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Applying the "Reasonable Compensation" standard in
"Excess Earnings" analysis.
By George M. Lewellen, CPA, J.D.
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Revenue Rulings 59-60 and 68-609 are cornerstone authorities as a basis for evaluating
professional goodwill in divorce cases. Their provisions are loosely referred to as the
"excess earnings" approach to small business valuation. They are particularly
useful in providing a rational basis for valuing small businesses when there are no
comparable sales or public exchanges of traded stocks for similar businesses. Both Revenue
Rulings caution they should be used only when there is no better evidence of value. As an
interesting background, both are an outgrowth of A.R.M. 34 (1920). This was a formal
statement of approach used by the Treasury for compensation during Prohibition when many
companies were put out of business by the banning of alcoholic beverages manufacture and
sales.
Rev. Rul. 59-60, Section 4 (d) (2), discusses the use of several years' profit and loss
statements as representative of operations. They should reflect, among other things,
"officers' salaries, in total if they appear to be reasonable or in detail if they
seem excessive." This ruling gives little addition 'compensation' guidance other than
this simple statement.
Rev. Rul. 68-609 provides, "If the business is a sole proprietorship or a
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." This
statement appears to simply acknowledge that in Schedule C's for sole proprietorships and
1065's for partnerships, there are no provisions for quantifying owner's compensation as
the net profits "flow through" as taxable income to the taxpaying owners of the
enterprises.
In Valuing Small Businesses & Professional Practices, 3rd edition, Shannon Pratt, at
page 117 comments, "The general idea of the compensation adjustment is to substitute
the cost of hiring and paying a non-owner employee for the compensation actually paid to
the owner to perform the same function. Another way to look at it is to compare the actual
compensation paid to some average amount that other people normally are compensated for
performing similar services."
The issue these two Revenue Rulings and Shannon Pratt are confronting is discussed by
Pratt, "Actual compensation tends to be based upon what the entity can afford or how
the owners wish to be compensated, and may bear little or no relationship to the economic
value of the services the owners actually perform." The three following California
Family Law cases have wrestled with the concept of "reasonable compensation" in
application of the excess earnings method in resolving business valuations. Interestingly,
all three cases involve the valuation of law practices.
In re Marriage of Garrity and Bishton (1986), 181 Cal. App.3d, 675, at FN14, the court
summarized, "One then determines the annual salary of a typical salaried employee who
has had experience commensurate with the spouse who is the sole practitioner or sole
owner/employee." The court goes on to say," Then, one determines the 'excess
earnings' by subtracting the annual salary of the average salaried person from the average
net pretax earnings of the business or practice…"
The Garrity and Bishton opinion certainly conforms with the two revenue rulings and
Pratt's comments. However, the issue gets more complex when the compensated services
provided by the owner cannot be closely compared with the "average salaried non-owner
employee."
In re Marriage of Rosen (2002) 105 Cal. App. 4th, 808, the issue was again confronted. In
this case, the application for the Excess Earnings method as applied by the Garrity and
Bishton court was criticized. Amicus Curiae California Society of Certified Public
Accountants explained in its petition that the "annual salary of the average salaried
person" standard of In re Garrity and Bishton was not the only standard for
establishing reasonable compensation under the excess earnings method. Amicus curiae
explained reasonable compensation may also be based upon " the cost of hiring a
non-owner outsider to perform the same average amount that other people are normally
compensated for performing similar services, - the "similarly situated
professional" standard.
This opinion sets out two alternative standards for establishing the compensation
component. One standard is the "average salaried person" standard, In re
Marriage of Garrity and Bishton, and now a second or modified standard as "similarly
situated professional", In re Marriage of Rosen. This case also illustrates the
danger in utilizing an expert who fails to follow accepted methodology in his analysis
with," We could not express the principle better than this: 'The correct rule on the
necessity of expert testimony has been summarized by Bob Dylan: 'You don't need a
weatherman to know which way the wind blows."
In re Marriage of Iredale and Cates III, (2004) Cal. App.4th, gives additional guidance in
choosing which one of the two standards illustrated in Rosen should be applied. Iredale
was a successful attorney in a large firm. In becoming a partner, Iredale was not required
to buy into existing partnership assets such as fixed assets, accounts receivable, work in
process or goodwill. Upon withdrawal, the partnership agreement also provided she was not
entitled to an interest in any of these assets. Iredale was not involved with management
of the firm, however, she was required to spend hundreds of hours on non-billable career
advancement and business promotion activities.
Cates argued the excess earnings method required the spouse's earnings must be compared
not to the earnings of her peers, but to the cost of replicating her earnings by a
salaried employee whose compensation did not include a share of the firm's profits, citing
In re Marriage of Garrity and Bishton. The court, however, disagreed and cited Rosen,
" We conclude that the trial court's use of the "similarly situated
professional" standard to calculate goodwill was entirely reasonable and supported by
substantial evidence. Cates' own expert had to concede that his method of comparing
Iredale's compensation to what it would cost to hire an associate (actually 1.4
associates) did not account for the non-billable hours expended by Iredale, nor would an
associate be likely to have a client base comparable to Iredale's. Comparing Iredale's
compensation to that of similarly situated professionals, rather than to a salaried
employee, was indeed a more rational and reasonable method by which to calculate the value
of Iredale's goodwill in this case." Iredale now brings to the table an analysis of
the entrepreneurial interest of an owner rather than relying simply upon the technical
skills and experience of a salaried non-owner employee.
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