By Guest Columnist:
Laura S. Leopardi, CPA/ABV/CFF/CGMA, MBA
Family law cases involving community businesses inevitably require an analysis of business owner compensation. Privately-held (also referred to as closely-held) business owners tend to compensate themselves in a variety of ways— not just a W-2 wage. Additional sources of compensation may include potential wages paid to a spouse/party not actually working in the business, dividends or distributions, shareholder loans, corporate perquisites, deferred compensation (401k plan contributions), or payment from affiliate entities (such as holding companies).
Wages— are they reasonable?
The issue with W-2 wages paid to community business owners is whether or not they are reasonable. The Internal Revenue Service uses a two-prong test for payroll deductions— the pay must be 1.) reasonable and 2.) it must be for services performed. I.R.S. Publication 535 (2013), Business Expenses, states “To be deductible, your employees’ pay must be an ordinary and necessary business expense and you must pay or incur it.” Reasonableness tests consider efforts contributed, the level of wages paid commensurate with duties performed, and industry standards. In addition, wages paid to spouses of business owners not actually working in the business but intended to earn social security and Medicare credit are disallowed by law and can be treated as compensation of the working spouse.
Distributable— not just distributed, income should be assessed. When valuing a business, dividend paying capacity is assessed. Dividends or distributions authorized can be traced to corporate resolutions approved by the Board of Directors. Undistributed earnings should be analyzed to assess whether such monies are truly necessary working capital needed to fund business operations or potential owners’ compensation— especially in businesses solely owned by the community.
Some business owners tend to borrow money from their company. A key consideration here is the intent to repay. The Internal Revenue Service looks for a fully executed formal promissory note with the principal amount borrowed and terms of repayment, including a stated rate of interest, payment schedule, and maturity date. Applicable Federal Rates are published monthly by the Internal Revenue Service for debt instruments used in property transactions between related parties— including shareholders [https://apps.irs.gov/app/picklist/list/federalRates.html]. Often, there is no note, no interest rate, no historical payments, and…no intent to repay. Look for increases in shareholder loans reported on the balance sheet from year to year. The annual increases may very well be treated as business owner compensation. Shareholder loans typically represent community obligations— monies payable to the business. However, the disposition of such monies is often investigated in a forensic accounting or business valuation.
Travel, meals, entertainment, health insurance, vehicle loan or lease payments, and club membership dues are all examples of expenses that can be material and construed to reduce personal living expenses. Consequently, discretionary expenses paid by an employer can be attributable to the employed spouse’s compensation.
Business owners can establish deferred compensation plans whereby part of their compensation is deferred until retirement age. Nonqualified deferred compensation plans are an employer’s unsecured contractual commitment to pay employee compensation in future tax years to a select management group or highly compensated employees. Certain plans have both a salary deferral and profit-sharing portion to deferred compensation. According to plan documents and as allowable by law, employers may match part of employee contributions. Some plans allow loans against deferred assets— another source of income. Other forms of nonqualified deferred compensation include incentive stock options, restricted stock, stock appreciation rights, and phantom stock.
Payments from Affiliate Entities
A typical scenario in Arizona is a community business that is an operating company paying rent (which may or may not reflect market value) to an affiliated holding company— another community business. Such rents reduce the operating company’s taxable income and value. A property management fee can be taken, which minimizes the holding company’s taxable income and value. Payments from affiliate entities for services rendered may be treated as compensation.
Child Support Guidelines
Arizona Child Support Guidelines are an excellent resource when analyzing gross income from self-employment. Determination of the Gross Income of the Parents delineates components of income from self-employment including income from rents, royalties, proprietorship of a business or joint ownership of a partnership or closely held corporation. Regarding perquisites, expense reimbursements or benefits received by a parent in the course of employment or self-employment or operation of a business shall be counted as income if they are significant and reduce personal living expenses. Permissible deductions from gross income include ordinary and necessary expenses required to produce income, which include one-half of self-employment taxes actually paid. Concepts of unemployment or underemployment are addressed and are also pertinent considerations as is a productivity adjustment to business owners in relation to their industry counterparts.
Laura S. Leopardi, CPA/ABV/CFF/CGMA, MBA is Managing Member of Laura S. Leopardi, CPA, pllc and is a credentialed and experience business valuator and testifying expert witness in family law cases including business valuation, income from self-employment, lifestyle analysis, and commingling issues. Laura can be reached at 602.595.3962 or [email protected]