Estimating Replacement Compensation in Divorce

Replacement compensation can become a contentious issue in divorce, especially when the spouse owns a private business and has the control to set his or her salary, benefits and dividends. When either spouse owns a private business interest, the divorce settlement is only as reasonable as the value of the business and the compensation of its owners.

Reasons for Compensation Variances

The amount a spouse takes home from operating a private business may not accurately reflect his or her contribution to the business. Owners may under or over compensate themselves for a variety of reasons. For example, a startup or distressed business may not have enough cash available to pay the owner a full salary. In these situations, owners often have an unwritten understanding that they'll take more pay when business improves.

Perhaps an owner is unaware of how much money he or she could make working in Corporate America, based on years of experience and breadth of responsibilities. Or a C corporation owner might take an above-market salary in lieu of dividends, because the latter is subject to two layers of tax. Some unscrupulous owners even underpay themselves in anticipation of an impending divorce to lower projected maintenance payments.

Whatever the reason, an owner's actual compensation may not reflect what the company would pay an unrelated person to perform the same tasks. Always evaluate owners' compensation levels when either spouse owns a business — an equitable distribution of the marital estate hinges on it.

Complicated Effects

Many people presume that replacement compensation isn't that big of a deal, because it will all "wash out" in the end. If below-market compensation lowers maintenance payments, won't the value of the business be higher, thereby increasing the value of the marital estate? Not necessarily. Such generalizations can result in unfair settlements. To illustrate, consider the following scenarios:

Example 1: Below-market compensation. You're a private business owner who recently filed for divorce. You've been underpaying yourself for the past three years, because your firm lost a major customer. Your spouse stays at home with the kids and will receive child support and alimony based on a statutory percentage of your annual income. Maintenance payments will probably be set at a lower amount based on your recent below-market compensation. But, you rationalize that's okay, because your marital estate includes the value of your business, which would have been lower if you took a salary commensurate with your contributions to the firm.

Example 2: Above-market compensation. Alternatively, suppose your spouse owns half of a family business with a sibling. You stopped working to raise the kids. Your spouse has temporarily taken a little extra salary to help pay for home improvements and medical costs for his or her parents. You signed a prenuptial agreement that excludes the family business from your marital estate. Unless it's adjusted to market rates, your spouse's above-market compensation will be used to determine your child support and alimony payments, which in your case, will extend until your youngest son graduates college.

Is either of these situations equitable? Maybe not and here's why:

1. Maintenance payments will be paid over several years, depending on the age of the children and the terms of the settlement agreement. But distribution of marital assets is a one-time event. So, you're not comparing apples to oranges.
2. States vary significantly when it comes to how much of a company's value is included in a marital estate. In states that exclude all or part of goodwill from the marital estate (more than half of the states), the nonowner spouse may never get credit for the incremental value attributable to below-market compensation, unless you adjust compensation to market rates. In other words, it's not a wash. It's more complicated.
3. Above or below market compensation also creates inequity if the spouses signed a prenuptial agreement or owned a business prior to the marriage, thereby limiting the amount of business value includable in the marital estate. Tax issues may also come into play.

Factors Worth Considering

To untangle this confusing situation, it's usually easier to estimate replacement compensation and then adjust the value of the business accordingly. But how much should an owner receive for his or her contribution to the business?

Personal characteristics to consider when quantifying replacement compensation for an owner include:

• Daily responsibilities, including primary and ancillary job descriptions,
• Education level, training, licensing requirements and other qualifications,
• Years of experience and previous salary history,
• Age and health,
• Personal attributes, including strategic vision, energy, and mentoring abilities,
• Average hours worked each week, and
• Personal guarantees on company debt.

Company-specific factors that might affect an owner's salary level include:

• Employee turnover rate,
• Prevailing compensation rates for other workers at the same or similar companies,
• Size and financial condition,
• Geographic location, and
• Industry trends and norms.

You also might consider using an approach similar to the IRS's Independent Investor Standard to indirectly determine replacement compensation. This backdoor approach estimates how a hypothetical third-party buyer would compensate an employee if the business were sold. As long as the hypothetical investors would receive a reasonable return on their investments, the IRS presumes owners' compensation is reasonable.

Getting It Right

One of the biggest expenses that businesses deduct on their tax returns and financial statements is owners' compensation. Compensation and dividends also factor into maintenance payments. So, getting these numbers right is an important ingredient in an equitable distribution of a marital estate that includes a private business interest. A financial expert is familiar with common sources of reasonable replacement compensation and can help you quantify how much a spouse should receive in salary, benefits and dividends.