Spring 2007
Focus on Reasonable Compensation Economic Analysis and Other Economic Analyses
Editors for This Issue: Pamela J. Garland and Victoria A. Platt
Reasonableness of Compensation Analysis Insights
Feature Article:Reasonable Stock-Based
Compensation: Valuation of Common Stock in Compliance with Internal Revenue Code
Section 409A, SFAS No. 123(R), and AICPA Practice Aid Guide
James G. Rabe
Both public corporations and private corporations
may have to deal with stock valuation methods to measure (and disclose)
stock-based compensation amounts. Such amounts may have to be reported
on the corporation’s financial statements and such amounts may have to
be reported on the corporation’s income tax returns. Serious negative
consequences (to the corporation and to the executives) may result if
the subject company does not comply with the appropriate professional
guidance with regard to the measurement of stock-based compensation.
This discussion summarizes some of the most commonly referenced
professional guidance with regard to the valuation of stock and stock
options for stock-based compensation reporting purposes.
Reasonableness of Close
Corporation Shareholder/Executive Compensation Analysis for Income Tax Deduction
Purposes
Robert F. Reilly and Ashley L. Reilly
Financial advisers routinely analyze the
reasonableness of close corporation shareholder/executive compensation
for various reasons, including taxation, financial accounting,
regulatory compliance, financing, ownership transition, litigation, and
corporate governance reasons. Over the years, most of the statutory
authority, administrative rulings, and judicial precedent related to
the reasonableness of compensation have related to federal income tax
controversies. Therefore, financial advisers often rely on this
taxation-related professional guidance—even when analyzing the
reasonableness of shareholder/executive compensation for nontaxation
reasons. Accordingly, this discussion focuses on the analytical methods
and the quantitative/qualitative factors developed by the Internal
Revenue Service and by the federal courts—with regard to the
determination of the reasonableness of shareholder/executive
compensation.
Reasonableness of Executive Compensation—Economic Analysis Illustrative Case
Study
Robert F. Reilly and Chip Brown
First, this illustrative case study summarizes the
economic analysis problem—that is, to estimate a reasonable amount of
compensation for a closely held corporation to pay its three senior
shareholder/executives. In this hypothetical example, certain minority
shareholders of Widget Manufacturing Company have brought a lawsuit
against the corporation. The complaint alleges the oppression of the
minority shareholders and the dissipation of the corporation assets.
The plaintiffs allege that the close corporation is paying more than a
reasonable amount of compensation to three shareholder/executives: the
principal shareholder and his two children. Second, this case study
presents an illustrative set of facts and circumstances related to this
hypothetical family-owned corporation. Finally, this case study applies
a generally accepted set of economic analyses to the hypothetical fact
set, in order to determine a reasonable range of compensation for the
subject corporation shareholder/executives.
When Enough is Too Much: Excess Compensation for Nonprofit Entity Executives
Edward B. Chansky, Esq
The Internal Revenue Service has significantly
increased its examination of not-for-profit entities, particularly with
regard to the reasonableness of executive compensation. Various state
regulatory authorities have also increased their scrutiny of “excess
benefit transactions” related to not-for-profit organizations. This
discussion presents several recent examples of allegations of nonprofit
entity excess compensation. In particular, the Internal Revenue Service
“intermediate sanctions” rules are discussed. And, recommended “best
practices” procedures for nonprofit entity compliance with these rules
are presented.
SEC Amends Rules on Executive Compensation Disclosure
Cara Jordak
The Securities Exchange Commission recently adopted enhanced
executive compensation disclosure requirements for proxy statements, registration
statements, and annual reports filed by public companies. The purpose is to provide
investors with more complete and useful disclosure about executive and director
compensation, in light of increasing objections over excessive and hidden compensation
practices. An overview of the significant changes in the disclosure rules is presented,
as well as a summary of potential implications for litigation that are being discussed
within the legal community.
Reasonableness of Executive Compensation Economic Analysis Data Sources
Victoria A. Platt
There are three categories of factors that are typically considered
in a reasonableness of executive compensation economic analysis. The first category
relates to documenting the specific responsibilities and accomplishments of the subject
executive at the subject employer organization. The second category relates to the so-
called independent investor test. That is, would a hypothetical independent investor be
satisfied with his or her return on investment in the subject corporation? If so, that
hypothetical investor would, presumably, vote to approve the subject executive’s
compensation. The third category relates to comparisons of the subject executive
compensation to the compensation of comparable executives at comparable companies. This
third category of factors often considers published empirical data and industry surveys.
This discussion focuses on (1) the use/misuse of and (2) the strengths/weaknesses of such
empirical data sources as part of a reasonableness of executive compensation economic
analysis.
Recent Court Decisions Related to the Reasonableness of Executive Compensation
Pamela J. Garland
In litigation controversies related to the income tax deduction of
shareholder/executive compensation as a business expense, the courts generally apply a
multi-factor test to determine if the compensation is reasonable. Nonetheless, the courts
apply this multi-factor test with an emphasis on the perspective of a hypothetical
independent investor. In this reasonableness of compensation analysis, the extent to
which the courts accept and rely on compensation data from published compensation surveys
and/or from comparable company analyses varies. The courts often rely on expert witnesses
to provide valuable guidance with regard to the reasonableness of shareholder/executive
compensation. However, the courts only rely on expert witnesses if they provide thorough
qualitative and quantitative economic analyses.
What is Wrong with Using the Income Approach Value to Calculate the Economic
Obsolescence Component in the Cost Approach?
We are pleased to receive letters to the editor regarding previous
Insights articles. This letter relates to a Spring 2006 article: “Economic
Obsolescence is an Essential Procedure of a Cost Approach Valuation of Industrial or
Commercial Properties.” That article rejected a method of quantifying economic
obsolescence where the analyst calculates: cost approach value indication minus income
approach value indication equals economic obsolescence. That article called that flawed
analysis the “plug number” procedure. In the following letter, the author
asks: Exactly, what is wrong with the ”plug number” procedure for measuring
economic obsolescence?
Procedures to Identify and
Quantify Economic Obsolescence in the Property Tax Valuation of Industrial and Commercial
Properties
Robert F. Reilly
One of the most common types of microeconomic analysis in the
investment community relates to the measurement of economic obsolescence. Economic
obsolescence occurs in an investment when the price of the investment is too high to
allow the owner to earn a fair, market-derived rate of return on the investment. In such
a situation, the market bids down the price of the investment until the owner can earn a
fair rate of return on the devalued price. The investment fair rate of return is
typically equal to the investor’s market-derived cost of capital (i.e., the
required rate of return on an investment of comparable risk). In the property tax
discipline, the measurement of economic obsolescence is an important component in the
cost approach valuation of any income-producing or special purpose property. Most large,
integrated manufacturing or processing facilities are either income-producing, special
purpose, or both. In this context, economic obsolescence occurs in a property when the
cost (however measured) of the property is too high to allow the owner/operator to earn a
fair, market-derived rate of return on the property investment. In such a situation, the
market bids down the cost of the property until the owner/operator can earn a fair rate
of return on the depreciated cost. The property fair rate of return is typically equal to
the owner/operator’s market-derived cost of capital (i.e., the required rate of
return on a property of comparable risk). Economic obsolescence can be measured at a
business enterprise level, an operating business unit level, or a line of business level.
For property tax purposes, economic obsolescence is typically measured at the level of
the unit of operating assets that is subject to ad valorem taxation. This discussion will
focus on the microeconomic analyses that are commonly used to measure economic
obsolescence related to complex industrial or commercial facilities.
What You Need to Know About the Valuation Requirements Related to Charitable
Contribution Deductions
Robert F. Reilly
The Pension Protection Act of 2006 increased the requirements related
to income tax deductions for charitable contributions. These increased requirements
affect donor taxpayer, donee charitable organizations, and charitable contribution
appraisers. Whether you are a high net worth individual, a tax adviser, an estate
planner, or a valuation analyst, you should be aware of these increased substantiation
and documentation requirements. Do you think you are a charitable contribution valuation
expert? Take this “quiz” and find out. Good luck!
The Application of Daubert Challenges to Economic Damages Expert Testimony in
Commercial Litigation Matters
Robert P. Schweihs
Trial judges perform a “gatekeeping” function, deciding
whether to admit or to exclude expert witness testimony as trial evidence. Trial judges
often apply the four factors articulated in the Supreme Court Daubert decision in their
judicial decisions regarding the admission of expert testimony. This discussion
summarizes the evidentiary considerations regarding (1) the level of certainty in the
causation of economic damages and (2) the level of certainty in the measurement of
economic damages. This discussion describes the general application of Daubert challenges
to the admissibility of economic damages expert testimony in commercial litigation
matters.