Decisions you’re making every day as a controlling owner may give you a false sense of business value. These are ones I often see that you should review.
Owner Compensation
Most companies I value are corporations. You should be paying yourself W-2 compensation if you’re providing labor and you’re profitable. But, is your salary arm’s length? If you had to hire someone to do what you do, would you have to pay more or less? This may be motivated by payroll and income taxes. In an S corporation, there may be motivation to keep the salary low so that profit can be shifted away from payroll taxes. In a C corporation, there’s usually motivation to keep salary high so that you can avoid double-taxation on dividends. The problem is that tax motivations may not match fair market value. Keep in mind that if the salary should be adjusted up, business value will go down and vice versa. There are multiple sources you can use to estimate an arm’s length salary.
Rent
It’s common for the business owner to own the building that the operating business uses. It’s usually structured so that the operating business pays rent to the owner or their LLC that separately holds the building outside the operating business. If you’re doing this, when was the last time you reviewed the rent to make sure it’s arm’s length? A real estate appraisal is usually the best way to determine this, but that might not be feasible every year. A suggestion is to have the building appraised every few years and increase or decrease rent in the interim years using updated data. A rent adjustment has the same impact as owner compensation and may also be motivated by taxes. I valued a business a few years ago and the owner was paying himself no rent for the building he also owned. Unfortunately, the business had little value after rent expense was added.
Summary
It’s a good idea to review your financial statements regularly for all expenses that may not be arm’s length. You may need to adjust them up or down and maintain a file supporting your past and ongoing decisions. This will serve the dual purposes of staying in compliance with authorities and making sure you understand the impact on business value. Otherwise, when you’re ready to sell or transfer the business, you could be in for an unwelcome surprise.
Josh Horn, CPA, CVA
Horn Valuation
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