification, but most businesses are valued as a multiplier of earnings before interest, taxes, depreciation, and amortization (EBITDA).

When more wages are taken out than what is reasonable, the value of the business will be understated. This will cause the company and the shareholders to pay more in payroll taxes than they should. If fewer wages are paid out than what is reasonable, then the company value will be overstated.

If the purpose of the valuation is for a sale, the financial statements could be recast or normalized for the sale. Unfortunately, if the purpose is for a merger, the recasting will send a message to the other party that it is acceptable to do things wrong or at best bend reality as the shareholders see fit.

If the valuation is due to death, there could be an estate tax generated by having the company overvalued. For example, if the compensation taken was $40,000 when reasonable compensation should have been $100,000, then $60,000 less was paid in compensation than should have been paid.  Assuming the cap rate on sale was 20% (or a factor of five), the value of the company would be overstated by $300,000 ($60,000 x 5). If the descendant had a taxable estate, there would be an additional estate tax of $105,000.

Let’s look at the opposite situation. $100,000 was taken in compensation when reasonable compensation would have been $40,000. In this case, the business valuation is understated by $300,000. Not only has the business been paying an extra $9,180 in payroll taxes, but whomever also inherits the business misses out on a step up in value to the current fair market value, thereby paying more in capital gain or reduced depreciation deductions when the business is subsequently sold or operated. This will be the fact in the majority of situations as most people do not have a taxable estate and most people pay more than they should for compensation due to their own egos.

The bottom line comes down to this, it is better to do the work up front to determine reasonable compensation while you can be proactive, then have the consequences taken out of your control.

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