Income Approach (AKA Independent Investors Test)
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.
The income approach can only be correctly applied when the Fair Market Value (FMV) of the company is available for each year that compensation is examined.
The rationale behind the Independent Investor Test is that investors pay employees to work to increase the value of the assets entrusted to their management. A high rate of return indicates that the assets’ value increased and that the employee provided valuable services. Thus, if investors obtain returns above what they should reasonably expect, an employee’s salary is presumptively reasonable. The Income Approach generally works best when there is no comparability data available.