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Robert P. Schweihs
Managing Director
Willamette Management Associates

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

There has been a lot written recently about the reasonableness of executive compensation. Why is this issue so high-profile, and is this issue primarily of concern only to public corporations?

One reason this issue is so high-profile is the publicity surrounding recent corporate scandals, including the perceived abusive compensation practices at many publicly traded companies. Shareholders are understandably concerned. In addition, the Internal Revenue Service (IRS) in recent years has aggressively challenged (1) the deductibility of “excessive” executive compensation for closely held C corporations and (2) the avoidance of payroll-related taxes by S corporations due to unreasonably low executive compensation.

There are many reasons why reasonableness of executive compensation is of concern to both public and privately held corporations. This is also an important topic to the boards of directors of not-for-profit organizations related to private inurement issues.

What are some of those reasons?

For a privately held corporation (either an S corporation or a C corporation), the reasonableness of executive compensation is of interest principally to the IRS. For the closely held S corporation, the IRS is typically concerned with whether shareholder/employees are paid an unreasonably low level of executive compensation. This is because unreasonably low levels of S corporation shareholder/employee compensation are not subject to FICA, Medicare, FUTA, SUTA, and other compensation-related employment taxes. Instead of being paid reasonable levels of compensation, S corporation shareholder/employees often “pay” themselves by taking periodic S corporation income distributions. Since these income distributions do not qualify as wages, they are not subject to the above-mentioned employment taxes.

For the closely held C corporation, the IRS is typically concerned with whether shareholder/ employees are paid an excessive amount of executive compensation. The IRS is concerned with this compensation issue because:

1. reasonable amounts of compensation payment are a tax deductible expense of the C corporation, but
2. the excessive (or unreasonable) amounts of shareholder/employee compensation are often reclassified as nondeductible dividend payments.

How about for publicly traded corporations?

For a publicly traded corporation, however, the IRS has little interest in the reasonableness of the executive compensation paid. This is because the compensation payments made to public corporation executive officers are almost always taxable to the employees (ignoring timing issues), and the compensation payments made to public corporation executives are almost always deductible to the corporation (ignoring timing issues).

The IRS typically concludes that the executive officers of a public corporation cannot set their own compensation. This is typically true even if the executive is also a significant shareholder of the public corporation. This is because executive officers are ultimately responsible to the board of directors (and particularly to the board compensation committee) with regard to compensation matters. And, the public corporation board of directors is ultimately responsible to the shareholders. Therefore, unlike in a closely held corporation where shareholder/employees often determine their own compensation levels, there is typically an independent review of the reasonableness of executive compensation (by the board directly and by shareholders indirectly) in a public corporation.

It is the public company directors who should be interested in whether or not the compensation of the corporate officers is reasonable. Of course, the shareholders should also be concerned that executives do not receive unreasonable levels of compensation. Shareholders should be concerned from both a corporate governance perspective and an economic self-interest perspective.

Obviously, shareholders are concerned that unreasonably high executive compensation payments result (1) in a dissipation of corporate assets and (2) less cash being available to pay shareholder dividends. And, corporate directors are concerned that the executive compensation plan motivates executives to act in a manner consistent with the shareholders’ long-term value appreciation objectives.

Lastly, not-for-profit institution directors are concerned that the IRS may conclude that their organization pays unreasonably high levels of executive compensation. The payment of excessive compensation to not-for-profit executives results in the private inurement of the organization’s funds. At the extreme, the organization could risk having its not-for-profit tax status revoked. Accordingly, the directors of such organizations often want independent assurance that they are not authorizing the payment of unreasonable levels of executive compensation.

What can a board member do to assure that the compensation paid to its senior executives is reasonable?

To minimize (or defend against) allegations of unreasonable executive compensation, corporate directors often rely on an objective, independent financial adviser to perform a reasonableness of executive compensation analysis.

An independent reasonableness of executive compensation analysis can help directors of closely held corporations with income tax concerns. This analysis can assist not-for-profit organization directors with regard to IRS concerns of private inurement. And, an independent reasonableness of executive compensation opinion can assist directors of public corporations with shareholder harmony, corporate governance, and Sarbanes-Oxley compliance concerns.

Independent reasonableness of executive compensation analyses (and the resulting independent financial adviser opinions) can assist public corporation, private corporation, and not-for-profit organization directors fulfill their responsibilities with regard to corporate governance, income taxation, and private inurement issues.

Robert P. Schweihs is managing director of Willamette Management Associates. He has performed the following types of valuation assignments: merger and acquisition appraisals, post-acquisition purchase price allocation appraisals, business and stock valuations, real estate valuations and evaluations, tangible personal property appraisals, real estate feasibility and investment analyses, ad valorem assessment appeal appraisals, construction cost segregation appraisals, insurance appraisals, litigation support, ESOP appraisals, forensic valuation analyses, and expert witness testimony. Schweihs is an accredited senior appraiser (ASA), certified in business valuation, of the American Society of Appraisers. He is also a Certified Business Appraiser with The Institute of Business Appraisers, Inc. He is also a former Trustee of The Appraisal Foundation. He holds a Bachelor of Science in Mechanical Engineering from University of Notre Dame and a Master of Business Administration, Economics and Finance from the University of Chicago, Graduate School of Business.