Adjusting Owner’s Compensation

Impact of Adjusting Owner’s Compensation in Business Valuations for Divorce

Making adjustments to a company’s financial statement is often times necessary to reflect the economic reality. Income statement adjustments are made to reflect what a hypothetical buyer might expect.

A majority owner has the ability to set his or her compensation at whatever level they choose, which may be above-market or below-market levels, for a variety of reason, which may include:

• Shifting part of the owner’s compensation to family members (spouse, children, etc.) to avoid taxes.
• C Corporation owners may be overcompensated to avoid dividends and double taxation.
• S Corporation owners may be undercompensated to minimize payroll taxes.
• Owners may take compensation in other forms, such as rent or loans, to avoid taxes.
• Owners may also undercompensate themselves in divorce planning.

The goal in adjusting owner’s compensation is to more closely reflect the reasonable compensation of a replacement. The amount of the adjustment, if applicable, is the difference between actual compensation paid and the average amount paid to someone in the same line of work in the same industry.

An adjustment to owner’s compensation can have an inverse relationship with the conclusion of value. For example, assume that a company’s value is determined to be four times EBITDA and owner’s compensation was reduced by $100,000. The impact of this adjustment could increase the conclusion of value by $400,000:

Another issue to consider when adjusting owner’s compensation in a divorce case is double-dipping, which occurs when adjusting owner’s compensation in a business valuation but using historical compensation for support purposes.