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What It’s Worth
What is Reasonable
Compensation?
Authored by:
Kevin R. Yeanoplos, CPA/ABV ASA
Ronald L. Seigneur, MBA, CPA/ABV, CVA
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What is Reasonable Compensation?
Kevin R. Yeanoplos, CPA/ABV ASA
Ronald L. Seigneur, MBA, CPA/ABV, CVA
Often the most important variable in a business appraisal assignment is the
selection of what constitutes reasonable compensation for employee-owners. For
closely held businesses, in many instances, no single operating expense impacts
the bottom-line profit as much as officers’ compensation. Clearly, an expense
that is discretionary to the owner in terms of its magnitude, timing and method of
payment, may represent not only compensation for services rendered, but may
also be a disguised dividend or a distribution of profits. The amount of profits
determined to be “reasonable” for tax reporting purposes can easily be
manipulated by adjusting officers’ compensation.
This article is intended to provide fundamental guidance for practitioners
whenever employee-owner compensation is subject to review and adjustment1.
In most instances, this focus will relate to normalization adjustments made in the
context of the appraisal of a closely held business security, but the same
concepts and analytical framework can be of benefit in the assessment of
reasonable compensation for other purposes, such as the valuation of a non
compete agreement and in the segregation and measurement of
personal/professional versus enterprise goodwill2. Another emerging area where
these principles can be applied is in the evaluation of excess or inadequate
compensation challenges by the Internal Revenue Service with respect to closely
held C corporations or Subchapter S corporations, respectively.
Any approach that uses compensation in the derivation of enterprise earnings
should be scrutinized to ascertain that the compensation is reasonable.
Otherwise, the result can be to misrepresent enterprise profitability as
compensation.
Obviously, owners’ compensation should be evaluated closely for business
valuation purposes; because the overstatement of officers’ compensation can
lead to an understatement of the value of the business enterprise within the
application of several commonly used valuation methodologies
The ultimate opinion of value can turn on the ability to support compensation for
the controlling owner or professional practitioner. The expense that is deducted
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |1
should represent the compensation that would be paid to the practitioner in an
arm’s-length arrangement for the duties and services performed. The following
characteristics should be considered in addressing reasonable compensation:
1.
Experience of the owner/practitioner;
2.
Hours worked on a daily or periodic basis;
3.
Responsibilities of the position;
4.
Primary and ancillary duties performed;
5.
The age of the owner/practitioner;
6.
Nature of the business/professional practice;
7.
Geographic setting of the business/professional practice;
8.
Demographic characteristics of the area served by the
enterprise/professional practice; and
9.
Sustainable revenues of the practice.
Rev. Rul. 68-609 provides some guidance in the selection process:
The past earnings to which the formula is applied should fairly reflect
the probable future earnings. Ordinarily, the period should not be
less than five years, and abnormal years, whether above or below
the average, should be eliminated. If the business is a sole
proprietorship or partnership, there should be deducted from the
earnings of the business a reasonable amount for services
performed by the owner or partners engaged in the business.
Certainly, the selection of a reasonable compensation is crucial when valuing a
professional practice as well.
The term reasonable compensation is actually derived from Section 162(a) of the
Internal Revenue Code. Section 162(a) provides for a corporation to deduct as a
business expense “a reasonable allowance for salaries or other compensation for
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |2
personal services actually rendered. Although tax courts have frequently
addressed the reasonable compensation issue, divorce courts have not routinely
devoted as much attention. The importance of this issue should not be
understated. The valuation of a business or professional practice may be greatly
affected by the absence or existence of excess owners’ compensation.
The adjustment for reasonable compensation is critical. At the same time, it is
one of the most difficult adjustments to quantify. The goal is to set the salary to
an amount that is what someone would be paid to perform the same services
and duties as the current manager/owner does. To determine a fair salary, one
needs to determine what a hypothetical replacement employee would be paid to
perform the same services with the same skill level, education, and so forth.
The tax courts have identified many factors as being meaningful in the
determination of the level of reasonable compensation. In Pulsar Components,
Inc., v. Commissioner3, the Tax Court set forth an extensive list of the factors to
consider in a reasonable compensation analysis. The factors articulated in this
case are:
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 prevailing general economic conditions;
6.
A comparison of salaries with distributions to officers and retained
earnings;
7.
The prevailing rates of compensation for comparable positions in
comparable concerns;
8.
The salary policy of the employer as to all employees;
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |3
9.
The amount of compensation paid to the particular employee in
previous years;
10.
The employer’s financial condition;
11.
Whether the employer and employee deal at arm’s length;
12.
Whether the employee guaranteed the employer’s debt;
13.
Whether the employer offers pension or profit-sharing plans to its
employees; and,
14.
Whether the employee was reimbursed for expenses that the
employee paid personally.
Tax Courts have considered the owners’ experience and education to be
particularly important in determining the reasonableness of the compensation
paid. The courts have historically responded favorably in cases where the
taxpayer presented strong evidence of formal education directly related to the
business of the company and technical or managerial experience of value to the
company.
In Elliots, Inc. v. Commissioner4, the Tax Court set forth an oft-cited standard to
determine the reasonableness of compensation for owners of closely held
corporations:
1.
The owners’ qualifications and role in the corporation;
2.
The corporation’s character and condition;
3.
Compensation levels for comparable positions in similar companies;
4.
The corporation’s salary policy; and,
5.
The Independent Investor Standard.
The fifth criterion was a judicially created analysis that determined how a
hypothetical third-party purchaser of the corporation would compensate the
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |4
executive position at issue. This Independent Investor Standard has received a
large amount of attention in other cases as a meaningful way to indirectly
measure the propriety of owner-employee compensation through an analysis of
the returns provided at the enterprise investor level. The concept here is that if
an independent investor in the enterprise is considered to be receiving a
satisfactory arms length return on his or her investment, then the amounts being
paid to the owner-employee(s) must be reasonable in relation to the remaining
returns available at the investor level.
One divorce court addressed the first of the Elliot criteria in determining
reasonable compensation for the owner-spouse of a physical therapy practice.
In McCoy v. McCoy, the husband owned 55 percent of four physical therapy
offices. He and his partner each operated two locations. The trial court adopted
the wife’s expert’s testimony that the husband’s interest was worth $2 million. A
key component of the expert’s testimony was that the salary replacement cost of
the husband was $75,000. In actuality, however, the husband’s salary in the
relevant year was $420,000.
On appeal, the husband argued that the wife’s expert undervalued the
replacement cost of himself and his partner. Although a U.S. News and World
Report survey (the basis for the wife’s expert’s testimony) indicated that the
average self-employed physical therapist earned approximately $72,000 per
year, the court of appeals noted that the husband and his partner played a role in
the business of considerably more than just physical therapists. Rather, the two
partners were primarily managers of the business rather than practicing physical
therapists. Accordingly, the court found that “the managerial replacement cost
used in the “…..evaluation and accepted by the court was not supported by
competent or credible evidence.”
The McCoy decision highlights the importance of establishing similar job
qualifications and activities when evaluating reasonable compensation. Lawyers
and law firms are good examples. Although a law firm may have hundreds of
equity partners, some are the rainmakers and some spend countless hours as
litigators or focusing on other specific areas of law, while others spend the bulk of
their time running the day-to-day operations of the firm. It is simply poor
valuation technique for an expert to fail to consider the actual role played by the
employee in question. In many instances, it is a more complex assessment of
the multiple roles fulfilled by the owner/professional practitioner.
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |5
The Mad Auto Wrecking, Inc. v Commissioner5 decision indicated the factors that
can be considered in determinations of reasonable compensation, include:
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.
Comparison of salaries paid with the employer’s gross and net
income;
5.
The prevailing 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 concerns; the salary policy of the employer as to all
employees;
8.
The amount of compensation paid to the particular employee in
previous years;
9.
The employer’s financial condition;
10.
Whether the employer and employee dealt at arm’s length;
11.
Whether the employee guaranteed the employer’s debt;
12.
Whether the employer offered a pension plan or profit-sharing plan
to its employees; and
13.
Whether the employee was reimbursed by the employer for business
expenses that the employee paid personally.
The Court indicated that, in analyzing the above factors, there must be
convincing evidence that the purported compensation was paid for actual
services rendered by the employees/shareholders, as opposed to a distribution
of earnings to them that the payer could not deduct. On the other hand, it is
recognized that ambition, inventiveness and energy play a role in the success of
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |6
the enterprise and these attributes should be rewarded. In the specific instance
of this case, the Court recognized that the subject employee/Shareholder’s
contributions to the enterprise were “fundamental, substantial and allencompassing”.
In re Marriage of Ackerman6, the Court made its own determination of reasonable
compensation, considering factors including:
1. The situation of the business premises;
2. The amount of patronage;
3. The personality of the parties engaged in the business;
4. The length of time the business has been established; and
5. The habit of its customers in continuing to patronage the business.
The Court continued in its analysis to indicate it used a “commonsense view” by
considering the evidence of the actual business situation, talent, training,
expertise, and reputation.
While there are several other significant tax court cases that deal with reasonable
compensation determinations, two are particularly noteworthy examples of
instances where the Internal Revenue Service has lodged challenges. In Exacto
Spring7, seven factors were identified as relevant to determinations of reasonable
compensation:
1. Type and extent of the services provided by the business owner-employee;
2. Scarcity of qualified replacement employees;
3. Qualifications and prior earnings capacity of the employee;
4. Contributions of the employee to the business venture;
5. Net earnings of the employer;
6. Prevailing compensation paid to employees with comparable jobs; and
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |7
7. Peculiar characteristics of the employer’s business.
In a similar challenge to the notion of reasonable compensation by the Internal
Revenue Service, in LabelGraphics8, the following factors were considered:
1. Employee’s role in the Company;
2. Comparison of the business owner-employee’s compensation with those
paid by similar companies for similar services;
3. Character and condition of the Company;
4. Potential conflicts of interest; and
5. Evidence of an internal inconsistency in a Company’s treatment of
payments to employees.
It is interesting to note the emphasis in these two cases on an evaluation of the
Company itself and its ability to find replacement services for the subject
employee. This is particularly relevant to owner-employees that multi-task
providing an array of contributions to the enterprise, fulfilling a work schedule that
provides a wide range of expertise and service, often with excess hours of
service, as compared to traditional employees, if sufficiently examined. That
said, it is also difficult in many instances to distinguish the subtle areas where an
owner-employee often contributes to enterprise success, including mentoring
others, marketing and business development, management and leadership,
recruitment and training, discipline and performance evaluation, and strategic
vision, just to indentify a few areas.
An interesting extension of these arguments, similar to the findings in the Exacto
and Elliots cases, outlined above, is found in the Owensby 5th Circuit case9,
where the taxpayers argued that if the enterprise is providing a sufficient return to
satisfy an independent investor, after paying compensation to a
shareholder/employee, a substantial presumption should be created that the
compensation paid to shareholder/employee is reasonable.
In yet another landmark tax court case, the 2001 Pediatric Surgical Associates
(PSA)10 findings are instructive. In this matter, the Internal Revenue Service
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |8
determined that the compensation paid to the shareholder physicians was
unreasonably high because the IRS believed it exceeded the value of the
services being performed by the shareholder physicians. It is not unreasonable
to draw parallel conclusions from the PSA decision that many other professional
corporations, and non professional practices for that matter, may be subject to
the same concepts when determining appropriate compensation levels for
shareholder-employees. This case will be discussed in more detail a bit further
on in this article.
As noted above, under the Internal Revenue Code and related regulations,
compensation is generally deductible when it is deemed to be ordinary,
necessary paid or incurred during the year for personal services rendered, and
reasonable in amount. Professional practices, regardless of form of organization,
primarily do one thing. They provide services that are largely the result of the
personal services rendered by the professionals within the enterprise. It is logical
to conclude that the net earnings of the professional practice represent the
reasonable compensation to those professionals, after an allowance for other
ordinary, necessary and reasonable operating expenses.
This holds even for large compensation amounts as seen in Richard Ashare,
P.C. v. Commissioner (Ashare)11 where "a lawyer was the sole shareholder and
professional employee in a law firm that devoted itself to a single class action
and won a $12.6 million contingent fee from a 1989 settlement. The fee was
paid in 1989-92, and the P.C. paid out the fee as compensation, including $1.75
million in 1993, long after the lawyer ceased performing substantial services.
Still, the Tax Court acknowledged that all of the compensation was reasonable,
because the shareholder's personal services had earned the fee."12
The concept that the net earnings of a practice represent reasonable
compensation is further supported in Bianchi v. Commissioner Bianchi13. The
Tax Court "held that is proper to examine the prior self employment earnings of a
corporate employee to determine whether compensation currently paid to such
employee is reasonable”. In Bianchi, the corporate employee, a dentist, had
incorporated his individual proprietorship, transferring to the corporation (which
elected status as an S corporation) the equipment previously used in the
proprietorship, accounts receivable and goodwill. In determining what would be
reasonable compensation for his services provided to the corporation, the Tax
Court said:
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
Page |9
"It cannot be questioned that the clearest evidence of the worth of the petitioner's
services is petitioner's earnings from his dentistry practice as an individual
proprietor." ...It is clear that, in referring to "petitioner's earnings", [the Tax Court
was] referring to the profit earned by the dentist as an individual proprietor.
Indeed, [the Tax Court] restated [their] point as follows: "[T]he best evidence of
the value of his personal services is the profit he derived from his own practice."
...Undoubtedly, [the Tax Court was] using the term "profit" to refer to the excess
of the dentist's receipts from his practice of dentistry over the costs of earning
those receipts but without any reduction for the value of the dentist's own
services."14
Ashare and Bianchi establish yet another rational framework for reasonable
compensation in professional practices and provide strong support for the notion
that in most instances professional practitioners would have the same relative
amounts of compensation available to them after allowance for reasonable and
required overhead burdens, just as if the same practice was undertaken as a
sole proprietorship.
Similar to Bianchi, the value of each individual's
contributions to the practice can be viewed as a function of the excess of what
each individual is capable of producing over the cost of realizing that production.
The Pediatric Associates decision is a logical next step for evaluating reasonable
compensation on this basis.
The Pediatric Associates Case
The professional corporation in this instance provided pediatric surgical services
as its primary area of focus. PSA employed shareholder and non-shareholder
surgeons, operating as a Texas personal service corporation. The IRS
disallowed portions of the officer's compensation expense and reallocated it to
dividends, thereby creating a layer of double taxation. The IRS also applied the
accuracy-related penalty15 to the returns for all open tax years. The findings in
this case turned on the issue of profits generated by the non-shareholder
surgeon employees. The Tax Court analyzed the amount of profits generated by
the non-shareholder surgeons16. Collection records were inadequate to clearly
determine an appropriate allocation. The parties stipulated to one nonshareholder's collections and the Tax Court used a percentage of the net billings
for this stipulated allocation to determine the approximate net billings for the
other non-shareholder surgeons. Expenses for non-shareholder employees
consisted of salaries17 and an allocation of overall overhead burdens. The Tax
Court looked to the employment contracts to guide its reasoning as to what
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 10
expenses were or were not apportionable. Rent and other costs relating to the
operation of the practice were included. Shareholder automobile expenses were
excluded. The Tax Court then applied the parties' allocation methodology of
apportioning such expenses on an equal basis among the surgeon employees
based on the number of months they were employed during the year. The net
profits18 of the non-shareholder employees constituted the unreasonable
compensation. The Tax Court held "that the deductions claimed by petitioner for
1994 and 1995 for salaries paid to the shareholder surgeons exceeded
reasonable allowances for services actually rendered by them....and that such
amounts, therefore, are not deductible by petitioner..."19 The up side to this is
that the amounts the court determined were excessive was essentially limited to
the profits earned on the non-shareholders efforts on behalf of the corporation,
thereby leaving the profits of the shareholders in excess of their share of the
costs as reasonably paid compensation for their contributions to the enterprise.
In PSA, the Tax Court also affirmed the accuracy-related penalty, stating: "It is
the shareholder surgeons' utter indifference to the possibility that a portion of the
annual pre-bonus profits might have been derived from collections generated by
non-shareholder surgeons that justifies respondent's imposition of the accuracyrelated penalty in this case."20
Obviously, one of the key points to take away from the PSA findings is the
methodology used in this instance to substantiate unreasonably high
shareholder-employee salaries, in the instance of a professional service
corporation subject to the onerous corporate level 35% federal income tax rates
in enterprise taxable income. Given recent attention to closely held Subchapter
S corporations and the potential for unreasonably low shareholder-employee
wages, as a strategy to avoid employment taxes, it is critical to keep all of this
discussion in perspective with respect to the motivations of the shareholderemployees.
Determinations of adjustments to normalize for reasonable compensation have
traditionally been one of the key elements of difference between business
valuation analysts. It is also becoming a key area of focus for these tax related
purposes, yielding opportunities for practitioners to add value in these areas of
planning and dispute resolution.
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 11
Determining Reasonable Compensation
Given the wide range of considerations and factors noted above, it should not be
a surprise that there is no consensus among valuation analysts concerning the
appropriate measure of “comparable earnings” for the purpose of applying
various appraisal models/methodologies, including the as utilized within an
Excess Earnings Methodology (EEM). Alternative measures of reasonable
compensation are virtually endless and produce dramatically different results in
the ultimate computation of value.
In selecting the reasonable compensation, there are many different options. For
instance, in valuing a medical practice using an EEM methodology, a valuation
analyst can compare the subject professional to:
1.
an employee physician in a large group practice;
2.
an employee physician in a corporate practice;
3.
the median physician in the United States;
1.
the median physician in a particular region of the United States;
2.
the median physician in United States metropolitan areas of certain
populations;
3.
the median physician of similar age or years in practice;
4.
the median solo practitioner;
8.
the median physician in the same specialty or subspecialty
(including any permutations or combinations of the foregoing
categories);
9.
the “mean” physician in any of the foregoing categories; or,
10.
some particular combination of the foregoing categories (if such data
is available).
The obvious easy answer is, it depends. Is depends on the exact facts and
circumstances of the engagement, it depends on the jurisdiction, it depends on
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 12
many variables. Perhaps the most important consideration in the selection of
reasonable replacement compensation is comparability. These same points are
relevant regardless of the profession or industry being examined.
It is important to remember that “comparability” doesn’t necessarily mean a
“perfect match” is required. In many cases, it may be impractical or impossible to
find a perfect match for replacement compensation. At the same time, analyzing
the underlying characteristics of the subject practitioner allows the valuation
analyst to select replacement compensation that is both reasonable and
defensible.
The valuation analyst should select a replacement compensation that is deemed
most comparable in terms of:
4
type of professional service(s) offered (some foster more
repeat business than do others; some specialties foster more
referrals than do others);
4
type of specialty, if any;
4
practice location;
4
age and health of the professional;
4
nature and duration of the professional’s practice, either as a
sole proprietorship or as a member of a partnership or
professional corporation;
4
how fees are billed, i.e., insurance, government programs,
patient/client pay, etc.;
4
specific practitioner’s hours worked and production;
4
other management and administrative responsibilities of the
practitioner;
4
economic and demographic conditions in the practice’s market
area; and,
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 13
4
number of locations the practice utilizes.
For most professionals there are several available sources for replacement
compensation, including but not limited to:
h
Bernan – Distributor of U.S. Government Publications, Statistics of
Income: Corporation Income Tax Returns, 4611-F Assembly Drive,
Lanham, MD 20706-4391, (800) 274-4447
h
Financial Research Associates, Financial Studies of Small
Businesses, Financial Research Associates, 510 Avenue J S.E.,
Winter Haven, FL 33880 (941) 299-3969
h
National Institute of Business Management, Executive
Compensation, National Institute of Business Management, 1101
King Street, Alexandria, VA 22314, (800) 248-6426
h
Panel Publishers, Officer Compensation Report, Panel Publishers, a
division of Aspen Publishers, Inc., 7201 McKinney Circle, Frederick,
MD 21701, (800) 901-9074
h
Robert Half International, Salary Guide, Robert Half International,
P.O. Box 883128, San Francisco, CA 94188, (415) 854-9700
In addition, sources of compensation data for physicians and attorneys for the
appraisal of professional practices include, among others:
h
Medical Group Management Association, Physician Compensation
and Production Survey, Medical Group Management Association,
104 Terrace East, Englewood, CO 80112-5306, (303) 643-4439
h
American Medical Group Association, Medical Group Compensation
and Financial Survey, Alexandria, VA, 702-838-0033,
www.amga.org.
•
Altman Weil Publications, Survey of Law Firm Economics and
related publications, Altman Weil Publications, Two Campus
Boulevard, Suite 200, Newton Square, PA 19073, (888) 782-7297
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 14
Trade organizations to which the subject closely held company belongs are often
another good source of salary information related to specific industries.
Frequently, trade associations compile financial performance data (including
compensation information) for various companies in an industry.
While it may require more research and resourcefulness in order to locate it, the
most comparable replacement compensation for use in establishing a benchmark
for reasonable compensation may be that of an associate (i.e., a non-owner
professional) working in the same city, with similar experience and training.
Valuation analysts can often use personal and business contacts in order to
determine such numbers.
One note of caution – any of these sources may define “income” or “earnings”
differently from another. In addition, the characteristics of the underlying
professional sample often vary significantly, even within the same profession or
industry. It is vital, therefore, to take steps to insure “apples to apples”. We will
illustrate the importance of considering this later in this article.
Even if the valuation analyst is able to identify a reasonable replacement
compensation, there may be need for additional adjustments to the
compensation, particularly with professional practitioners. The potential for a
productivity adjustment to the reasonable compensation figure is particularly
important to consider.
In some cases, this can be addressed by scaling up or back the actual
compensation of the subject professional by a work hour factor to compare the
actual compensation to the norm (assuming there is a reported work hour figure
for the mean, median, or other measure of compensation determined to be fair
compensation for normal work hours). Alternatively, the valuation analyst can
scale up or down the comparable compensation for comparison to actual
compensation earned for a specific number of work hours.
At the same time, mean or median compensation survey data does not
necessarily represent the mean or median compensation of professionals
working mean or median hours. Professionals working various numbers of hours
are included in the median income numbers. This is true even when the studies
are stratified based on some broad range of hours worked. A valuation analyst
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 15
may thus be mixing apples and oranges by computing a productivity adjustment
by applying work hour adjustments to mean or median compensation figures.
The reasonable compensation number is generally a median net profit before
taxes number, which incorporates all expenses of the practice. Those expenses
include all of the fixed costs of the practice. Proportionally increasing the
replacement compensation to reflect additional work hours presumes that the
harder working physician will have directly proportionate expenses attributable to
working longer hours.
However, that is not the case. The marginal cost of working longer hours should
be less than the average hourly cost attributable to working the median number
of work hours, because the fixed costs do not change. This essentially
overstates the practice costs and can thereby significantly overstate goodwill
attributable to any physician who works more than the average.
To be conceptually correct, the valuation analyst should calculate the marginal
cost of working additional hours. The valuation analyst should determine
additional labor costs, additional cost associated with keeping the office open,
additional expenses for office supplies, additional transcription expense and
similar items.
Generally, for a professional practice, total earnings are defined as all earnings
available to the practitioner and are computed as follows:
h
The net income of the practice, including salary and benefits to the
practitioner;
h
Plus nonrecurring expenses less nonrecurring income; and,
h
Plus excess expenses (expenses not related to the generation of
practice income).
If the earnings survey used is of self-employed practitioners, step 3 shown in the
excess earnings method earlier is generally not calculated (computing a return
on tangible assets). The reason is that the earnings surveys of self-employed
practitioners already include income that represents the return realized on the
tangible assets of the practice. If such a survey is used and the subject
practice’s income level is reduced to reflect a return on net tangible asset value,
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 16
in effect a double reduction in income has occurred because the survey’s
reported income also includes a return on net tangible asset values. Of course, if
the earnings survey is of non-owner-employed practitioners, step 3 is an
appropriate calculation, as the employed non-owner practitioner has no
investment in the tangible assets.
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 17
Case Study21
In order to illustrate the importance of the selection of reasonable replacement
compensation using an excess earnings calculation, we present the following
example. The assumptions and variables within this case are provided for
illustrative purposes only, and may differ significantly from variables used in an
actual valuation.
Dr. Seth Isaak is a pediatrician practicing in a group, Camino Lauren Pediatrics,
PLLC (“CLP”), with three partners in an Arizona city of 900,000 people. Dr.
Isaak’s wife of twenty years filed for divorce on December 31, 2007, and the
practice will be valued as of that date. Ms. Aubrey Sabino, the principal valuation
analyst, has determined that CLP’s normalized practice net earnings before
physician compensation is $650,000. CLP’s balance sheet indicates that it has
$300,000 of tangible assets (accrual basis). The four partners own CLP equally.
Dr. Isaak is 58 years old, self-employed and nets $180,000 annually, including
his earnings or losses from the partnership. He has been practicing for 17 years.
Compensation is primarily based on production. The other physicians are similar
in all respects. He works 50 weeks per year on average, which is comparable to
other physicians within his specialty. CLP derives 80% of its practice revenue
from private pay patients and the remaining 20% from managed care. CLP
provides general pediatric care.
A capitalization rate of 25% has been selected as appropriate for the risk
inherent in CLP. An analysis of several different compensation studies yields the
following:
2007 (Based on 2006 data) MGMA Physician Compensation and Production
Survey (all are medians)
Classification
All pediatricians
Single specialty
Single specialty – western
46 weeks or more
40 or more Clinical Hours
In practice 8-17 years
Physician
Compensation22
$161,331
$168,138
$161,175
$161,458
$165,453
$170,020
Retirement Benefits
$12,651
$ 9,884
N/A
N/A
N/A
N/A
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 18
100% productivity compen.
$175,872
N/A
Generally, the valuation analyst should select a median measure, rather than a
mean23. The mean measure is more subject to the impact from a particular
anomaly within the sample.
While the valuation analyst could make a case for any of these measures, the
“single specialty practice – western region” median appears to be the most
comparable.
In addition, the median reasonable compensation for all
classifications seems materially similar. The excess earnings calculation based
on this replacement compensation follows.
Figure 1
Camino Lauren Pediatrics, PLLC – Excess Earnings Calculation
Normalized practice net earnings
before physician compensation
$
Reasonable earnings for 4 pediatricians –
Single specialty – western region
Retirement (based on single specialty)
644,000
40,000
Excess earnings
Intangibles capitalization rate
750,000
66,000
÷
25.0%
Indicated value of intangible assets
264,000
Appraised value – net tangible assets
300,000
Total operating value (rounded to thousands)
$
564,000
Value of Dr. Isaak’s 25% Interest in CLP
$
141,000
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 19
1
Readers are cautioned that the relevant factors in any particular compensation determination matter are
fact and circumstance specific. The content of this article do not necessarily represent the views and
opinions of the authors that would apply in any specific instance and are provided for example and
educational purposes only.
2
See Identifying and Measuring Personal Goodwill in a Professional Practice, by Mark O. Dietrich,
CPA/ABV, AICPA CPAExpert, Spring 2005
3
T.C. Memo 1996-129
4
Elliots, Inc. v Commissioner, 716 F, 2d, 1241, 1983, U.S. App.
5
Mad Auto Wrecking, Inc. v. Commissioner, TC Memo, 1995-153, 69 TCM 2330, April 5, 1995.
6
In re Marriage of Ackerman (2006), Cal.App. 4th, December 27, 2006.
7
Exacto Spring Corp. v CIR, 196 F.3d 833 (7 Circuit, 1999)
8
LabelGraphics, Inc. v. CIR, 221 F.3d 1091 (9th Circuit, 2000)
9
Owensby & Kritikos, Inc. 819 F.2d 1315, 60 AFTR2d 87-5224 (CA-5, 1987)
th
10
11
Pediatric Surgical Associates P.C. v. Commissioner, T.C. Memorandum 2001-81
T.C. Memorandum 1999-282.
12
Page 13-11, Tax Planning for Corporations and Shareholders, Second Edition, Zolman Cavitch, LEXIS.
13
Bianchi v. Commissioner, T.C. 324 (1976) 522 F.2d, 83 (2nd Circuit, 1977)
14
15
Pages 20 and 21, T.C. Memorandum 2001-81.
The accuracy-related penalty is 20% of any portion of a tax underpayment
attributable to:
(a) negligence or disregard of rules or regulations,
(b) substantial understatement of income tax, or
(c) other misconduct with regard to asset valuation or pension liability overstatement.
Based on IRS instructions to Form 8275.
16
It should be noted that subsequent to this opinion being rendered, some analysts have raised
significant challenges to the approach taken by the Tax Court in reaching its conclusions.
17
19
20
The non-shareholder employee surgeons had employment contracts. There were
no provisions for bonuses for these employees
The collections as determined less the expenses as determined on the personal services of the non-shareholder
employees.
Page 31, T.C. Memorandum 2001-81.
Page 34, T.C. Memorandum 2001-81.
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 20
21
It is critical to emphasize that this Case Study is provided merely as an example of certain fundamental
aspects related to reasonable compensation determinations and their impact on valuation calculations
and conclusions.
22
Intended for example purposes only.
23
While the use of a median over a mean measure is generally considered to be the better alternative, it
is critically important for the valuation analyst to fully comprehend the impact of overall effort and
production of the individual, wherein the selected median may be subject to significant adjustment, up or
down, for differences in the productivity of the individual from the sample group.
What is Reasonable Compensation?
Kevin R. Yeanoplos, ASA, CPA/ABV
Ronald L. Seigneur, CVA, CPA/ABV
© 2008 All Rights Reserved.
P a g e | 21