The reasonableness of executive compensation is often an important issue for companies involved in a bankruptcy proceeding. This is particularly true for closely held companies where there is a controlling stockholder who is also involved in the management of the company. For purposes of this discussion, such an individual is referred to as an owner/manager. In such instances, the owner/manager often sets his or her own level of compensation, without any independent negotiation or review.

Closely held company owner/managers typically set their compensation levels so as to minimize the combined levels of corporate and individual taxes (both income taxes and employment-related withholding taxes). This is why the issue of reasonableness of owner/manager compensation is often an interest to the Internal Revenue Service (IRS). However, troubled companies typically do not generate high levels of taxable income, either before or during bankruptcy proceedings. Therefore, the IRS may not focus on such companies, even if they have unreasonable levels of owner/ manager compensation.

However, the issue of owner/manager compensation is often a concern to the various parties involved in a closely held company bankruptcy, including (1) the nonemployee shareholders who are interested in retaining whatever equity value possible, (2) the creditors (both secured and unsecured) that are interested in maintaining the debt-payment capacity of the company, (3) any administrative creditors that are interested in the company's current net cash balance and flows, (4) the bankruptcy court that is concerned with any dissipation of the estate's income and assets, and (5) any party that may rely on the company's reorganization plan.

For the typical closely held company (either an S corporation or a C corporation), the reasonableness of owner/manager compensation is of interest principally to the IRS. For the closely held S corporation, the IRS is typically concerned with whether owner/managers are paid an unreasonably low level of compensation. This is because unreasonably low levels of S corporation owner/manager compensation are not subject to FICA, Medicare, FUTA, SUTA and other compensation-related employment taxes. Instead of receiving reasonable levels of compensation, S corporation owner/managers often "pay" themselves by taking periodic S corporation income distributions. Since these income distributions do not qualify as wages, they are not subject to the above-mentioned employment taxes.

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The reasonableness of closely held company owner/manager compensation is often an important issue to parties to a bankruptcy proceeding.

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For the closely held C corporation, the IRS is typically concerned with whether owner/managers are paid an excessive amount of compensation. The IRS is concerned with this compensation issue because:

1. reasonable amounts of owner/ manager compensation payment are a tax-deductible expense of the C corporation, but
2. the excessive (or unreasonable) amounts of owner/manager compensation are often reclassified as non-deductible dividend payments.

For these reasons, the IRS has developed guidelines and analytical methods to assess the reasonableness of owner/manager compensation. In addition, since this issue is often litigated in the federal income tax arena, the federal courts have also developed factors that they regularly consider with regard to this issue. Valuation analysts and other financial advisors often rely on these taxation-related methods and factors for professional guidance to assess the reasonableness of owner/manager compensation within a bankruptcy context.

Reasonableness of Owner/Manager Compensation Factors

When deciding the reasonableness of owner/manager compensation in a closely held company taxation context, there are several factors that the IRS and the federal courts have routinely considered. A good question for the valuation analyst or forensic accountant to ask is this: If the company in bankruptcy protection was hiring a nonshareholder employee, how much compensation would it pay in an arm's-length employee negotiation? Eight factors that the IRS and the federal courts often consider regarding the reasonableness of owner/manager compensation are delineated in a landmark, 50-year old decision, Mayson Manufacturing Co., 178 F2d 115 (6th Circuit, 1949). The Mayson case is particularly significant to valuation analysts and forensic accountants because the reasonableness of owner/manager compensation factors delineated in this case are almost identical to the factors specified by the IRS in its audit manual (see Internal Revenue Manual §4.35.2.5.2.2 (3/1/02)).

The Mayson case outlined the following eight factors with regard to the reasonableness of owner/manager compensation: (1) the employee's particular qualifications for the job, (2) the nature, scope and extent of the work actually performed by the employee, (3) the size and complexity of the particular business enterprise, (4) the economic conditions and background of the industry involved, (5) the particular company's dividend history, (6) comparable salaries in the industry, (7) the compensation paid to the company's other employees and (8) the employee's prior-years' compensation (especially for years in which the subject employee was clearly undercompensated).

According to Henry Shotmeyer, TC Memo 1980-238, the analysis of reasonableness of owner/manager compensation is a cumulative test. This analysis should focus on all years in which the owner/manager rendered services to the subject corporation. According to Elliots Inc., 716 F2d 1241 (9th Cir. 1983), the eight Mayson factors should be individually researched and analyzed. The analyst should not give undue weight to any one of the eight Mayson factors.

The following court case involves the reasonableness of owner/manager compensation for federal income tax purposes. This case should be informative to valuation analysts and other financial advisors in that it details how the court applied the eight Mayson factors to a specific fact set.

Haffner's Service Stations Case¹

Haffner's Service Stations was a closely held C corporation with three officers: Haff (the president); his father (Emile) and his mother (Louise). During the years 1990-92, Emile and Louise were paid $2.3 million in owner/manager bonuses by Haffner's. Upon audit, the IRS claimed that these bonuses represented unreasonably high levels of owner/manager compensation. Therefore, the IRS concluded that these payments were not deductible to the C corporation.

At the trial court level, the tax court agreed with the IRS regarding the disguised dividend nature of the parents' compensation. The taxpayer corporation appealed the unfavorable tax court decision to the U.S. Court of Appeals for the First Circuit. In this 2003 appeals court decision, the First Circuit affirmed the tax court's ruling.

In deciding whether owner/manager compensation is unreasonable for tax purposes, federal courts often use either (1) a single-factor independent investor test or (2) a multifactor test. Using a single-factor independent investor test, the court asks whether an independent investor would be satisfied with the implied rate of return implicit on the hypothetical investor's investment in the subject company. This implied rate of return is calculated based on the company's taxable income—that is, a level of income after deducting the expense of the owner/manager compensation.

The appeals court used a multifactor reasonableness of compensation test in the Haffner's case. The First Circuit enumerated the following 10 factors that should be considered to determine the reasonableness of C corporation executive compensation:

1. the employee's qualifications: In the subject case, neither Emile nor Louise had extensive or unique skills.
2. the nature, extent and scope of the work: In the subject case, the court concluded that the parents' work was nonessential.
3. the size and complexity of the subject business: In the subject case, the court concluded that the Haffner's business was neither complex nor large.
4. comparison of owner/manager compensation paid with the company's gross income (vs. taxable income): In the subject case, the percentage of Haffner's gross income represented by the subject owner/manager compensation was very high.
5. the general economic conditions: In the subject case, there were no unusually adverse economic conditions to overcome during the 1990-93 period; therefore, the court concluded that Emile and Louise did not cause the company's financial success.
6. comparison of salaries paid (a) to shareholder profit/dividend distributions and (b) to total retained earnings: There were no dividends paid to the shareholders in the Haffner's case. In addition, the court did not determine if any nonemployee shareholders had received a reasonable rate of return on their investment in the Haffner's stock.
7. prevailing rates of compensation for comparable positions in comparable companies: There was no information presented to the court by either litigant to determine this factor in the Haffner's case.
8. salary policy for other (nonshareholder) employees: No other employee was paid a six-figure level of compensation at Haffner's.
9. whether the compensation paid to owner/managers in prior years was deficient: In the years at question, Emile and Louise needed money to finance a family lawsuit; the court concluded that they had not been undercompensated in any prior years (i.e., the 1990-92 payments did not represent "catch-up" compensation for prior years).
10. absence of a pension/profit-sharing plan: There was no documented pension or profit-sharing plan for any of the employees at Haffner's.

In the Haffner's decision, the appeals court added two additional factors to the eight classic Mayson factors: (1) comparison of owner/manager compensation to the company's gross income and (2) existence/absence of a profit-sharing or pension plan. Based on its individual assessment of each of these factors, the appeals court concluded that the Haffner parents received an unreasonable (and nondeductible) amount of owner/manager compensation.

Illustrative Example of Owner/ Manager Compensation Analysis

To assess the reasonableness of owner/manager compensation in a closely held company, parties to a bankruptcy proceeding often rely on a valuation analyst or other financial advisor to perform a reasonableness-of-compensation analysis. A typical reasonableness-of-owner/manager compensation study includes several component analyses, including:

1. a historical financial ratio analysis of owner/manager compensation to company sales, profit before interest and taxes, assets, etc.; this financial-ratio analysis is typically performed on both (a) an historical, trend-line basis and (b) a cross-sectional, comparative company/industry basis.
2. an industry salary survey analysis; such a survey analyzes the levels of actual owner/manager compensation paid to comparable executives within the subject industry.
3. a proxy statement analysis related to the levels of compensation paid to comparable executives of comparable public companies.
4. a fair rate of return to shareholders' analysis, assessing the reasonableness of the subject company actual rate of return on owners' equity compared to a market-derived required rate of return on owners' equity; this analysis may be calculated at various assumed levels of owner/manager compensation.

This Alpha Widget Corp. illustrative example summarizes the quantitative components of a reasonableness of owner/ manager compensation study. In a comprehensive reasonableness of compensation analysis, both the quantitative and the qualitative Mayson factors would be considered. This example—and the associated analyses—are deliberately simplified and are presented for illustrative purposes only. Alpha manufactures and distributes widgets and is a regular C corporation for federal income tax purposes. Harry Smith serves as both the president/ chief executive officer and the chief marketing officer of the corporation. Owning 80 percent of the outstanding stock, Smith is also the principal stockholder of Alpha.

Alpha assumed too much debt in its recent attempt to expand into the widget market. After experiencing difficulty meeting its debt obligations, Alpha filed for bankruptcy protection in 2004. For the 2004 year, Alpha generated revenue of $10 million, and the average assets of Alpha were $4 million. For the 2004 year, Alpha paid Smith $1 million in owner/manager compensation. While they want Smith to remain with the company and implement its reorganization plan, the company's secured creditors are concerned that Smith's compensation is excessive. A valuation analyst has already been retained to value Alpha. The creditors asked the valuation analyst to focus on the issue of Smith's compensation.

It is noteworthy that Alpha has two corporate officers: Harry Smith (who was paid $1 million in 2004) and Ben Jones, vice president, chief financial officer and secretary (who was paid $600,000 in 2004). Therefore, in 2004, Alpha total officer compensation was $1.6 million. Jones owns the remaining 20 percent of the outstanding Alpha stock. Since Smith is the principal Alpha stockholder, he sets Jones' salary. Based on all indications, Jones' salary is set based on arm's-length negotiations and is intended to represent a market level of compensation. Therefore, there is no concern regarding the reasonableness of Jones's compensation.

Exhibit 1 summarizes a simplified salary survey analysis. Such an analysis looks to published executive compensation survey data. Such data are typically presented by size of the company and by subject industry.

In this particular example, the valuation analyst relied on four executive salary surveys: (1) the Economic Research Institute (ERI) Executive Compensation Assessor as of July 1, 2004, (2) the Watson Wyatt Data IRS's 2004/2005 Top Management Compensation Calculator, (3) Compensation in Manufacturing, 24th Ed. (2004), by Abbott, Langer & Associates Inc. and (4) Widget Weekly 2004 Salary Survey, published by the American Widget Association.

Exhibit 1 presents a range of the maximum reasonable compensation levels for executives performing comparable duties to Smith at comparable companies. Based on the various published salary survey analyses summarized in Exhibit 1, the range of maximum reasonable owner/manager compensation for Smith is $850,000 to $1,292,000.

Exhibit 2 summarizes a simplified financial ratio analysis and presents the total reasonable compensation levels for all of the Alpha corporate officers (as a group). Exhibit 2 reports illustrative industry financial ratio data from two commonly referenced annual publications: (1) the Almanac of Business and Financial Ratios and (2) the Risk Management Association Annual Statement Studies.

The particular financial ratio analysis presented in Exhibit 2 considers the compensation levels for all company officers as a group. After subtracting the Ben Jones $600,000 compensation, the Exhibit 2 financial ratio analysis presents a residual range of the maximum reasonable compensation for Harry Smith. Based on the various financial ratio analyses summarized in Exhibit 2, the maximum reasonable range of owner/manager compensation for Smith is $1,270,000 to $2,450,000.

Exhibit 3 summarizes a simplified independent-investor test with regard to the reasonableness of Smith's owner/ manager compensation—a single-factor test that has been widely relied upon by federal courts in recent years.

The independent-investor test is based on a fair rate of return on capital (typically, equity capital) analysis. Exhibit 3 presents an estimated value for the Alpha total owners' equity at the end of 2004 and a hypothetical independent investor's required fair rate of return (current income yield component) on the total equity capital. Subtracting (1) the independent investor's required return on equity capital from (2) the company's pretax net income indicates (3) a reasonable level of compensation for the subject company total officer group.

After subtracting the Ben Jones $600,000 compensation, the Exhibit 3 independent-investor test analysis presents a residual range of the maximum reasonable owner/manager compensation for Harry Smith. Based on the independent-investor test summarized in Exhibit 3, the maximum reasonable owner/manager compensation for Smith is $1,040,000.

Exhibit 4 summarizes the conclusions from the three reasonableness of owner/ manager compensation analyses presented in this Alpha Widget Corp. illustrative example.

Based on the reasonableness-of-compensation analyses illustrated in Exhibits 1, 2 and 3 and summarized in 4, the Harry Smith $1 million compensation paid by Alpha in 2004 is reasonable. Of course, this illustrative example—and the corresponding analyses—are deliberately simplified. In addition, only the quantitative reasonableness-of-compensation analyses are illustrated in this example. In an actual reasonableness-of-compensation analysis, both qualitative and quantitative analyses would be considered. In addition, both the Alpha financial condition and results of operations would be analyzed in much greater detail.

Summary and Conclusion

The reasonableness of closely held company owner/manager compensation is often an important issue to parties to a bankruptcy proceeding. This discussion summarized the methods and factors that the IRS and the federal courts consider in assessing reasonableness of owner/manager compensation in income tax disputes. Valuation analysts and other financial advisors often rely on these tax-related factors for professional guidance in bankruptcy-related compensation analyses. This discussion also presented a simplified illustrative example of several common reasonableness of owner/manager compensation analyses.

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Footnotes

¹ Haffner's Service Stations Inc. v. Commissioner, 326 F.3d 1 (1st Cir. 2003). Return to article