What’s “reasonable” is in the eye of the beholder
Determining replacement compensation

When entrenched in a divorce proceeding, the parties seldom agree about what’s fair or reasonable. One of the most frequently contested financial issues is “reasonable compensation.” Here is a brief guide on how to estimate reasonable (or replacement) compensation.

Why does reasonable compensation matter? - Divorce attorneys and their clients typically need to consider reasonable compensation if:

1. One spouse will be required to pay the other support payments - In marital dissolution cases, one spouse’s salary is frequently the basis for alimony and child support payments. For instance, family court judges often determine child support payments based on a statutorily determined percentage of the noncustodial parent’s salary and related income. Such predetermined rates work well for traditional employees — but things become blurrier when a spouse owns his or her own business.

2. Either spouse entirely or partially owns a private company - Private business ownership further complicates a divorce because the business interest may be an asset in the marital estate. To properly estimate the value of the spouse’s business interest, a valuation professional needs to look at the company’s cash flow, which includes the owner’s salary. Unless the valuator adjusts the company’s cash flow for reasonable owner’s compensation, its value could be inaccurate. For example, if an owner receives too much compensation, the company will likely be undervalued, unless the valuator properly adjusts its income stream.

So, what is reasonable? - The term “reasonable compensation” is rooted in tax law. Salary expense lowers the company’s taxable income, but dividends aren’t tax deductible. So some C corporation owners pay themselves exorbitant salaries — in lieu of dividends — to get cash out while simultaneously lowering the company’s tax bill.

To close this loophole, the IRS audits companies with high owners’ salaries and doles out penalties on any salary in excess of what the IRS deems reasonable. Of course, the IRS makes no adjustment for salaries below the reasonable amount.

Here is an important distinction to keep in mind: A taxpayer’s objective is to overstate salary to minimize corporate-level tax. But business owner spouses have the opposite agenda. Their goal is to understate compensation to lower alimony and child support payments. Therefore, the IRS’s method of determining reasonable compensation may not be effective in divorce cases.

To complicate matters further, when considering a private business owner’s compensation, “reasonableness” is in the eye of the beholder. Some private business owners underpay themselves and make up the difference by treating the corporate bank account as their personal piggy bank. Other business owners overpay themselves, because they have unrealistic opinions of their day-to-day contributions to their companies. And some unscrupulous spouses purposely underpay themselves in anticipation of an impending or ongoing divorce. But if asked in a court of law, all of these business owners are likely to adamantly contend that their compensation is reasonable.

So when broaching the subject of reasonable compensation, some attorneys use a synonymous term with a less subjective connotation. For instance, the term “replacement compensation” triggers fewer emotional responses and is more concise. But whether the valuator is determining “reasonable” or “replacement” compensation, the intent isn’t to argue over what’s morally reasonable or fair but to estimate what it would objectively cost to hire an employee to perform the owner’s day-to-day duties.

What factors come into play? - In estimating replacement compensation, a common approach is to start at a micro-level and work up from there. In other words, under this approach, the valuator would start with the individual owner, then move on to the company, the industry and, finally, the general economy. Here’s a look at each:

The individual owner - At the most basic level, the valuator should write up an accurate job description, keeping in mind that many existing job descriptions are inaccurate or outdated. He or she should also list the educational and work history prerequisites a replacement candidate should possess.

If the spouse has advanced education or other qualifications that are unrelated to his or her responsibilities (such as an architect with a law degree), the additional qualifications should not factor into the estimate of replacement compensation. (This point highlights the importance of substituting the term “replacement” for “reasonable.”)

The company - Next, the valuator considers the company’s characteristics. Healthy companies — those with high growth and profits — tend to pay employees more than financially distressed entities. Also consider the company’s size in terms of sales and market share. Although larger companies tend to pay more than their smaller counterparts, some smaller companies must pay a premium to persuade key employees to leave competitors (and to retain them once they leave).

The industry - No estimate of replacement compensation would be complete without an evaluation of the industry’s trends. A valuator needs to research the industry to understand how much competition exists and its typical methods of compensation, including base salaries, bonuses, commissions, benefits and stock options. If the industry is cyclical, he or she needs to find out whether it is currently at a peak, a trough, or somewhere in between. When evaluating the industry, it’s important to research external compensation studies and to interview recruiters.

The general economy - Finally, the valuator must consider the state of the economy. He or she starts with local economic conditions, such as the cost of living at the company’s location. A replacement would be paid less if the company were located in West Virginia than if it were located in Silicon Valley. The national economy is also important. For instance, people are generally paid less in a recession — when profits are down, cash is tight and jobs are hard to come by — than when the economy is booming.

What is fair? - As with most valuation issues, reasonable compensation is more complicated than it may first appear. To reach an equitable conclusion in any marital dissolution matter, you need to consult an expert and experienced valuation advisor. Please call with your questions regarding reasonable, or replacement, compensation. We would be glad to assist you.

Sidebar: The perils of “double-dipping”

As a word of caution when estimating support payments and the value of a business interest, a valuator must be careful not to “double-dip.” For instance, if a business owner’s dividends are included in his or her compensation and used to determine alimony, the nominated spouse’s alimony payments already include some of the business interest’s value.

But because an investor’s return contains two elements (dividends and capital appreciation), just considering dividends alone and ignoring the rest of the value of the shareholder’s interest when splitting up the marital estate may not be sufficient. The portion attributable to capital appreciation is effectively “trapped” in the company and can’t be realized until the company is sold or liquidated.

In addition, depending on the case’s jurisdiction, goodwill — an intangible asset beyond the scope of this brief article — may further complicate matters. The best way to avoid double dipping is to hire a valuation professional who understands the overlap between these conflicting concepts as well as relevant state law and legal precedent.