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socrateaser
socrateaser, Attorney
Category: Business Law
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Experience:  Retired (mostly)
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In an S-corp, the major shareholders total W-2 wages and compensation

Customer Question

In an S-corp, the major shareholders total W-2 wages and compensation is $90k. Comparables based on revenues ($5mil) # XXXXX employees, (110) and industry, (healthcare/call center) suggests a median salary of $230k for CEOs. Should the currnet CEO wages be subtracted and a fmv for that role added back? In the case of this company, the $140k difference would more than wipe out ALL net income in the past 4 years, and future projections for at least 3 years.
Submitted: 4 years ago.
Category: Business Law
Expert:  INFOLAWYER replied 4 years ago.
Are you asking from a practical perspective if this should be done? Please explain the context and purpose.
Customer: replied 4 years ago.

A formal external valuation has been completed for this firm for the pupose of a marrital dissolution. The valuation firm did NOT make an adjsutment for owner's salary, citing that good comparables were not available.

 

However, a reveiw of market salary data on-line suggests that some reasonable comparable may indeed be available by taking a different view of the market. Furthermore, the delta between the owners total comp package is between the 3rd and 8th percentile for CEO and business owner. We believe that, given the size of the difference, an adjustment and addback for even a portion of the difference between the fmv and the owner's comp may be material to determining a fvm for the firm.

 

Given the very low EBITA for this firm (less than $60k average over last 4 years), we are interested in the appropriateness and impact of such an adjustment.

 

Expert:  INFOLAWYER replied 4 years ago.
I am going to refer this question to a colleague with more experience on this issue. Please hang on.
Customer: replied 4 years ago.

Thank you. I will be away from the computer for about 15 mintues......

 

Expert:  INFOLAWYER replied 4 years ago.
Sounds good.
Customer: replied 4 years ago.

Hi, I'm not sure if I have missed a response during the course of the day. Please advise at your next opportunity.

 

Thank you.

Expert:  socrateaser replied 4 years ago.

If the goal is to reduce the value of the business so as to similarly reduce the nonowner spouse's equalizing interest in divorce, then this action will probably get the judge annoyed as hell, because it will appear that the entire scheme is intended to undue the tax-advantaged choices made during the course of the marriage.

 

In short, no matter how logical it all seems, it will backfire and the judge will ignore all the evidence in favor of the nonowner spouse.

 

Hope this helps.

 

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Customer: replied 4 years ago.

Interesting. The first goal is to merely establish the firm's fmv. To the extent the owner's compensation is relevant in a valuation, then the assumption is that this would indeed lower the firm's valuation and therefor, the settlement amount and dissolution.

 

Alternately, if the owner decided not to purchase the non owner spouse's interest in the business, and instead decided to sell the business to satisfy the dissolution, wouldn't you expect any sales price to be impacted by the owner's comp issues and similarly reduce the value?

 

If owner's compesation issues are relevant to valutions in general, then why would this not be true in divorce cases?

 

Which tax advantaged choices are you assuming?

 

Thanks

Expert:  socrateaser replied 4 years ago.

Alternately, if the owner decided not to purchase the non owner spouse's interest in the business, and instead decided to sell the business to satisfy the dissolution, wouldn't you expect any sales price to be impacted by the owner's comp issues and similarly reduce the value?

 

A: Personal service businesses are only as viable as the person who is providing the service. The sale value of the biz is probably negligible.

 

If owner's compesation issues are relevant to valutions in general, then why would this not be true in divorce cases?

 

A: The judge will believe that what was done during the divorce was done for a reason that benefited the parties during marriage, and that any change in valuation during divorce is being done to advantage the party asserting the change. The judge will go with the former, rather than the latter, because the evidence is more credible.

 

Which tax advantaged choices are you assuming?

 

Distributions do not incur payroll taxes, i.e., FICA, Medicare, Workers Comp, Unemployment Insurance. Those extras add up fast.

Customer: replied 4 years ago.

Thanks,

 

It may be worth clarifying that this question is not so much about changing an established value. Rather the current undertaking is to conduct a valuation for the purpose of marital dissolution. The firm's last valuation is more than 5 years old. The concern with the methodolgy of the current valuation process is that it has not taken into account onwer compensation. The question is whether it is reasonable to assert that it should be accounted for through an addback of a reasonable fmv for executive compensation.

 

Refering to the tax advantage of distributions. In this case, there have been no distributions paid to owners in more than 5 years, other than those minumum distributions to negate the shareholder's tax burden. So the very low owner comp is not made up for by other types of owner benefits such as distributions, nor is there much in the way of personal expenses paid for by the company, use of company vehicles, etc...none of which apply.

 

This is a situation where the owner has essentially received no additional benefits other than the $90,000 annual salary and employee benefits package of health care and paid time off.

 

Expert:  socrateaser replied 4 years ago.

If it's a sub-s corp, then any income not paid out as wages, is passed through to the owners as distributions, even if no actual distributon is made. Those retained earnings are more valuabe than the wages because they are not subjected to any payroll taxes. That is the tax advantage I'm describing.

 

You are asking an accounting question. I'm giving you a family law judge answer. You can make the accounting rationale any way you wish. But, the judge will wonder why there is a change in accounting now that the parties are divorcing?

 

You need to be able to explain why it's not a means of unfairly benefiting a party -- otherwise, the judge will ignore your math and leave the valuations where they are.

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