Executive compensation can become an issue for private companies and their owners, especially if an owner is getting divorced.
Owning a business complicates the divorce process. When either spouse owns a private business interest, the divorce settlement is only as reasonable as the value of the business and the compensation of its owners.
That’s because one of the biggest expenses that businesses deduct on their tax returns and financial statements is owners’ compensation. Compensation and dividends also factor into maintenance payments. So, getting these numbers “right” is an important ingredient in an equitable distribution of a marital estate that includes a private business interest.
Reasons for Compensation Variances
The amount a spouse takes home from operating a private business may not accurately reflect his or her contribution to the business. Owners may under or over compensate themselves for a variety of reasons. For example, a startup or distressed business may not have enough cash available to pay the owner a full salary. In these situations, owners often have an unwritten understanding that they’ll take more pay when business improves.
Perhaps an owner is unaware of how much money he or she could make working in Corporate America, based on years of experience and breadth of responsibilities. Or a C corporation owner might take an above-market salary in lieu of dividends, because the latter is subject to two layers of tax. Some unscrupulous owners even underpay themselves in anticipation of an impending divorce to lower projected maintenance payments.
Whatever the reason, an owner’s actual compensation may not reflect what the company would pay an unrelated person to perform the same tasks. Always evaluate an owner’s compensation level when either spouse owns a business — because an equitable distribution of the marital estate hinges on it.
Many people presume that replacement compensation isn’t that big of a deal, because it will all “wash out” in the end. If below-market compensation lowers maintenance payments, won’t the value of the business be higher, thereby increasing the value of the marital estate? Not necessarily. Such generalizations can result in unfair settlements. To illustrate, consider the following scenarios:
Example 1: Below-market compensation. You’re a private business owner who recently filed for divorce. You’ve been underpaying yourself for the past three years, because your firm stalled during the recession. Your spouse stays at home with the kids and will receive child support and alimony based on a statutory percentage of your annual income. Maintenance payments will probably be set at a lower amount based on your recent below-market compensation. But, you rationalize that’s okay, because your marital estate includes the value of your business, which would have been lower if you took a salary commensurate with your contributions to the firm.
Example 2: Above-market compensation. Alternatively, suppose your spouse owns half of a family business with a sibling. You stopped working to raise the kids. Your spouse has temporarily taken a little extra salary to help pay for home improvements and medical costs for his or her parents. You signed a prenuptial agreement that excludes the family business from your marital estate. Unless it’s adjusted to market rates, your spouse’s above-market compensation will be used to determine your child support and alimony payments, which in your case, will extend until your youngest son graduates college.
Is either of these situations equitable? Maybe not and here’s why:
- Maintenance payments will be paid over several years, depending on the age of the children and the terms of the settlement agreement. But distribution of marital assets is a one-time event. So, you’re not comparing apples to oranges.
- States vary significantly when it comes to how much of a company’s value is included in a marital estate. In states that exclude all or part of goodwill from the marital estate (more than half of the states), the non-owner spouse may never get credit for the incremental value attributable to below-market compensation, unless you adjust compensation to market rates. In other words, it’s not a wash. It’s more complicated.
- Above or below market compensation also creates inequity if the spouses signed a prenuptial agreement or owned a business prior to the marriage, thereby limiting the amount of business value includable in the marital estate. Tax issues may also come into play.
Factors Worth Considering
To untangle this confusing situation, it’s usually easier to estimate replacement compensation and then adjust the value of the business accordingly. But how much should an owner receive for his or her contribution to the business?
Personal characteristics to consider when quantifying replacement compensation for an owner include:
- Daily responsibilities, including primary and ancillary job descriptions;
- Education level, training, licensing requirements and other qualifications;
- Years of experience and previous salary history;
- Age and health;
- Personal attributes, including strategic vision, energy, and mentoring abilities;
- Average hours worked each week; and
- Personal guarantees on company debt.
Company-specific factors that might affect an owner’s salary level include:
- Employee turnover rate;
- Prevailing compensation rates for other workers at the same or similar companies,
- Size and financial condition;
- Geographic location; and
- Industry trends and norms.
You also might consider using an approach similar to the IRS’s Independent Investor Standard to indirectly determine replacement compensation. This backdoor approach estimates how a hypothetical third-party buyer would compensate an employee if the business were sold. As long as the hypothetical investors would receive a reasonable return on their investments, the IRS presumes owners’ compensation is reasonable.
Sources of Replacement Compensation Data
Common sources of comparable data that are used to quantify replacement compensation for a spouse include:
- Executive Compensation Assessor & Survey (Economic Research Institute)
- Salary Guide (Robert Half);
- Annual Statement Studies (Risk Management Association);
- Statistics of Income: Corporation Income Tax Returns (IRS); and
- Executive Compensation report (Compdata Surveys).
Salary data also may be published by the Bureau of Labor Statistics, as well as trade associations and executive recruiters.
When comparing multiple sources of compensation data it’s imperative to understand the terminology and nuances of each source. For example, some sources just report owners’ salaries and bonuses. Others may include such items as payroll taxes, retirement benefits, quasi-business expenses and other perks.
Divorcing spouses may not see eye-to-eye on how to quantify replacement compensation. A financial professional can help provide an unbiased assessment that’s supported by objective empirical data.
Nebraska Case Proves Replacement Compensation Matters
Owners’ replacement compensation was the source of a major discrepancy between the conclusions of two valuation experts in one Nebraska divorce case.
In the case, the Nebraska Court of Appeals considered — among other issues — whether the district court erred in its valuation of a concierge medical practice and abused its discretion in awarding alimony. The appellate court sided with the wife on these claims.
Value of the Practice
The husband is a physician who owns two medical practices. One is Doctors for Senior Health (DSH), a concierge practice. Concierge doctors charge patients a membership fee in exchange for more access to a physician than is provided by standard practices.
At trial, the couple disagreed about the value of DSH to include in the marital estate. So each spouse hired a valuation expert.
Both experts used the capitalization of earnings method to value the husband’s interest in DSH — but their conclusions were very different. The primary reason for the discrepancy was the adjustment for the husband’s annual compensation, which was $60,552 in 2010.
The husband’s expert felt his annual replacement compensation from DSH should be $176,000, based on the amount the practice paid to an independent contractor for performing similar services. Using the capitalization of earnings method, the husband’s expert valued DSH at $104,000. Using the adjusted net asset method, the husband’s expert valued DSH’s tangible assets at $14,000.
He assigned the difference between these two value indicators ($90,000) to intangible assets. Then, he allocated 80 percent of the intangible value (or $72,000) to personal goodwill, which is specifically excluded from marital estates in Nebraska. Therefore, his expert asserted his interest in DSH was worth between $14,000 and $32,000, after adjusting for replacement compensation and personal goodwill.
The wife’s expert valued the husband’s interest in DSH at $380,000, after adjusting for replacement compensation. Her expert estimated the husband’s replacement compensation at just $100,000, arguing that DSH could not afford to pay the husband $176,000. Her expert also disagreed with the opposing expert’s treatment of goodwill. If the opposing expert’s analysis would have taken into account the $88,000 note payable from the husband — by adding it back to the adjusted net asset value of $14,000 — the professional goodwill issue that the husband’s expert used would have been largely eliminated.
The husband’s expert testified that if he used $100,000 for his replacement compensation, his conclusion would have increased by approximately $250,000, significantly narrowing the disparity between the experts’ conclusions.
The appellate court ruled that the district court didn’t err when it chose the value set forth by the wife’s expert. The decision underscores the importance of thorough, persuasive replacement compensation testimony at the trial court level. Appellate courts grant lower courts significant leeway in determining what’s reasonable.
An owner’s compensation also affects maintenance payments. The husband argued that the district court’s monthly alimony award of $3,500 for 114 months was unreasonable, because the wife received a substantial amount of liquid assets in the property settlement.
The appellate court opinion did indicate that the husband’s average yearly income from both medical practices for the three-year period prior to the divorce was approximately $450,000, according to the couple’s joint tax returns. Given the income level, the appellate court felt the district court didn’t abuse its discretion and upheld the alimony award. (Sharp v. Sharp, Neb. App. No. A-12-751, April 9, 2013)