Abstract:   When a divorcing spouse owns or is a partner in a closely held business, its value — particularly the amount of compensation the business provides to its owners — can play a significant role in the divorce case’s financial outcome. This article discusses the factors a professional valuator considers to determine reasonable compensation.

When divorce cases get sticky
Make sure business owners base their pay on current market rates

Divorce can be messy, especially when it involves a controlling interest in a closely held business that has the power to set compensation levels. A professional valuator can help evaluate owners’ compensation, providing objective data sources that enable you to arrive at a fair outcome for both parties.

Replacement compensation

How much compensation a divorcing business owner receives can dramatically affect his or her property settlement and support payments. For example, Pat owns a construction company and decides to claim an above-market salary to reduce the business’s value and, in turn, the amount of the property settlement. Or, in a different scenario, Pat claims an artificially low salary to reduce alimony and child support obligations.

Ideally, replacement compensation for an owner of a closely held business like Pat’s is the compensation he or she would be paid in an arm’s-length transaction for the services performed. A valuation expert would, therefore, determine the amount that a hypothetical employee who doesn’t own part of the business would be paid to perform those same services. Replacement compensation needs to reflect the services rendered and shouldn’t be confused with distributions of the business’s earnings.

Weighing the factors

Valuators weigh a variety of factors when determining replacement compensation for a specific owner. Experts often look at an owner’s role in the business. A law firm, for example, may employ numerous “partners,” but they don’t all fill the same roles. Some are rainmakers, while others fight in the litigation trenches or manage the firm’s operations. A valuator considers the experience and qualifications necessary to fill the partner’s specific job, as opposed to simply the qualifications the partner happens to possess.

Understanding the comparable positions

The compensation received by similarly situated employees at similar companies is often useful. Valuators gather such data from a growing collection of sources, including the Bureau of Labor Statistics, the Medical Group Management Association, the Economic Research Institute and professional associations.

Also look inside the company to compare the specific owner’s compensation with salaries paid to nonowner employees. If the business consistently pays below-market rates for other employees, it may be harder to justify an above-market rate for the company’s owner.

Understanding the company’s characteristics

The business’s size, complexities, industry, competitive position, financial condition and history all affect replacement compensation levels. Companies with a long record of high revenues from loyal customers generally can afford to pay high compensation. But smaller companies might pay a significant salary premium to woo those same employees.

Moreover, a technology-based firm located in an urban area will probably have greater access to comparable employees than a similar company in a rural area. The cost of living is relevant, too. An owner in New York City requires more compensation than an owner in Detroit to maintain a similar standard of living.

Determining basic variables

When determining replacement compensation for a partner in a professional practice, valuators consider some basic variables. These include the type of professional services offered (such as accounting, law or financial planning) or medical practice specialty, and the duration of the partner’s practice.

Other factors might be the age and health of the partner, hours worked and general productivity, the practice’s market, and the number of locations in which the practice operates. Management or administrative responsibilities handled by the partner will also play a role in determining replacement compensation.

Finding holes in the testimony

Bringing on a professional valuator can help you avoid complications when it comes to assessing owners’ compensation. Remember that not all testimony carries equal authority. So consider issues that will affect the credibility of the valuator’s testimony on replacement compensation, including the source of data used to form the expert’s opinion.

The bottom line

It’s also critical to consider if the data has a regional or national scope, the sampling sizes, and if the data provides means (average values) or medians (middle values). Finally, consider whether the data includes owners whose compensation is made up of both straight compensation and a stake in the business’s profits.