Articles

© 2013 American Institute of CPAs - All Rights Reserved.
Reprinted with permission from the September 2013 issue of Journal of Accountancy.

►  IRS scrutiny of excessive executive compensation is increasing, affecting many types of taxpayers.  CPAs need to advise their clients on steps they can take to lessen their exposure in this area.

By Stephen D. Kirkland, CPA, CMC, CFF

As a result of IRS training initiatives, three types of entities draw the most attention and therefore need good advice from CPAs. First, closely held C corporations are examined to determine whether they have overpaid their shareholder-employees. These corporations are allowed to deduct only “reasonable” compensation paid to shareholder-employees. So, examiners are looking for a disguised dividend, which is corporate profit being treated as compensation. Since a dividend is not deductible, but compensation is, the IRS may treat the portion of the compensation that it considers excessive as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest, and penalties on the deficiency.

Conversely, S corporations are audited to determine whether they have underpaid their shareholder-employees. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions. Since compensation is subject to payroll taxes, but distributions are not, some tax savings can be realized by simply reducing a shareholder’s compensation and increasing his or her distributions. But, like C corporations, S corporations are expected to pay reasonable compensation to their shareholder-employees.

Nonprofit organizations are the IRS’s third area of focus. Because key employees may be able to increase their own pay, these nonprofits are often audited to determine whether they have paid excessive compensation. If the IRS finds that insiders have abused their authority by setting their own compensation at unreasonable levels, it will treat the payment of the unreasonable compensation as an “excess benefit transaction” subject to excise taxes under Sec. 4958. This section imposes a 25% excise tax on the recipient of the unreasonable compensation and, in addition, imposes a 10% excise tax on the organization’s managers who permitted the unreasonable compensation payment. These taxes are applied to the portion of the compensation that exceeds the amount considered reasonable. Note that both excise taxes are imposed on individuals, not the charitable organization. Therefore, CPAs should caution any charitable boards they may serve on, as well as their nonprofit clients, of the potential for personal liability.

Executives are often surprised and feel personally insulted when an IRS auditor challenges their pay. In response, they may blame their CPA for not warning them. To prevent such frustration, a few simple steps can be followed.

First, CPAs should make sure the appropriate people are aware of this issue. Clients and their board members do not need to become compensation experts, but they should know that this is a major hot point in audits.

To reduce the likelihood of such a challenge and to minimize the damage if one occurs, CPAs should advise clients to carefully document each executive’s qualifications, duties, and key accomplishments. This documentation is extremely helpful when responding to an IRS challenge.

Advise clients to take time to include more than just the most apparent factors when describing an individual’s qualifications. Education and experience are obvious, but one of the most important factors may be professional goodwill, which includes reputation and relationships in the industry. Effective communication skills are another critical leadership talent sometimes left out of documentation.

In making note of duties and accomplishments, clients should consider the importance of intangibles such as strategic decision-making, leadership, and impact on employee morale. If an individual personally guarantees the employer’s debts, a guarantor fee should be separately computed to keep any compensation issue out of the equation.

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A Primer on the Tax Law Issues

By Stephen D. Kirkland, CPA, CMC, CFF
Originally published by NACVA in QuickRead on July 6, 2023

Years ago, “golden parachute” payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code § 162. However, due to controversy over large executive pay packages, the Tax Reform Act of 1984 added § 280G to the Internal Revenue Code. This article discusses planning and tax deductibility issues under the current law.

Golden parachute arrangements typically provide for large cash payments to a corporation’s key executives if those individuals are terminated due to a change in the control of the company.

Years ago, these payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code § 162. However, due to controversy over large executive pay packages, the Tax Reform Act of 1984 added § 280G to the Internal Revenue Code.

General Rules
Section 280G provides that no deduction is allowed for any “excess parachute payment” paid because of a change in effective control of the corporation or a change in the ownership of a substantial portion of its assets. The affected payment may be to an employee, independent contractor, or other person who performs personal services for the company and is an officer, shareholder, or highly compensated individual (§ 280G(c)).

In addition, Code § 4999(a) imposes a 20 percent excise tax on the recipient of any such payment. Since the payment would be taxed to the recipient as ordinary income, his or her total tax could exceed 65 percent. This could include federal income tax, Medicare tax, the 20 percent excise tax, and any state and local income taxes.

Determining an “Excess” Parachute Payment
The rules for determining an excess parachute payment are somewhat complex. The first step is to determine whether a “parachute payment” even exists. A parachute payment is defined as any payment in the nature of compensation to an officer, shareholder, or highly compensated individual which is contingent on a change of control, if the aggregate payment equals or exceeds a dollar figure equal to three times such person’s “base amount” (§ 280G(b)(2)).

For this purpose, the base amount is an individual’s average annualized compensation for the five taxable years ending prior to the year of the change of control (§ 280G(b)(3)(A)).

If the aggregate amount contingent on a change of control exceeds three times the base amount, the excess parachute payment includes the entire portion of such payment which exceeds the base amount. Notice that if the total contingent payment exceeds three times the base amount by even one dollar, the entire amount of the contingent payments in excess of the base amount is an excess parachute payment subject to the loss of deduction and the 20 percent excise tax (§ 280G(b)(1)).

Example
Pam’s average annual compensation for the prior five years was $400,000. Upon a change of control and her impending termination, she is to receive a parachute payment of $1,250,000. Since this amount exceeds three times her base (by $50,000), the entire portion in excess of her base amount ($400,000) is an excess parachute payment. Therefore, $850,000 is non-deductible by the company and Pam must pay an excise tax of $170,000 (20 percent of $850,000). If the payment to her had been one dollar less than $1,200,000, it could have all been deductible and none would have been subject to the excise tax.

Closely Held Companies
Although the golden parachute rules were primarily intended to deal with perceived abuses at publicly traded companies, these rules can also apply to closely held companies. Under § 280G(b)(5), these rules apply to a small business unless the shareholders approve the payment by a super majority vote of more than 75 percent and there was adequate disclosure to shareholders of “all” material facts concerning “all” parachute payments.

Special Rules
The parachute payment amount includes the fair market value of any property. Present value is determined by using a discount rate equal to 120 percent of the applicable Federal rate under § 1274(d), compounded semiannually (§ 280G(d)(3)).

In the case of stock options which provide for accelerated vesting upon a change of control, the regulations include a method for calculating the value of such acceleration (Reg. 1.280G-1, Q/A-13).

Payments to or from a qualified retirement plan are not considered to be parachute payments (§ 280G(b)(6)). However, any compensatory payment made in violation of securities laws may be treated as a parachute payment (§ 280G(b)(2)(B)).

If the excess payment is made while the individual is still an employee, the employer must withhold the full 20 percent excise tax in addition to any other withholding (§ 4999(c)(1)).

Also, note that if an agreement to pay was entered into or amended within a year prior to the change of control, it is “presumed to be contingent” on a change of control unless clearly shown not to be (§ 280G(b)(2(C)(ii)).

Exception for Services to be Provided
Any amount paid for personal services to be rendered on or after the date of the change in control is not considered to be a parachute payment if the company establishes by “clear and convincing evidence” that the amount is “reasonable compensation.” There is a similar exception for reasonable compensation paid for services rendered before the change of control (§ 280G(b)(4)).

Conclusion
There are potential tax traps to avoid while designing parachute payments, so § 280G and § 4999 should be read carefully. The regulations under § 280G were written in a question and answer format. And, although these regulations are lengthy, they should be perused before any agreement providing for a parachute payment is finalized or modified.

By Stephen D. Kirkland, CPA, CMC, CFF

Originally published in QuickRead on May 4, 2022.

Internal Revenue Code § 4958 imposes excise taxes on the excessive portion of compensation paid by a non-profit organization. Excise taxes must be paid by “disqualified persons” who receive unreasonable compensation as well as by the individuals who approve it. Despite the “excise tax” label, these taxes are generally considered to be a severe form of penalty.

In considering whether compensation is unreasonable, it is important to determine whether any part of the compensation qualifies as a “fixed payment.”

Internal Revenue Service (“IRS”) Regulation § 53.4958-4(a)(3)(ii) explains which payments or benefits are fixed payments. It says, “fixed payment means an amount of cash or other property specified in the contract, or determined by a fixed formula specified in the contract, which is to be paid or transferred in exchange for the provision of specified services or property.” Fixed payments are distinguished because the property or the amount of cash is not subject to management’s discretion after the terms of a contract have been set. The amounts of such payments may be determined by a formula “provided that no person exercises discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus).”

As such, the term “fixed payment” could include a certain amount of cryptocurrency or an investment such as the future cash value of a life insurance policy after the employer commits to putting a certain amount into the policy each year.

Regulation § 53.4958-4(b)(2) addresses the timing of reasonableness determinations. Regulation § 53.4958-4(b)(2)(i) says, “The facts and circumstances to be taken into consideration in determining reasonableness of a fixed payment (within the meaning of paragraph (a)(3)(ii) of this section) are those existing on the date the parties enter into the contract pursuant to which the payment is made.” Regulation § 53.4958-4(b)(2)(iii) includes examples to “illustrate the timing of the reasonableness determination.” In the examples, H is the employee and G is the employer.

In the first example, a disqualified person enters a multi-year employment contract that provides for payment of a salary and provision of specific benefits pursuant to a qualified pension plan and an accident and health plan. The example says, “The contract provides that H’s salary will be adjusted by the increase in the Consumer Price Index (CPI) for the prior year. The contributions G makes to the qualified pension plan are equal to the maximum amount G is permitted to contribute under the rules applicable to qualified plans. Under these facts, all items comprising H’s total compensation are treated as fixed payments within the meaning of paragraph (a)(3)(ii) of this section. Therefore, the reasonableness of H’s compensation is determined based on the circumstances existing at the time G and H enter into the employment contract.”

The second example involves the transfer of a car’s title to an employee under the condition that, if the employee fails to complete a certain number of years of service, title to the car will be forfeited back to the employer. It says, “Although ultimate vesting of title to the car is contingent on H continuing to work for G for x years, the amount of property to be vested (i.e., the type of car) is specified in the contract, and no person exercises discretion regarding the type of property or whether H will retain title to the property at the time of vesting. Under these facts, the car is a fixed payment within the meaning of paragraph (a)(3)(ii) of this section. Therefore, the reasonableness of H’s compensation, including the value of the car, is determined based on the circumstances existing at the time G and H enter into the employment contract.”

Based on the IRS regulations, the current value of an amount paid currently may not be a consideration. Instead, the timing of the reasonableness determination may be back when the compensation terms were established.

Severance pay often falls under the definition of fixed payment. For example, an employment contract may state that the employee will be paid a certain percentage of his or her base salary for a certain period following termination of employment. To determine the reasonableness of the severance, you may need to look back to the facts that existed and were known when the agreement was reached. Those facts may include the severance terms typically offered by similar organizations to similar employees at that time. The key facts may also include the anticipated value of any restrictive covenants that extend beyond termination of the individual’s employment. Common restrictions address nondisclosure of confidential or proprietary information, non-competition, and non-solicitation of employees.

The excise taxes under § 4958 are not limited to compensation paid to employees. They also apply to amounts paid to independent contractors who are disqualified persons. Section 4958(f) defines this term to include, among others, “any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.”

A similar rule applies to deductible compensation expense paid by for-profit entities. Regulation § 1.162-7(b)(3) says, “The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.”

By Stephen D. Kirkland, CPA, CMC, CFF
Originally published in The Value Examiner (January/February 2017) which is a publication of the National Association of Certified Valuators and Analysts.

One key difference between successful and unsuccessful financial service firms is the way that partner compensation amounts are determined. Successful firms have strong compensation plans that help retain their top performers and motivate all partners to do their best. Other firms have plans that encourage average or below-average performers to stay and send the best looking for greener pastures.

The partner compensation plan serves many purposes and risk mitigation may be the most important. Business valuators understand that all professional service firms face many risks, and the defection of a top performer can be one of the most difficult risks to manage.

One of the worst ways to compensate partners (or other owners) may be to share pay equally regardless of individual results. This type of plan is not a motivator and does not give everyone enough incentive to go the extra mile. In today’s highly-competitive environment, each owner needs to be fully incentivized. Although there are exceptions, firms paying all owners equally usually do not achieve the long-term stability, growth, or profitability that the owners desire. Even for those who are not motivated primarily by money, being paid equally can be a powerful de-motivator.

"When performance is irrelevant to compensation, the organization gets less than it pays for," says compensation expert E. James Brennan.

A better approach may be to keep base salaries (aka show-up pay) to no more than about 70% of total expected pay. This allows for sizeable bonuses, which can be powerful motivators.

Incentive bonuses are effective not only because of the financial reward, but also because everyone appreciates having their hard work recognized and rewarded. For both of these reasons, well-designed incentive bonuses can bring out the best in everyone.

Alan Weiss, an advisor to consultants, warns against trying to manage (lower) the amount paid to a partner. Instead, he suggests trying to manage (raise) the partner’s value.

Weiss also reminds firms to design their plans for the future, not for the past.

“You want to foster an environment where everyone believes that one partner’s success is best for the firm rather than detrimental to another partner,” says James “Jim” George CPA, CVA, JD.

One of the first questions to answer is: who will design and update the partner compensation plan? Larger firms often have an executive committee or a compensation committee which is charged with that responsibility. For smaller firms, it may be most appropriate for the managing partner to make these decisions. Regardless of who handles this important task, the following reminders may be helpful.

Pay bonuses often. Annual bonuses are golden handcuffs which may keep employees on board until the annual bonuses are finally paid. But in today’s want-it-now society, a year can be a long time. More motivation can be derived from quarterly bonuses because the longer the interval between the desired performance and its reward, the less affected the bonus is. Paying a bonus as soon as practical after the amount has been determined can surely help morale. One CPA firm saw attitudes sour quickly when they postponed payment of “tax season” bonuses until June.

Early in my career I learned the hard way that coming between someone and their paycheck was a quick way to lose an employee. Once someone feels that they have earned their money, they do not want to wait for a committee to meet or for any other delay.

Customize. Although it takes some time and thought, the best way to achieve fairness and maximize profitability may be to customize a bonus plan for each owner annually. All owners do not perform the same services or bring the same amount of value to the firm. Someone spends more time on administrative matters, for example, and deserves to be paid for that. Another may be the best rainmaker and someone else will have the most billable hours. Therefore, one bonus plan may not fit all.

Start by determining what is needed from each partner. This usually includes a mix of client service, recruiting, staff development, business development and firm administration. The priorities may change from one year to the next. This year the firm may need extra attention on business development, and the next year it may need more emphasis on recruiting. Just be careful what you promise to pay for, because you will surely get more of it, and you probably prefer quality over quantity.

Mike Gregory, an independent consultant who championed the IRS team on reasonable compensation years ago, says, “We get what we measure. If a partner is being is given an incentive to prioritize certain actions, ensure the actions are clearly articulated orally and confirmed in writing.”

Try to balance fairness, simplicity and transparency. It is best for everyone if bonus plans are kept fairly simple. For good reasons, professionals are skeptical of anything they do not fully understand. You also want the plan to be straight forward so you can compute bonus amounts quickly after quarter end or at other times.

Jim George adds, “I would make sure that any creative bonus plans are in writing and explain the rationale for how they are calculated. This will be important later, if any disputes arise between partners or if the partnership needs to be valued. When disputes occur, without proper documentation, it may be difficult to remember or justify why a certain partner’s bonus was larger than others.”

And, as with other aspects of managing a firm, transparency among the partners is also important.

Components. Despite the need for simplicity, a bonus plan could be made up of multiple components. Therefore, each bonus could actually be a combination of small amounts from the various components. For example, one owner may have a component for client service, and that may be measured in part by billings and collections. That component of her bonus may be equal to 30% of the amount by which her collections exceed her target for the quarter. When designing the components, remember that most workers focus their attention on the specific areas that directly affect their compensation.

And be sure that bonuses are based more on individual performance than on seniority or equity ownership.

Business development. To encourage on-going business development, consider a component that pays the generating partner 5 to 10% of any fees collected from a new client during the first year. This strongly encourages the rainmaker to help get invoices out, and cash payments in, during that first year. However, since it is easy to bring in poor-paying clients, it may be wise to provide that the 10% is not paid if realization on a client is below a set level.

However, there may be disputes when new clients come in. Perhaps two or more owners may each claim that they helped attract a new client. To avoid fistfights, it may be feasible to split the bonus component between them. However, one successful firm simply assigns each new client to the person who “received the initial email or answered the phone call.” Other firms have allowed their managing members to determine which owner was the principal rainmaker in these situations. Just decide how you to want to handle this scenario; put it in writing and then follow your policy. And don’t forget to prepare for those situations when a member of your staff, and not an owner, is really the one who brought in the new client.

Recruiting. For many financial service firms, attracting great employees is currently a significant challenge. To encourage owners to help find qualified candidates, bonuses could include a component which is based on the starting salary of any new hires they personally locate. The amount may not need to be more than 30% of what would have been paid to a placement firm. Consider paying this component on the six-month anniversary of the new employee’s start date and make it contingent on that new employee performing satisfactorily up to that time.

Use the bonus plan to unify, not divide, your team. Even though each owner does not have the same bonus terms, be sure each plan includes firm-wide incentives. To create a team that works together, the bonus plans must give each owner an incentive to see that the whole firm succeeds. Otherwise, you may be creating a collection of sole proprietors.

One way to create teamwork is to agree that every owner’s bonus will include a component each time the firm’s collections exceed the total for the same quarter of the prior year by more than 10%.

If every owner gets a cash bonus when the whole firm exceeds budget, they will pull together. Even a small cash bonus can be a big motivator since it acknowledges successful effort.

Client service. Owner bonuses should also reflect client service. One component I seldom see, but highly recommend, is based on client satisfaction surveys. Consider having your managing member send out client surveys regularly, or use an independent firm to perform the survey. Add a certain amount to the bonus of the owner receiving the highest scores each quarter.

Flexibility. Include some flexibility and subjectivity so the managing partner or executive committee can adjust the amounts upward or downward for hard-to-measure attributes like ethics and attitude. You do not want to be contractually committed to paying a bonus to someone who undercut team incentives for personal benefit. One firm was contractually obligated to pay a large bonus to a former partner who had just been kicked out of the firm for committing an ugly crime.

It really is the thought that counts. Give the managing member the authority (and the responsibility) to award small, impromptu bonuses. These “spot bonuses” quickly recognize someone’s unexpected, extraordinary performance through an at-the-moment reward. These bonuses are effective in showing immediate appreciation for exceptional accomplishments. They should be completely subjective.

Minimize risk. To help encourage owners to exercise due care, consider requiring the responsible owner to pay all or most of the deductible if and when a lawsuit is filed against the firm. Such payment could be made by reducing that person’s next bonus by the amount of the deductible. If one owner is negligent, or agitates a client, the other owners will not want to share in the payment of the deductible.

Delivery. Rather than simply having the net bonus amounts electronically deposited, consider hand-delivering paper checks. The managing member could look the other owners in the eyes, shake their hands, and say “Thank you!” while handing them their checks. Or, she could mail hand-written notes to their homes with the checks. We live in an electronic age, and that makes the old-fashioned personal touch more special.

However, even with these minor details, there are advantages and disadvantages to every option. For example, one valuation professional heard of a company who once mailed bonus checks to the employees’ homes thinking it would impress their spouses and make the employees feel more proud. Instead, one employee’s spouse asked how many other bonuses the employee had received over the years that she didn’t know about. She discovered that the prior bonuses had been deposited into a secret account that had never been disclosed to her, and the valuation professional got to work on their divorce case!

Delays. If bonuses must be delayed for some reason, be very careful. Employment agreements and state laws may limit an employer’s ability to postpone payment of wages. Also, strict requirements must be met to avoid tax problems associated with nonqualified deferred compensation (see Internal Revenue Code section 409A).

Compliance. Get legal counsel on any obligation your firm makes to its owners (or other employees) and be sure your firm keeps the right to modify the incentive plan going forward.
Final thoughts. Give all owners a chance to provide their input on any changes to the compensation plan. Be sure it is clear and put in writing. Ensure that you are paying for performance and avoiding perverse consequences such as encouraging internecine warfare or intra-employee rivalry. Teamwork is the foundation of profitability.

Note: This article is provided to stimulate thought and discussion. It is not advice for any particular situation.

By Stephen D. Kirkland, CPA, CMC, CFF

Originally published in The Tax Adviser, September 2022. Copyright: AICPA.

It is common for business owners to personally guarantee company debts. This is a valuable service since many private companies could not otherwise obtain financing in the current lending market. Indeed, business owners already face considerable risks and may not want to assume more. When they do, they provide value that justifies additional compensation for themselves.

A recent Tax Court opinion laid out the requirements that must be met to support the payer’s deduction for any such fees. In Clary Hood, Inc., T.C. Memo. 2022-15, the issue was whether the owner/CEO of a construction company had been paid unreasonable compensation. Among his many duties, the CEO had guaranteed business loans, credit lines, capital leases, and surety bonds for the benefit of his company. Expert testimony pointed to the CEO’s personal guaranties of these obligations as partial justification for his multimillion-dollar compensation.

The court agreed that it is customary for the owners of construction companies to guarantee debts and bonds and that compensation for these guaranties is appropriate. The court also acknowledged that such fees may qualify as a deductible business expense under Sec. 162(a). However, the court stated that Clary Hood Inc. had not met all five requirements for deductibility of the guaranty fees. The court’s analysis considered:

• Whether the fees were reasonable in amount, given the financial risks;
• Whether businesses of the same type and size as the payer customarily pay such fees to shareholders;
• Whether the shareholder-employee demanded compensation for the guaranty;
• Whether the payer had sufficient profits to pay a dividend but failed to do so; and
• Whether the purported guaranty fees were proportional to stock ownership.

Reasonable in Amount

The first factor above requires that such fees be “reasonable in amount.” Under Sec. 162, reasonableness may be determined by benchmarking the amount against amounts paid for similar services. Regs. Sec. 1.162-7(b)(3) says, “It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”

The Amount of Risk

The first factor also calls for an assessment of the financial risks. However, risks can vary dramatically, even among otherwise similar companies.

Historically, banks offered loans that were collateralized by the borrowers’ assets but were not guaranteed by their shareholders. Back then, banks also offered lower interest rates if and when the borrowers’ shareholders personally guaranteed the loans. Once both rates were known, the risks could then be evaluated from the difference in such rates. However, it is not that simple now, since lenders have stopped offering unguaranteed loans, even when the company provides hard assets and receivables as collateral.

Now, a wider range of factors may need to be considered. The analysis might focus on the number of guarantors and their liquidity and net worth. The analysis could also consider whether the guaranty was required by a government agency, such as the U.S. Department of Agriculture (see Bordelon, T.C. Memo. 2020-26). Any requirement for the shareholder’s spouse to also provide a guaranty, or the need to allow a lien to be placed on the guarantor’s residence, could speak to the risks, as well as affect any comparison to “like services.” The borrower’s revenue stability, profitability, debt-to-equity ratio, and liquidity could also be among the top factors in assessing risks.

The type of guaranty agreement could significantly affect the risks. A guaranty of payment (the more typical type) obligates the guarantor to pay the outstanding debt upon default without the lender’s having to make additional demands of the debtor. Alternatively, with a guaranty of collection, the lender must exhaust all other legal remedies before requiring payment from the guarantor. For a minority shareholder who is not an officer of the company, risks may be higher by virtue of the lack of control.

Customary Fees

The second factor listed by the court considers whether similar businesses “customarily pay such fees.” It does not speak to the value of the guaranty to the business, the risks involved, or the fee amount. Instead, it simply refers to practices at other companies. Obtaining evidence of such practices at other private companies may be difficult, especially with those that bundle any guaranty fee into salary or bonuses with no bifurcation. Private companies do not commonly designate separate amounts for individual services provided by officers.

Demand for Compensation

Note that the third factor above requires that the guarantor “demand” a fee in exchange for the guaranty. This would presumably occur before signing the documents. Assessing risk would also occur before signing the documents, since Regs. Sec. 1.162-7(b)(3) says, “The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.” This requirement may prevent a shareholder’s guaranty from being used to justify the amount of his or her compensation after the fact, such as in an audit or court case, if it was not documented earlier.

Contributions to Capital

If no fee is paid, the shareholder will have made an unrecorded contribution to the capital of his or her company, which would not affect his or her basis in the stock. However, if the shareholder, at any point, makes a personal payment to the lender, such payment would likely be a contribution to capital and would increase the shareholder’s stock basis.

S corporation shareholders do not obtain additional basis by acting as a guarantor of corporate debt but do receive additional basis upon making a payment to the lender (see Regs. Sec. 1.1366-2(a)(2)(ii)). However, different rules apply to partnerships. A partner providing a personal guaranty may be entitled to an increase in the basis of his or her partnership interest by virtue of guaranteeing the partnership’s debt (see Regs. Sec. 1.752­1 regarding a partner’s treatment of recourse liabilities).

Methodology

Due to these complications of assessing risks and identifying amounts paid by similar companies for similar guaranties, there is not a well-established, one-and-only method of computing the fee amount. Each situation must be considered individually with whatever reliable information is available. Certainly, determining a guaranty fee requires careful consideration of both the amount of the exposure and the risk of default.

The analysis may also include comparing the cost of the debt to the cost of equity. It may not make sense for the cost of debt, including the interest paid to the lender plus the guaranty fee, to exceed the return that potential shareholders would expect on their investments in the company. In determining an appropriate fee amount, the analyst may need to make certain assumptions. For example, it may be necessary to assume that the guaranty agreement is enforceable and that the loan was in fact made to the company and not indirectly to its owner.

The form or method of fixing compensation is not decisive as to deductibility (Regs. Sec. 1.162-7(b)(2)). Once determined, the guaranty fee may be paid in the form of a separate fee, a higher salary, or a cash bonus. It could also be paid in the form of equity in the company (see Davis, T.C. Memo. 2011-286, aff’d, No. 12-10916 (11th Cir. 5/16/13)). If equity is used as the form of payment, the guarantor may need to find a source of cash to pay income taxes. Alternatively, it may be possible to structure the guaranty as a tax-free contribution of property to the company under Sec. 351 rather than as a service. The distinction between property and service may be swayed by whether the guaranty is provided because the shareholder is protecting his or her investment or because an officer is protecting his or her future compensation.

Dividends

The fourth and fifth factors listed in Clary Hood are intended to weed out fees that are in fact disguised dividends to the shareholders, which would not be deductible. In Clary Hood, the court noted that the business did have profits but had not paid dividends. However, the court considered the totality of the facts, with no specific weight given to any particular fact. If the tests for deductibility are not met, any fee paid separately may receive dividend treatment.

Final Thoughts

Even though a guarantor may never have to make a personal payment toward the company’s debt, the guaranty may cause issues for the guarantor. For example, that contingent liability could hurt the guarantor’s credit rating. Yet, for the owners of private companies, providing personal guaranties may be a necessary part of the process.

Contingent compensation may be a discretionary bonus or an amount to be determined by a written formula. Either way, it should meet the same standards of reasonableness and compensatory intent as traditional salary compensation.

To determine whether an amount is reasonable, consider the facts and circumstances which existed at the time the bonus was declared or when the formula or contingent arrangement was adopted. Treasury Regulation § 1.162-7(b)(2) says:

“The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.”

Bonuses for executives are sometimes based on a percentage of EBITDA or some variation of income. Neither the regulations nor the Tax Court have established specific guidelines as to the percentage of EBITDA that may be paid out as reasonable compensation. In various published cases, amounts as high as 65% have been considered to be reasonable and amounts as low as 20% have been determined to be unreasonable compensation. The differences are key factors such as the size of the companies, their industries, and the nature and extent of the duties performed by the shareholder-employees.

A contingent compensation formula does not necessarily have to be applied to other (non-owner) employees in order for it to produce reasonable compensation for the CEO.

One factor to be considered is the contingent pay plan’s approval by other directors and/or shareholders. In Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286, the Tax Court allowed a closely-held payday lender to deduct $37 million when the former CEO exercised a stock option that had been granted with the consent of other shareholders.

Clearly, there is  much to consider for any employer who wants to motivate its executives to provide their best services, and also to avoid payment of unreasonable compensation.

Beginning with Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6^th Cir. 1949), the courts have developed various factors to consider in determining whether compensation amounts were reasonable.  Some of the key factors are:

·       The employee’s qualifications, including education and training,

·       The nature, extent and scope of the employee’s duties,

·       The amount of compensation paid for similar services by similar businesses

·       The ratio of compensation to gross revenue and to net profits (before salaries and federal income tax)

·       Whether compensation was set by independent directors

·       Correlation between employee’s compensation and his/her stockholdings

·       The corporation’s history of paying or not paying dividends

·       Prevailing economic conditions

·       Whether payments were needed as an inducement to keep the employee at the employer

·       The financial condition of the company after payment of compensation

·       Scarcity of qualified employees

·       Discretionary bonus paid at end of year

One court listed a total of 21 factors.  See Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-89 (1981).

Several of the above factors do not directly address the reasonableness of the compensation amount.  For example, the correlation between an employee’s compensation and his/her stock-holdings does not directly speak to the amount of pay.  In addition, the corporation’s dividend history does not determine whether the compensation amount was reasonable.  Instead, these factors may help determine the company’s intent when the payments were made.  Was a payment intended to be compensation for services rendered or was it intended to be a distribution of profit?  If year-end bonus payments are in the same ratio as stock holdings, this factor may suggest that the intent was the sharing of profit.

Cases suggest that the factors listed below may indicate that a payment was compensation.

·       Long hours worked

·       Uniqueness of skills/contribution

·       Success in turning the company around

·       Above average growth and/or profitability

·       Extensive experience of the employee

·       High productivity and effectiveness of employee

·       Bonus arrangements/formula entered into prior to becoming a stockholder

·       Employee offered higher salary by other employers

·       Inability of employee to control compensation levels and/or dividends

·       Salary compares favorably with that of similar employees at peer companies

·       Employee was under-compensated in previous years

·       Return on equity is high

Case law suggests that the factors listed below may indicate that a payment was a dividend.

·       Compensation amount exceeds that of peers at comparable companies

·       Lack of dividend payments in prior years

·       Inappropriate compensation formulas

·       Lack of uniqueness of employee’s skills

·       Employee spends little time on the job or works less than in previous years

·       Board of Directors/decision makers are not independent

·       Increase in salary without increase in duties

·       Bonus formulas changed because of high profits

It is important to remember that none of these factors are controlling by themselves.  They do not all carry the same weight.

Every executive and every company is different from others, and that is why many factors need to be carefully considered. Don’t forget to consider whether the officer is multi-lingual or has other valuable communicating, selling or negotiating skills. Expertise with technology is valuable in some industries, as is personal or professional goodwill.

Executive compensation can be a complex matter and amounts  are not determined by completing a simple checklist. Due to the difficulties in assessing these factors, expert witnesses are commonly used in conferences with the IRS Appeals Office and at Tax Court to help determine whether unreasonable compensation was paid.

I am offering no opinions in this article as each situation depends upon its own facts and circumstances.

We often need to determine reasonable compensation amounts for executives, attorneys, charity managers, trustees, or retirement plan service providers. This is an important process and should not be taken lightly. 

At first blush, it is tempting to assume that the market establishes reasonableness. Hence, we often use benchmarking, which involves comparing one person’s pay level to amounts paid by other companies. 

Surveys or collections of actual compensation amounts are known as comparability data. The idea is that, “If similar companies paid their CEOs $x, then that amount must be reasonable for our CEO.” This is a way of letting the market decide what is reasonable. Here are some words of caution, however.

It is always interesting to see what others have been paid, but we should not be too quick to draw conclusions. First, let’s ask whether all incumbents provided the same value. Carefully consider these questions: Do all doctors provide the same service? Do all attorneys provide their clients the same value? Do all consultants perform the same work? And do all executives do the same tasks and accomplish the same results? 

The point is – be careful when benchmarking. Do not be too simplistic in the approach and don’t make careless assumptions. 

Of course, it would be great if we could get some exact matches. This would mean finding similar-sized companies in the same industry and the same geographic area that had a similar growth rate and comparable profitability, and where the individuals being benchmarked had the same duties and performed at the same level. Finding exact matches is usually not possible. Therefore, we often use surveys or compilations of amounts paid by companies in the same or similar industries. 

Below are a few examples of sources of compensation comparability data, although the fact that they are listed here should not be considered to be an endorsement. Each has its own strengths and weaknesses, and none of them are a perfect fit for every situation.

Publicly traded companies file financial information with the United States Securities and Exchange Commission (SEC.gov). The SEC then publishes some of that information, including total compensation amounts for each company’s top officers, on its EDGAR database (Electronic Data Gathering, Analysis and Retrieval). The Summary Compensation Table shows compensation by person, by year and by type. The data goes back for years. Compensation amounts available through EDGAR can be helpful in certain situations, although publicly traded companies tend to be much larger, more diversified and have more layers of management than closely held companies.

The United States Department of Labor’s Bureau of Labor Statistics gathers and publishes wage data on its website: www.bls.gov/ncs  (NCS = National Compensation Survey). The data is available by state. In addition, the DOL's Occupational Employment Statistics (OES) program produces employment and wage estimates annually for over 800 occupations. These estimates are available for the nation as a whole, for individual states, and for metropolitan and nonmetropolitan areas. National occupational estimates for specific industries are also available at www.bls.gov/oes.  In addition, the Department of Labor’s Employment and Training Administration sponsors America’s Career InfoNet at www.acinet.org. This website offers free salary information by zip code or state for 800+ occupations. Some people who want to consider DOL data find it helpful to use a service that sorts and compiles that data based on their own facts, such as RCReports (www.RCreports.com).  

Trade associations often conduct surveys of their members and share the results with their members. These surveys usually include questions about officer compensation. Non-members can often purchase these surveys as well, although the price may be higher for non-members. 

GuideStar (Candid) collects financial data from non-profit organizations and publishes that data on its website (GuideStar.org). The data comes from annual reports filed by the non-profits with the Internal Revenue Service (IRS Form 990). Form 990 asks charities for a considerable amount of information about officer compensation, including explanations of how the compensation amounts were determined.

There are also ways to obtain data from multiple sources. Commercial services obtain large amounts of data from multiple compensation surveys and compile that data into their own databases. For example, ERI Economic Research Institute (ERIERI.com) conducts their own surveys and purchases other surveys. They also pull data from EDGAR and GuideStar (Candid). ERI officials have told me that they believe their database to be the most robust collection of compensation amounts available. Regardless, by using their database, we can draw compensation amounts from many different sources at one time. RCReports is another popular source of comparability data that contains data from multiple sources.

Comparability data may also include compensation amounts paid to the same individual in an earlier year. The theory is: if her services were worth $x in earlier years at a previous employer, then her services must be worth at least $x now. Prior pay can be especially helpful if it came from a company that the subject employee did not control at the time. In other words, it is more telling if the prior pay came from a third party and not from a company where the subject had the ability to set his or her own pay level. But even then, it is usually not that simple.

The Tax Court has examined this issue in several cases, including Choate Construction Company, T.C. Memo. 1997-495.

More words of caution: When it comes to finding comparability data, try to ensure that the industry data comes from reliable sources and apply careful judgment.

After carefully making market comparisons, you may find that your subject was paid above the average market amounts. But this may not necessarily mean that he or she received unreasonable compensation. After all, someone has to be above average, or it’s not an average. 

Rather than focus entirely on paying median or mean market rates, I suggest focusing on some other questions: Did he or she provide above-average results? Or below-average results? Are we getting what we pay for? Does the value we receive equal or exceed the cost? Could we somehow get more for our money? 

If an individual is truly unique because of special skills, duties, or spectacular results, then his or her compensation may need to be set by means other than comparability data. Some people are simply off-the-chart.

Please remember that executive compensation is a complex matter. To be fair, many factors must be considered. What appears to be unreasonable compensation may not be once all factors are considered. Rules of thumb can be dangerous. There is often an answer that is simple, and wrong. It usually takes expertise, thoughtful analyses, and judgment to arrive at reasonable compensation amounts for those with broad ranges of duties.

Note: This article is provided to stimulate discussion and not to give advice for any specific situation.

In determining reasonable compensation, the courts (and the IRS) have looked to a number of factors and have used various approaches over the years. Typically, the approach has been to apply from 5 to 12 (or more) factors to determine whether compensation amounts were reasonable. In recent years, the courts continue to use these factors; however, some courts, beginning with Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9^th Cir. 1983), have used the independent or “hypothetical” independent investor test as an important consideration in determining whether compensation is reasonable.

Under this test, compensation is presumed to be reasonable in amount if an independent investor in the company would still be receiving a reasonable return on his/her investment after the compensation was paid. If the return was reasonable in light of returns achieved by peer companies, then this suggests that the officer had not drained company profits as disguised compensation.

The independent investor test has been applied in different ways by the courts that have adopted the test. Calculating the company’s return on equity is a prime consideration. However, in any version of this test it is always important to determine what the hypothetical independent investor is looking for, i.e., dividends and immediate return or future growth of the company, or both. See Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 837 (7^th Cir. 1999).

Regardless of the degree to which the test is applied, the independent investor test is, at a minimum, an additional consideration to be taken into account in applying the multi-factor approach. See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5^th Cir. 1987).

For example, in evaluating the traditional factors involving the employee’s long hours, experience, effectiveness, and his/her responsibility for the success of the business, an independent investor would pay a higher salary to an employee where the factors were favorable and a lower salary where the factors were not. The courts that cite Elliotts for reliance on the independent investor test still recite the factors set forth in Elliotts and other cases in their analyses. See Labelgraphics, Inc. v. Commissioner, 221 F.3d 1091 (9^th Cir. 2000). In fact, the Court of Appeals in Labelgraphics, in upholding the opinion of the Tax Court, stated that “the Tax Court carefully applied the five-factor Elliotts analysis” in relation to what an independent investor would expect.

The 7^th and 2^nd Circuits have joined the 5^th and 9^th Circuits in endorsing and enhancing the role of the independent investor test. See Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7^th Cir. 1999); and Dexsil Corp. v. Commissioner, 147 F.3d 96 (2^nd Cir. 1998). Earlier, the 5^th Circuit had indicated its approval of the independent investor test.  See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5^th Cir. 1987).

In Exacto Spring, Judge Posner, writing for the 7^th Circuit, adopted the “pure” independent investor test and strongly criticized the use of “factors” in determining reasonable compensation. He stated that the multi-factor approach leaves “much to be desired -- being, like many other multifactor tests, redundant, incomplete, and unclear.” Judge Posner went on to say that analyzing the factors test “invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts.”

I am offering no opinions on methods in this article as each situation depends upon its own facts and circumstances.

Yes, according to at least one opinion published by the United States Tax Court.

In Allen L. Davis, et al v. Commissioner of Internal Revenue, T.C. Memo 2011-286, the Tax Court considered an unusual set of facts.  Allen Davis and his two adult sons were shareholders of an extremely profitable S corporation.  When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense.

The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis’ sons had agreed to the option grant and they had interests that were adversarial to those of their own father.  (There was strife among the family and there had been litigation amongst them.)

The ruling is distinguished because the court did not rely on the usual multi-factor approach, comparability data or the hypothetical investor test. Instead, Judge Kroupa decided that Mr. Davis’ compensation amount must have been reasonable since the other shareholders had agreed to it when the option was granted.  The opinion states, “The granting of the Allen Option was reasonable because it was not a one-sided bargain.”  In effect, the court relied on the other shareholders to determine whether the compensation was reasonable.

In May 2013, the Eleventh Circuit affirmed the Tax Court’s decision, allowing the company to deduct the $37 million as compensation.

By Stephen D. Kirkland, CPA, CMC, CFF

Yes, according to some published Tax Court cases, including Choate Construction Company, T.C. Memo. 1997-495.

My report and courtroom testimony highlighted the fact that the founder had worked for minimal pay in the first years of the business. In his published opinion, Judge John Colvin (who later became the Tax Court’s Chief Judge), agreed that catchup pay should be considered when determining reasonable compensation for the services of Millard Choate:

“An employer may deduct compensation paid in a year for services rendered in prior year.  Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 [8 AFTR 10901] (1930); R.J. Nicoll Co. v. Commissioner, 59 T.C. at 50-51. Respondent [the IRS] contends that petitioner's pay to Choate in 1992 did not include catch-up pay for 1990 and 1991. We disagree. Choate testified that his compensation for 1992 included catch-up pay for his services to petitioner before 1992. Choate received no pay in his first 6 months working for petitioner. Petitioner underpaid Choate in 1990 and 1991 to keep more cash in the company so that it could obtain surety bonds. Choate awarded himself a large amount of catchup pay in 1992, when petitioner had become successful.”

The court went on to say that catchup compensation can be paid soon after it was earned or more than ten years after it was earned:

“Respondent points out that cases permitting catchup pay because of past under compensation usually involve a substantial base period. See Lucas v. Ox Fibre Brush Co., supra (14 years); R.J. Nicoll Co. v. Commissioner, supra (13 years); Acme Constr. Co. v. Commissioner, T.C. Memo. 1995-6 (7 years); Comtec Systems, Inc. v. Commissioner, T.C. Memo. 1995-4 (12 years). Respondent concludes from this that a deduction for catchup pay is not available in a company's third year. We disagree. If a taxpayer otherwise qualifies, it may deduct catchup pay. The fact that petitioner could provide catchup pay quickly is another measure of Choate's success.”
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An incredible amount of value can be derived from a single idea or a single relationship.

Relationships can be powerful in industries where owners have regular contact with customers, referral sources, suppliers and/or employees. The owners may have many good relationships and have outstanding reputations in their industries. These relationships and reputations are valuable intangibles that are referred to as professional goodwill.

When determining the value of a business, it is common for valuators to distinguish between professional goodwill, which are assets of the owners, and enterprise goodwill, which are assets of the business. It is wise to also consider professional goodwill when determining the value of the owner’s services. This may be a reason why reasonable compensation for one person should be toward the high end of the range.

For some businesses, such as professional service firms, it can be especially difficult to separate the professional goodwill from the enterprise goodwill. The relationship between the owner and the business may be so close that they almost seem to be one. But we must estimate the value of the individual’s services separate and apart from the value of the business enterprise. And there are various ways to go about this. For example, David Wood recommended using a point-scoring method to allocate between the two types of goodwill, rather than concluding that all goodwill is professional or all is enterprise (“Goodwill Attributes: Assessing Utility”  by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007). Of course, the exact same process may not be best for all situations. Ideally, whichever process is used to distinguish between the two types of goodwill, it should be well thought out and explained in clear terms.

In analyzing whether a C corporation’s payments to shareholder-employees were compensation or “disguised” dividends, the Internal Revenue Service and courts consider whether dividends were paid by the corporations.

The Regulations say it is “likely” that a compensation payment is in fact a dividend distribution when excessive payments correspond to or bear a close relationship to the recipient’s stockholdings in the company.  Treas. Reg. § 1.162-7(b)(1) and 1.162-8.  On the other hand, the lack of relationship between a recipient’s stockholdings and the proportion of the payment received (compared to other shareholder-employees) has been considered as evidence of compensation.  But neither situation is conclusive.  See Kennedy v. Commissioner, 671 F.2d 167, 175 (6^th Cir. 1982). 

The fact that a C corporation paid (or did not pay) a dividend is not solely determinative of whether shareholder-employee compensation was actually a disguised dividend.  The Service does not argue that the lack of dividend payments, irrespective of other factors, must result in a determination of some amount as a disguised dividend.  In Rev. Rul. 79-8, 1979-1 C.B. 92, the IRS said that “deductions for such compensation under section 162(a) of the Code will not be denied on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock.”  The Ninth Circuit rejected the automatic dividend rule in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1244 (9th Cir. 1983).

However, the IRS often considers a company’s dividend history when selecting companies for audit on the unreasonable compensation issue. Therefore, owners of profitable C corporations should remember that the lack of any dividends may be a “red flag.”  Some companies have, however, successfully rebutted a disguised dividend argument even though they had paid little or no dividends.  They did so by showing legitimate business reasons for paying minimal or no dividends, such as the need for funds for future growth of the business or capital improvements.

Under Internal Revenue Code section 404(c), plan sponsors have fiduciary responsibilities to protect the interests of the participants.  Among these responsibilities is an obligation to ensure that fees charged to participants’ accounts are reasonable.  This includes fees charged by investment managers, auditors, attorneys, advisors, and others.

In recent years, high-profile lawsuits were filed against plan sponsors, alleging that these companies allowed unreasonable fees to be charged by investment managers.

A second but related issue involves advisors who recommended certain investment managers and then benefited from revenue-sharing arrangements with those investment managers.

The sponsors’ fiduciary obligations to the participants require that the sponsors always have the participants’ best interests in mind.

On February 3, 2012, the U.S. Department of Labor issued final regulations under Section 408(b)(2) of the U.S. Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  These regulations, which became effective July 1, 2012, require service providers to disclose their fees to the plan sponsor.  Although much of the burden may be on the service providers and not the sponsors, plan sponsors should ask themselves this question: What process do we have in place to ensure that we receive the information that service providers are required to provide us under Section 408(b)(2)?

Also, to avoid common issues which arise during IRS and DOL exams, please be sure your plan documents have been signed (the plan document must be executed for it to be a qualified plan).  Also, the summary plan document must match the terms of the plan.  And please be sure you read the plan documents at least annually to ensure that the terms of the plan are being followed.  These are simple steps but they seem to be overlooked by some sponsors.

Over the last twenty years, an increasing number of attorneys have contacted me about litigation among shareholders of closely held businesses.

Shareholders of closely held businesses in various parts of the United States are embroiled in litigation with each other over the amount of compensation that one or more of the shareholder-officers received.

These lawsuits seem to be increasingly common at professional service firms, including law firms, medical practices, and CPA firms. These disputes have also become common in both old economy and new economy businesses.  The older businesses may have been passed along to the second or third generations of the founders’ families. The new economy companies involve e-commerce or intellectual property that has become valuable and the creators feel that they deserve compensation for work they did in the development stages.

In many of these cases, some of the shareholders may not have been aware of the compensation terms between their companies and the officers. Perhaps those terms were unwritten, or the officers were able to set their own bonus amounts.  Once other shareholders find out how much the officers were paid, they are often compelled to bring legal action against the officers, even though those officers may be their siblings, cousins, or long-time friends.

One of my professors used to say that there are no friends when it comes to money, and these cases illustrate what he meant.

This type of litigation quickly consumes considerable resources, including time and money. Customers and employees who are not directly involved in the disputes can also be affected.

By analyzing the officers' qualifications, duties, and accomplishments, I try to reach consensus by determining fair and reasonable compensation amounts for the officers. With some explaining, this may lead to a resolution of the matter.

Or, if given the opportunity early enough, we may be able to help prevent these disputes. To do so, we would need to clearly outline the duties and expectations of each officer, much the same way these companies may do with non-owner employees.  Each officer could be given goals with the potential for performance bonuses when the goals have been reached.  The idea is to create a win-win for all shareholders and all officers.  Get good results for the business - get a bonus.  Yet all too often these arrangements are not thought out, or agreed upon, in advance.  And when they are not, the business may become a "disruptor"...and not in a good way.

Thank you for visiting this website.  Information on this site is provided for discussion purposes only and should not be construed as advice for any specific situation.  Please seek wise counsel before making decisions.  Atlantic Executive Consulting does not provide legal advice or investment advice.

By Stephen D. Kirkland, CPA, CMC, CFC
Originally published in the September-October 2007 edition of Connector, the Institute of Management Consultants’ member newsletter.

Consultants in every field serve as expert witnesses to help judges and jurors understand complex issues in court cases. Many of these professionals have narrow niches, such as fingerprinting or handwriting analysis. Some specialize in broader fields, such as business valuations or, in my case, executive compensation and related financial issues.

So, what does it take to become an expert witness? There are several factors to consider before accepting that responsibility.

For example, an expert witness is usually hired and paid by an attorney representing one of the parties to a lawsuit. However, the witness must be able to remain objective, and not become an advocate for the plaintiff or the defendant. The truth must be told, no matter whose case is helped or hurt by it.

Extensive experience and formal training are necessary to gain the trust of the court. You may be asked to recite government regulations and definitions of words used in your field. You may be asked which publications you read to keep current.

During a deposition and court testimony, many detailed questions must be answered in ways that can be understood by jurors who have no experience in your field. An expert’s role is to explain and clarify complex issues so the judge and jury can do their jobs.

Your lifestyle and background must be able to withstand intense scrutiny. Before the trial, expect attorneys to closely examine your credentials, experience, training, and reputation. Expect them to know your credit rating, what bumper stickers you have on your car, where you were born, how much you paid for your house, and which organizations you have belonged to. They may ask, and you will answer under oath, questions about fun things like the prescription medications you take.

You must be able to remain composed during long hours of relentless questioning in depositions and courtroom testimony. Under cross-examination, the attorneys may do all they can to make you nervous and to say something foolish. It is critical to stay calm and focused throughout the deposition and trial.

Be flexible in your schedule. It is not uncommon to be engaged late in the process. Once you become involved in a case, you may need to peruse hundreds of documents in order to understand all the relevant facts. Ask a lot of questions. And be sure you have plenty of time to thoroughly research the issues and complete your analysis and form opinions in time to the meet the court’s deadline.

Court calendars are subject to change at any moment, and they expect you to be there when called. You must be ready to answer hundreds of questions about a report you wrote and submitted to the court months earlier.

So, why would anyone put themselves in this position? Very simply, because they have a great appreciation for our court system and enjoy the satisfaction of a job well done.