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.

Letter to the Editor Insights

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?

Economic Obsolescence Analysis Insights

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.

Charitable Contribution Deduction Insights

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!

Economic Damages Analysis Insights

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.