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Are you overpaid?

James Olan Hutcheson is founder and president of ReGENERATION Partners.

Can excessive executive compensation packages harm family-controlled corporations and those who work for them? It depends on how you define excessive pay, return on equity and the way the IRS sees things. James Olan Hutcheson explains

There's no question that a former Mississippi basketball coach named Bernie Ebbers founded and built one of the globe's biggest telecoms companies. At its peak, the company, had 20m customers and 54,000 employees. But there's also no question that Ebbers was also richly rewarded for his accomplishments in creating WorldCom, now known as MCI.

Among other things, Ebbers was able to borrow more than $400m from WorldCom, money which many say was improperly lent by the publicly held company. Ebbers proved better at company-building than individual financial management, building up $1.3bn in personal debt including the $400m insider loan, and eventually being ousted by the company's board in 2002.

In an episode that cost 20,000 people their jobs and investors more than $180bn, massive accounting irregularities were later exposed at WorldCom, ultimately driving the company into bankruptcy. In 2004 Ebbers was indicted by US federal attorneys for misleading investors by falsifying WorldCom's books, in an unsuccessful effort to keep the company's stock price up and stave off his own bankruptcy.

The problems that in recent years have beset WorldCom – as well as other high-profile, highly paid corporate executives such as Tyco's Dennis Kozlowski and Enron's Jeff Skilling – have made the question of whether Ebbers and other leaders are, in fact, over paid. It's a question of considerable relevance to family business owners far less prominent and rich.

What constitutes 'excessive'?
Some experts think the controversy is wrong headed. Tim Kane, an economist with the Heritage Foundation, a conservative Washington DC think-tank, is one of those. CEOs make a difference in the fates of companies and economies, Kane argues, and good ones are worth being paid more for their work. "You hire the wrong guy and 100 people lose their jobs," he says. "You hire the right guy and 100 people get jobs and also get bonuses. It's easy for people who don't have first-hand experience to be critical of this. And it's easy to fall for the old leftist labour value arguments. But results speak for themselves."

An owner and officer of a business need not be operating at Bernie Ebbers' level to be interested in getting help countering questions about whether their pay is excessive. The IRS takes the stance that employees of businesses can very easily be overpaid. The reasoning has to do with the way corporations – known as 'C' corporations because of the tax code that regulates their organisation – are taxed.
 
According to the IRS code, a corporation pays federal income tax only on its net income, which is defined as the profit that it earns, less all expenses. One of the expenses that is deducted from a corporation's income is salary paid to an officer. It makes no difference whether the officer also owns the corporation. Salary compensation is an expense that, like many other expenses, is deducted from taxable net income. So, the more salary a corporation pays to its officer, the less corporate income is owed.

The IRS takes a different view of corporate dividends. Dividends paid to shareholders are not deductible. So a corporation that pays dividends instead of salary to a shareholder-officer must pay tax on the dividends.

The individual owner-shareholder who receives salary and/or dividends also has to pay income taxes. The net effect is that dividends are subject to a double tax – first when the corporation pay taxes on dividends, and again when the individual reports dividends received as taxable income. This makes a large difference in the after-tax amount available to shareholder-officers who receive all or part of their pay in dividends.

Given the natural tendency of taxing authorities to maximise tax revenue, it should not come as a surprise that the IRS strongly prefers that some portion of the money paid to a shareholder-officers be in the form of a dividend, rather than salary. In other words, the IRS likes the double tax – more dividends, less pay.

Many lawsuits have been fought over the question of whether or not salaries paid to the shareholder-officer are reasonable. Case law defining what is excess compensation or unreasonable compensation has evolved over time.

In the 1960s and 1970s the courts developed tests to decide if compensation paid to the shareholder-officer was unreasonable. The test required the court to determine such things as "the type and extent of the services rendered," or "what an unrevealed third party would pay a comparable employee for the same services notwithstanding the fact that he is also a shareholder".

By the early 1980s, there were more than 15 recognised tests that defined unreasonable compensation. The complexity was increased by the fact that the tests were subjective and open to different interpretations. By the mid-to-late 1980s, however, changes to the tax code and the slowdown in the US economy made the issue of excess compensation less pressing. Excess compensation claims and litigation by the IRS declined significantly.

Then, as the American economy rebounded in the 1990s, the IRS began actively pusuing unreasonable compensation cases again. The courts had not been sitting still during the interim, and had fortunately begun to analyse the questions of owners' compensations in a more logical and objective fashion.

The new analysis is described in a case issued by the US Seventh Circuit court in a case called Exact Spring Corporation v Commissioner. This 1999 ruling holds that the question of the owner compensation should be viewed through the eyes of the shareholder as an investor, rather than just focusing on the amount of compensation paid to the owner.

The difference matters because, presumably, investors require an adequate rate of return on the investment to compensate them for the risk of the investment. An investor, as an owner, gets his return on an equity investment from two sources. The first source of investor income consists of dividends paid on the stock. The second is through increases in the value of the corporation's stock, or capital appreciation.

The new court test says compensation to officers is reasonable if the owner, as an investor, receives an adequate return on their equity investment when dividends from the corporation are combined with stock appreciation. It doesn't matter if the shareholder and the officer are the same person.

There's also a definition of what constitutes excessive pay. That occurs if the shareholder's return on equity is less than what it should have been over time.

Determining reasonable compensation
Family-owned businesses face several challenges as a result of this approach to determining excessive pay. The first issue is that family businesses, unlike publicly held corporations, seldom declare dividends. Without any dividends, capital appreciation is the only element that produces a shareholder's return on equity. However, a closely held family corporation has no public market for its stock. Therefore there is no simple way for an owner to determine fair market value.

What this boils down is that the question of reasonable compensation turns on what the value of a family business is now and how much has it increased since the owner purchased it. That situation gives rise to a number of uncertainties. To begin with, the valuation of a family business is often complex, and valuation experts frequently disagree.

The second challenge of the new test is determining the rate of return on equity that an investor should receive in order to have an acceptable rate of return. Investors in family businesses, like others, normally require a rate of return on an investment equal to the risk that they assume. US Treasury bonds are usually considered risk free since there is negligible risk of default. The risk of a US Treasury bond is measured by the interest rate that investors require before they will purchase the bond.

Today the 20-year US Treasury bond rate is around 5.5%. The rate on return that investors require from large publicly traded companies is equal to this risk-free rate plus a premium, which is sometimes referred to as the equity risk premium. This premium compensates for the fact that equity investments are more risky than bonds. Currently, the equity-risk premium for large public companies is about 8%. Adding this premium to the risk-free rate gives 13.5%, which is presumably the acceptable rate of return on an investment in a large public company.

Family businesses are different. An investor might well require a higher rate of return because a family business has more risk than a large publicly held company in terms of future cash flow and long term stability. The additional amount of return such an investor would require is subject to debate. The general wisdom is that an investor usually requires between 15% and 25% rate of return for an investment in a family business. However there is little agreement on how the rate should be calculated within this range.

Working with the tax authorities
Despite these uncertainties, analysis and discussion will likely result in an agreed-upon value as well as the rate of return over time that the shareholder has received on their investment. When this is calculated, the rate will be compared to what the investor would have normally required on a similar investment. If the rate of return is adequate, then the compensation paid to the officers is presumed to be reasonable.

This calculation and its product are significant because the taxes avoided as a result of showing that compensation is reasonable can generate after-tax savings of 30% or more, based on current IRS tax rates. They are well worth doing, and doing carefully, for any family-held corporation subject to IRS taxes.

Such family businesses need not and should not be passive and accept that they will receive a favourable ruling. There are several things family business owners can do – and would be well-advised to do – to protect owners compensation from IRS challenge.

First, give strong consideration to establishing a method or formula for determining an officer's compensation. In excess compensation cases, the courts have not been inclined to challenge the compensation paid to an owner if it is consistent with a long-standing and economically sensible formula or method. So, if the corporation has a method it follows over time that correlates the corporation's performance with compensation paid to officers, the IRS is less likely to successfully challenge compensation.

Also in very specific and somewhat unique circumstances the corporation could consider declaring dividends. If, for example, the corporation is very profitable and the cash is not needed for some other valid business reason, then declaring dividends may be appropriate. Historical studies show that over the past 15 years, 80-90% of returns that investors receive from an equity investment is from capital appreciation, not dividends. Thus, dividends do not have to be a big portion of the return on the investment. And the IRS will have a difficult time making the excess compensation argument if the corporation has declared dividends.

In addition, consider having the corporation elect so-called 'S' status. An S election is a special election that a regular C corporation can make, with the difference being that the S corporation does not pay any corporate income tax. (Like the C designation, an S corporation gets its name from the relevant section of the tax code.) Any net income that the S corporation makes, flows directly through to the shareholders and is taxed on them personally. Since there is no double tax possible with the S corporation, the IRS cannot raise the excess compensation issue with an S corporation.

An S corporation and taxation of its shareholders is complex, however, and there are negative aspects to an S election. Careful analysis should be undertaken before an S election is made.

Finally, if an owner has received a substantial salary and the corporation has neither a compensation formula nor a history of declaring dividends, consider obtaining a professional evaluation of the risk of a tax authority challenge on the basis of excessive compensation. A professional evaluation will help determine if there is a problem and help you decide what steps you might take in order to prevent a problem. A proactive change in compensation and dividend policy before an IRS audit will sometimes discourage the IRS from making the excess compensation argument.

Few if any such steps would have helped the Bernie Ebberses and Dennis Koslowskis of the world to evade legal and financial troubles. But these high-profile cases do demonstrate the powerful allure – and risk – of setting compensation without enough concern for the possible consequences.  

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