Valuing the Closely Held Business

In its decision in Mad Auto Wrecking Inc. v. Commissioner (T.C. Memo 1995-153, RIA T.C. Memo P.95153, 69 CCH TCM 2330), the court addressed several points that were considered and accepted in the determination of the level of compensation that should be afforded the two officers of Mad Auto Wrecking, an auto salvage business with gross revenues of approximately $2 million. The court stated that 'compensation must be both 1) reasonable; and 2) paid purely for services rendered to the corporation' in order for it to be deducted as 'an ordinary and necessary business expense' under Section 162(a)(1) of the Internal Revenue Code. The court identified and discussed 14 factors that may be considered including: 1) the employee's qualifications; 2) the nature, extent, and scope of the employee's work; 3) the size and complexities of the employer's business; 4) a comparison of salaries paid with the employer's gross and net income; 5) the general economic conditions; 6) a comparison of salaries with distributions to shareholders and retained earnings; 7) the prevailing rates of compensation for comparable positions in comparable companies; 8) the employer's salary policy as to all employees; 9) the amount of compensation paid to the particular employee in previous years; 10) the employer's past and present financial condition; 11) whether the employer and employee dealt at arm's length; 12) whether the employee guaranteed any of the employer's debt; 13) whether the employer offered a pension plan or profit-sharing plan to its employees; and 14) whether the employee was reimbursed by the employer for business expenses that the employee paid personally.

Haffner's Service Station v. Commissioner

Similarly, in Haffner's Service Station v. Commissioner, 326 F3d 1 (1^st Cir. 2003), the court, citing Mad Auto Wrecking, supra., identified the following 10 factors it considered in assessing the reasonableness of bonuses paid to two of its board members including the controlling shareholder/treasurer and her husband who was also the company's assistant treasurer and secretary: 1) the employee's qualifications; 2) the nature, extent, and scope of the employee's work; 3) the size and complexities of the employer's business; 4) a comparison of salaries paid with net and gross income; 5) the general economic conditions; 6) a comparison of salaries with distributions to shareholders and retained earnings; 7) the prevailing rates of compensation for comparable positions in comparable companies; 8) the employer's salary policy as to all employees; 9) the compensation paid in prior years; and 10) the absence of a pension plan/profit-sharing plan.

The Haffner's court also considered a then-more-recent Seventh Circuit Court of Appeals disagreement with the 'multifactor test' in favor of an assessment of whether an independent investor would have approved the amount of compensation paid to its employee. In addition, the Haffner's court also observed, and ultimately adopted, the Second and Ninth Circuits' Courts of Appeal requirement that 'the various factors of the traditional test be analyzed from the perspective of an independent investor.'

An Important Lesson

The Haffner's court decision provides an important lesson with regard to the sources and use of compensation data. After careful consideration of the testimony given by the witness that was called to testify on behalf of Haffner's and recognized by the court as an expert on reasonable compensation, the court ultimately rejected the reasonableness of the bonuses in question because the expert primarily relied on data received from a related and interested party, blindly relied on non-specific data compiled in an industry publication and compared Haffner's with four publicly traded companies that the court concluded were not actually comparable with Haffner's.

Accordingly, when it comes to using industry statistical data, it is imperative that the valuator exercise care and perform the necessary due diligence and avoid the blind use of those statistics that could be very misleading and produce a wrong result. Industry statistics are acceptable to use as a platform upon which to undertake a personalized analysis in arriving at the appropriate level of replacement compensation. The valuator must, however, read and understand the criteria under which the statistical sources are compiled and the foundational information contained in the study before a meaningful comparison can be made between the statistics and the subject individual.

Data Sources

Nonetheless, a number of empirical sources for salary surveys are available for use in assessing reasonable replacement compensation for valuation purposes. Not surprising, some sources are better than others, so the valuation expert must use his or her expertise and judgment to determine the relevance and reliability of data. Trade associations may provide a wealth of knowledge for salary data by position or job title within a specific industry. Examples include Altman Weil's annual Survey of Law Firm Economics and The Small Law Firm Economic Survey, which publishes compensation data for lawyers; Medical Group Management Association's (MGMA's) Physician Compensation and Production Survey, which publishes compensation data for medical specialties; and other similar surveys for specific job titles in other industries.

More generally, there are surveys that publish salary data by position or job title that may not be industry-specific, but that are still a reliable resource. Examples include the National Institute of Business Management's Annual Executive Compensation Survey Analysis and Gale Research's American Salaries and Wage Survey. A myriad of compensation databases are also available. Costs for these databases run the gamut, from those that can be accessed for free on-line to others that are available by subscription only for a cost of several thousands of dollars.

Data may also be available through business journals, employment agencies and executive recruitment firms. Another possible resource, depending on the size of the subject company being valued, is the salary disclosure information reported in documents filed with the Securities and Exchange Commission (SEC) on behalf of publicly traded companies.

It is, however, generally better to use salary surveys that report data by individual position or job title rather than as a percentage of revenues or other financial indicia, as some financial publications do. While this information may be useful for assessing financial trends in a given industry, it may not provide enough supporting details to determine such things as the product mix or geographic marketplace served by the businesses in the survey or the components of compensation that are included in the reported data.

Douglas v. Douglas

Replacement compensation can also be determined by an analysis
of the compensation practices employed by the subject company for their non-owner employees. Such was the case in Douglas v. Douglas, 722 NYS2d 87 (2001), in which this author's firm was retained as valuation experts. Here, the Appellate Division, Third Department, affirmed the methodology used to assess reasonable compensation, stating, 'Relying upon his previous experience in valuing the interests of partners in other large New York City law firms, [the valuation expert] ascertained the compensation level of senior associates in such firms engaged in the same area of practice as [Mr. Douglas] and adjusted upward to reflect the higher hourly billing rate attributed to him, [accurately reflected] reasonable compensation for a non-partner possessing [Mr. Douglas'] experience and skill levels.' The premise behind this analysis reasons that it is axiomatic that employees with no familial or business relationship with the owner, other than a pure employer-employee relationship, would expect to receive market-level compensation for the duties they perform. By comparing the duties, education and experience of non-owner employees with those of the owner, it is reasonable to assess a level of replacement compensation based on that data. In some cases, as it was in the Douglas matter, it may be necessary to apply a premium to account for duties, responsibilities, skills and experience differentials between the subject owner and the non-owner employee comparables.

Using a Specialist

There is yet another means by which to assess replacement compensation when all other avenues have been exhausted ' that is the retention of a third party compensation or vocational specialist. Even this approach has its drawbacks, however. The expense involved in hiring a specialist might exceed the benefit derived. In some instances, the specialist's fees have been known to surpass even the cost of an entire valuation engagement. Care must also be taken to ensure that the specialist has a reliable background and proven reputation if the opinion they express will be relied upon for one of the most significant adjustments for valuation.

The valuation expert should not take lightly the charge to determine replacement compensation in the valuation of any privately held entity. In a recent California decision regarding the dissolution of the marriage of Dr. Boris M. and Ms. Ann E. Ackerman (In re Marriage of Ackerman (2006), Cal.App.4^th, Superior Court of Orange County, No. 01D010971), the presiding judge dismissed the replacement compensation determinations of both parties' respective experts. In each instance, the expert relied on a distinctive industry statistical survey, each of which was generally accepted by valuation experts as an empirical study for purposes of assessing replacement compensation in the determination of goodwill for the valuation of a medical practice. Although one expert used broad national data and the other expert used region-based data, the court determined that neither was 'sufficiently fine-tuned' to the Newport Beach area in which the medical practice was located, or to Dr. Ackerman's 'peculiar talent, training and expertise.' In addition, neither party provided an opinion from a vocational specialist with local market familiarity. Ultimately, the court did utilize a methodology that was similar to that used by one of the experts, but the final assessment of replacement compensation was determined by the court's analysis and 'common sense view' rather than the statistical computations of either expert.

Conclusion

The assessment of replacement compensation should not be undertaken without careful consideration. The valuation expert must be able to demonstrate that the analysis has been conducted using the best available data, that it was properly researched for reliability, that the components of actual compensation and replacement compensation are similar in nature and that the resulting determination is not biased and does not advocate for any position.

Johanne M. Floser is a Certified Business Appraiser (CBA) and Manager with BST Valuation & Litigation Advisors, LLC, with offices in Albany, NY, and New York City. She has extensive experience in the valuation of privately held business enterprises, professional practices, professional licenses, advanced academic degrees and pension/retirement plans for use in matrimonial matters, litigation, buy/sell transactions, estate tax proceedings and other circumstances.

The assessment of replacement compensation generally includes a review of industry statistics and other pertinent factors, including the experience and judgment of the valuation expert. Before a level of replacement compensation can be determined, the valuator must consider numerous factors including, but not limited to, the types of duties that the owner performs in his/her position with the business, the owner's education and level of experience, and the number of hours the owner works in comparison to non-owner employees who perform similar duties and have a comparable educational and experience background as the owner. In addition, the size of the company, the complexity of its organizational structure and the geographical region of the country may impact the decision-making process relative to the level of replacement compensation to utilize.

In order for replacement compensation to have a true economic basis, it must be reasonable for the circumstances at hand. One of the most developed areas of the law involving replacement compensation issues evolved from tax court decisions that were argued for purposes of assessing the ordinary and necessary nature of the expense for executives and/or related parties. In addition, the tax courts have ruled, and have provided guidance, within the context of valuation for estate and gift tax purposes. As a result of the numerous tax court decisions that have been handed down on this subject area, it can be helpful to look to those court decisions for guidance in matrimonial cases.

Mad Auto Wrecking Inc. v. Commissioner

In its decision in Mad Auto Wrecking Inc. v. Commissioner (T.C. Memo 1995-153, RIA T.C. Memo P.95153, 69 CCH TCM 2330), the court addressed several points that were considered and accepted in the determination of the level of compensation that should be afforded the two officers of Mad Auto Wrecking, an auto salvage business with gross revenues of approximately $2 million. The court stated that 'compensation must be both 1) reasonable; and 2) paid purely for services rendered to the corporation' in order for it to be deducted as 'an ordinary and necessary business expense' under Section 162(a)(1) of the Internal Revenue Code. The court identified and discussed 14 factors that may be considered including: 1) the employee's qualifications; 2) the nature, extent, and scope of the employee's work; 3) the size and complexities of the employer's business; 4) a comparison of salaries paid with the employer's gross and net income; 5) the general economic conditions; 6) a comparison of salaries with distributions to shareholders and retained earnings; 7) the prevailing rates of compensation for comparable positions in comparable companies; 8) the employer's salary policy as to all employees; 9) the amount of compensation paid to the particular employee in previous years; 10) the employer's past and present financial condition; 11) whether the employer and employee dealt at arm's length; 12) whether the employee guaranteed any of the employer's debt; 13) whether the employer offered a pension plan or profit-sharing plan to its employees; and 14) whether the employee was reimbursed by the employer for business expenses that the employee paid personally.

Haffner's Service Station v. Commissioner

Similarly, in Haffner's Service Station v. Commissioner , 326 F3d 1 (1 st Cir. 2003), the court, citing Mad Auto Wrecking, supra. , identified the following 10 factors it considered in assessing the reasonableness of bonuses paid to two of its board members including the controlling shareholder/treasurer and her husband who was also the company's assistant treasurer and secretary: 1) the employee's qualifications; 2) the nature, extent, and scope of the employee's work; 3) the size and complexities of the employer's business; 4) a comparison of salaries paid with net and gross income; 5) the general economic conditions; 6) a comparison of salaries with distributions to shareholders and retained earnings; 7) the prevailing rates of compensation for comparable positions in comparable companies; 8) the employer's salary policy as to all employees; 9) the compensation paid in prior years; and 10) the absence of a pension plan/profit-sharing plan.

The Haffner's court also considered a then-more-recent Seventh Circuit Court of Appeals disagreement with the 'multifactor test' in favor of an assessment of whether an independent investor would have approved the amount of compensation paid to its employee. In addition, the Haffner's court also observed, and ultimately adopted, the Second and Ninth Circuits' Courts of Appeal requirement that 'the various factors of the traditional test be analyzed from the perspective of an independent investor.'

An Important Lesson

The Haffner's court decision provides an important lesson with regard to the sources and use of compensation data. After careful consideration of the testimony given by the witness that was called to testify on behalf of Haffner's and recognized by the court as an expert on reasonable compensation, the court ultimately rejected the reasonableness of the bonuses in question because the expert primarily relied on data received from a related and interested party, blindly relied on non-specific data compiled in an industry publication and compared Haffner's with four publicly traded companies that the court concluded were not actually comparable with Haffner's.

Accordingly, when it comes to using industry statistical data, it is imperative that the valuator exercise care and perform the necessary due diligence and avoid the blind use of those statistics that could be very misleading and produce a wrong result. Industry statistics are acceptable to use as a platform upon which to undertake a personalized analysis in arriving at the appropriate level of replacement compensation. The valuator must, however, read and understand the criteria under which the statistical sources are compiled and the foundational information contained in the study before a meaningful comparison can be made between the statistics and the subject individual.

Data Sources

Nonetheless, a number of empirical sources for salary surveys are available for use in assessing reasonable replacement compensation for valuation purposes. Not surprising, some sources are better than others, so the valuation expert must use his or her expertise and judgment to determine the relevance and reliability of data. Trade associations may provide a wealth of knowledge for salary data by position or job title within a specific industry. Examples include Altman Weil's annual Survey of Law Firm Economics and The Small Law Firm Economic Survey, which publishes compensation data for lawyers; Medical Group Management Association's (MGMA's) Physician Compensation and Production Survey, which publishes compensation data for medical specialties; and other similar surveys for specific job titles in other industries.

More generally, there are surveys that publish salary data by position or job title that may not be industry-specific, but that are still a reliable resource. Examples include the National Institute of Business Management's Annual Executive Compensation Survey Analysis and Gale Research's American Salaries and Wage Survey. A myriad of compensation databases are also available. Costs for these databases run the gamut, from those that can be accessed for free on-line to others that are available by subscription only for a cost of several thousands of dollars.

Data may also be available through business journals, employment agencies and executive recruitment firms. Another possible resource, depending on the size of the subject company being valued, is the salary disclosure information reported in documents filed with the Securities and Exchange Commission (SEC) on behalf of publicly traded companies.

It is, however, generally better to use salary surveys that report data by individual position or job title rather than as a percentage of revenues or other financial indicia, as some financial publications do. While this information may be useful for assessing financial trends in a given industry, it may not provide enough supporting details to determine such things as the product mix or geographic marketplace served by the businesses in the survey or the components of compensation that are included in the reported data.

Douglas v. Douglas

Replacement compensation can also be determined by an analysis
of the compensation practices employed by the subject company for their non-owner employees. Such was the case in Douglas v. Douglas , 722 NYS2d 87 (2001), in which this author's firm was retained as valuation experts. Here, the Appellate Division, Third Department, affirmed the methodology used to assess reasonable compensation, stating, 'Relying upon his previous experience in valuing the interests of partners in other large New York City law firms, [the valuation expert] ascertained the compensation level of senior associates in such firms engaged in the same area of practice as [Mr. Douglas] and adjusted upward to reflect the higher hourly billing rate attributed to him, [accurately reflected] reasonable compensation for a non-partner possessing [Mr. Douglas'] experience and skill levels.' The premise behind this analysis reasons that it is axiomatic that employees with no familial or business relationship with the owner, other than a pure employer-employee relationship, would expect to receive market-level compensation for the duties they perform. By comparing the duties, education and experience of non-owner employees with those of the owner, it is reasonable to assess a level of replacement compensation based on that data. In some cases, as it was in the Douglas matter, it may be necessary to apply a premium to account for duties, responsibilities, skills and experience differentials between the subject owner and the non-owner employee comparables.

Using a Specialist

There is yet another means by which to assess replacement compensation when all other avenues have been exhausted ' that is the retention of a third party compensation or vocational specialist. Even this approach has its drawbacks, however. The expense involved in hiring a specialist might exceed the benefit derived. In some instances, the specialist's fees have been known to surpass even the cost of an entire valuation engagement. Care must also be taken to ensure that the specialist has a reliable background and proven reputation if the opinion they express will be relied upon for one of the most significant adjustments for valuation.

The valuation expert should not take lightly the charge to determine replacement compensation in the valuation of any privately held entity. In a recent California decision regarding the dissolution of the marriage of Dr. Boris M. and Ms. Ann E. Ackerman (In re Marriage of Ackerman (2006), Cal.App.4^th, Superior Court of Orange County, No. 01D010971), the presiding judge dismissed the replacement compensation determinations of both parties' respective experts. In each instance, the expert relied on a distinctive industry statistical survey, each of which was generally accepted by valuation experts as an empirical study for purposes of assessing replacement compensation in the determination of goodwill for the valuation of a medical practice. Although one expert used broad national data and the other expert used region-based data, the court determined that neither was 'sufficiently fine-tuned' to the Newport Beach area in which the medical practice was located, or to Dr. Ackerman's 'peculiar talent, training and expertise.' In addition, neither party provided an opinion from a vocational specialist with local market familiarity. Ultimately, the court did utilize a methodology that was similar to that used by one of the experts, but the final assessment of replacement compensation was determined by the court's analysis and 'common sense view' rather than the statistical computations of either expert.

Conclusion

The assessment of replacement compensation should not be undertaken without careful consideration. The valuation expert must be able to demonstrate that the analysis has been conducted using the best available data, that it was properly researched for reliability, that the components of actual compensation and replacement compensation are similar in nature and that the resulting determination is not biased and does not advocate for any position.

Johanne M. Floser is a Certified Business Appraiser (CBA) and Manager with BST Valuation & Litigation Advisors, LLC, with offices in Albany, NY, and New York City. She has extensive experience in the valuation of privately held business enterprises, professional practices, professional licenses, advanced academic degrees and pension/retirement plans for use in matrimonial matters, litigation, buy/sell transactions, estate tax proceedings and other circumstances.