Normalizing Owner Compensation in Business Valuation for Disputes

Normalizing Owner Compensation in Business Valuation for Disputes

Executive Summary

Owner compensation is one of the most common (and most material) normalization adjustments in closely held business valuations. In disputes, owners can influence reported earnings by setting salaries, bonuses, and perks at levels that differ from market compensation for the work actually performed.

Normalization replaces discretionary or non-market pay with a reasonable compensation estimate supported by documents and objective benchmarks. Done correctly, it clarifies what the business can sustainably generate after paying for management—an input that often drives the value conclusion.

This guide explains when compensation normalization becomes contested, accepted methods used to support reasonable compensation, the documents needed to defend adjustments, common pitfalls opposing experts attack, and a numeric example that shows how the adjustment flows through to value.

Key point for disputes: the question is not whether compensation can be adjusted, but whether the adjustment is supported by the case record and applied consistently with the valuation standard and method.

Normalization can increase or decrease value depending on whether the owner was paid above or below market, and whether personal expenses were embedded in operating costs.

When This Issue Arises

Compensation normalization becomes contested when reported earnings are used to set a buyout price, allocate marital assets, calculate damages, or resolve partner and shareholder conflicts. The following situations are common:

• Minority shareholder and oppression disputes. Controlling owners can increase compensation (and run perks through the business) to reduce distributions and depress reported earnings, which can distort value conclusions in buyouts and damage analyses.
• Divorce and other family-law business interest disputes. Business values used for equitable distribution or support calculations are highly sensitive to discretionary owner pay and personal expenses embedded in operating costs.
• Buy-sell and partner exit disputes. When agreements do not clearly define how to treat owner compensation, parties often disagree on whether earnings should reflect the incumbent owner’s pay choices or market compensation for the role.
• Tax-driven compensation disputes. The characterization of payments as wages versus distributions (or vice versa) can become a dispute driver, and valuation analyses may need to separate compensation from returns on ownership.

Across these matters, disputes often center on (1) what the owner actually did day-to-day, (2) whether non-cash perks were effectively compensation, and (3) whether the opposing side’s benchmark data is truly comparable to the subject company’s size, industry, and geography.

Accepted Methods / Frameworks

A defensible normalization adjustment starts by identifying the owner’s total economic compensation, then estimating reasonable compensation for the work performed, and finally adjusting the financial statements consistently (including related payroll taxes/benefits when applicable).

In litigation, the best analyses are transparent: they show the inputs, connect them to the case record, and demonstrate that the adjustment is not double-counting items already captured in cash flows, discount rates, or valuation multiples.

In practice, compensation normalization is usually performed before selecting or applying valuation multiples (or capitalization rates). That ordering matters: if earnings are adjusted after multiples are applied, the analysis can become opaque and easier to challenge.

Step 1: Identify total owner compensation (cash + perks)

Normalization should start with the complete economic package, not just payroll wages. Owners may receive value through multiple channels that are scattered across the general ledger.

• Base salary and wages (W-2 or payroll registers)
• Bonuses and incentive pay (including discretionary year-end bonuses)
• Employer-paid benefits (health insurance, retirement contributions, HSA contributions)
• Perquisites and personal expenses run through the business (vehicle, travel, meals/entertainment, club dues, personal cell phone, personal insurance)
• Payments to related parties that function as compensation (family members on payroll; management fees to related entities)

Common red flags include unusually high travel and meals/entertainment, recurring “auto” or “insurance” expenses tied to personal assets, and vendor payments that appear to benefit the owner personally. In disputes, these items should be traced to invoices and receipts where available so the adjustment can be defended on evidence rather than assumptions.

Step 2: Estimate reasonable compensation using objective benchmarks

Reasonable compensation is typically supported with more than one method. Common frameworks in dispute valuations include:

**Market approach (salary surveys and labor market data).** Compare compensation for similar roles by industry, company size, and geography. This is typically the starting point when the owner’s duties resemble a recognizable executive/manager role.

**Replacement cost / “many hats” approach.** For small businesses where the owner performs multiple functions (sales, operations, finance, HR), break the role into components, estimate market pay for each function, and weight by time spent.

**Investor return reasonableness check.** Evaluate whether compensation leaves a sustainable return for ownership after paying market compensation for management. This is a reasonableness test—not a substitute for market data—when pay appears extreme relative to the business’s size and performance.

Company-specific factors often affect where within a benchmark range the conclusion should fall. Examples include:

• Whether the owner is full-time or part-time in the business (and what functions are delegated to other managers)
• The complexity of operations, regulatory environment, and the owner’s unique technical qualifications (licenses, certifications, specialized experience)
• Whether the business relies heavily on the owner’s personal relationships or reputation (key-person dependence)
• The extent to which profits reflect a return on ownership versus compensation for labor (especially in professional practices)

In litigation, it is usually more defensible to show a reasonable compensation range and then explain the selected point within that range using documented facts (duties, hours, complexity), rather than presenting a single number without context.

Step 3: Record the normalization adjustment consistently

Once reasonable compensation is estimated, the adjustment should be recorded in a way that matches the valuation’s benefit stream (e.g., EBITDA, pretax income, after-tax cash flow).

• Adjust the income statement line item (e.g., officer compensation) to market compensation.
• Adjust related employer-side costs that move with compensation (payroll taxes/benefits) when the benefit stream includes those expenses.
• Keep treatment consistent across years (avoid “one-year only” fixes unless the facts support a one-time anomaly).
• Document the rationale and the data source for each input (role description, time allocation, benchmarks, and any company-specific factors).

Entity type can influence how compensation is reflected in the financials. For example, in pass-through entities, owners may take a mix of wages and distributions. In disputes, the valuation analysis typically focuses on economic reality—what the business must pay for management—rather than the label assigned to payments for tax reporting purposes.

Numeric example: excess compensation normalization and valuation impact

Assume the valuation uses EBITDA as the benefit stream and applies a 4.5× multiple.

Reported EBITDA (after owner compensation) is **$500,000**.

Included in expenses is owner compensation of **$350,000**.

Based on documented duties and benchmark data, reasonable compensation is **$200,000**.

**Step A — Compensation adjustment:**

Reduce compensation expense by **$150,000** ($350,000 − $200,000).

**Step B — Related employer costs (illustrative):**

Assume employer payroll taxes/benefits attributable to wages are **8%** of compensation for illustration.

Payroll taxes/benefits reduction = **$150,000 × 8% = $12,000**.

**Step C — Normalized EBITDA:**

Normalized EBITDA = $500,000 + $150,000 + $12,000 = **$662,000**.

**Step D — Indicated value impact (multiple method):**

Value impact = ($662,000 − $500,000) × 4.5 = $162,000 × 4.5 = **$729,000**.

Result: Under these assumptions, excess owner compensation understated the indicated value by **$729,000**. In an actual case, the employer-cost rate and tax treatment depend on facts (wage base, benefits, entity type, and the valuation’s definition of the benefit stream).

Undercompensation can move value in the opposite direction. For illustration:

Assume reported EBITDA is **$700,000**, and owner compensation expense is **$120,000**.

Reasonable compensation is supported at **$220,000**.

Compensation increase needed = $220,000 − $120,000 = **$100,000**.

Assume employer payroll taxes/benefits at **8%** for illustration: $100,000 × 8% = **$8,000**.

Normalized EBITDA = $700,000 − $100,000 − $8,000 = **$592,000**.

If the multiple is 4.5×, indicated value impact = ($700,000 − $592,000) × 4.5 = $108,000 × 4.5 = **$486,000** decrease.

Documents & Data Checklist

A compensation normalization adjustment is only as strong as the documents supporting it. The following checklist focuses on items that most often matter in dispute settings.

• Owner/manager role documentation (job description, responsibilities, decision authority)
• Time allocation evidence (time logs, calendars, contemporaneous emails, or other corroboration of duties performed)
• Payroll registers and W-2/1099 records (including bonuses and other variable pay)
• General ledger detail for officer compensation and owner-related expense accounts
• Expense detail for perquisites (vehicle, travel, meals/entertainment, club dues, personal insurance, personal cell phone, etc.)
• Benefits and retirement plan records (employer contributions, premiums paid, fringe benefit policies)
• Financial statements for 3–5 years (income statement, balance sheet, and—if available—monthly detail)
• Tax returns for the same period (to reconcile reported wages/distributions and validate classification)
• Governing documents and agreements that affect compensation or distributions (employment agreements, shareholder/operating agreements, buy-sell provisions)
• Third-party benchmark support used for reasonable compensation (salary surveys, labor market data, and any industry-specific studies)

Common Pitfalls + Rebuttal Strategies

Opposing experts typically attack compensation normalization on support, consistency, and methodology. The items below are common failure points and practical rebuttal angles.

Pitfall: Treating owner pay as whatever the owner “decides” it should be

Rebuttal: Tie compensation to the work performed and objective benchmarks. Emphasize documented duties, time allocation, and the market data chosen (including why it is comparable).

Pitfall: Ignoring perks and personal expenses embedded in operating costs

Rebuttal: Identify total economic compensation by tracing owner-related expense accounts in the ledger and substantiating which items are personal versus business. Show the adjustment is captured once (and not double-counted elsewhere).

Pitfall: Cherry-picking salary data or using non-comparable benchmarks

Rebuttal: Use multiple sources when possible, explain the selection criteria (industry, size, geography, role scope), and disclose ranges—not just point estimates—then justify where within the range the conclusion falls.

Pitfall: Making the adjustment but not adjusting related employer-side costs

Rebuttal: If the benefit stream includes payroll taxes/benefits, adjust them consistently with the compensation change and show the arithmetic.

Pitfall: Inconsistent treatment across years or ignoring known anomalies

Rebuttal: Use a multi-year view to show trends, identify one-time items, and explain why any single-year deviation is (or is not) a normalization item.

Pitfall: Double-counting compensation risk already embedded in the valuation model

Rebuttal: Reconcile the normalization adjustment to the valuation method and demonstrate that the same economic factor is not being captured again through discount rates, multiples, or separate discretionary expense adjustments.

Cross-examination commonly targets the following questions (and the workpapers behind them):

• What specific documents prove the owner’s duties, hours, and decision authority?
• Which benchmark sources were considered and rejected, and why?
• How was company size and geography handled in the comparables selection?
• Were perks identified from the ledger and substantiated, or assumed?
• Is the payroll tax/benefit effect treated consistently with the chosen benefit stream?
• Does the valuation method already capture the same economic factor elsewhere (double-counting)?

FAQ

What does “normalizing owner compensation” mean in a valuation dispute?

It means adjusting reported earnings so owner pay reflects reasonable, market-based compensation for the work performed, rather than discretionary pay choices that can distort profitability.

How does excess owner compensation affect business value?

Excess compensation reduces normalized earnings and cash flow. Because many valuation methods capitalize or multiply earnings, even a moderate pay adjustment can materially change the value conclusion.

What counts as owner compensation beyond salary?

In closely held businesses it can include bonuses, employer-paid benefits, and perquisites such as vehicles, travel, meals/entertainment, club dues, and other personal expenses paid by the business.

How do valuation professionals estimate reasonable compensation?

Common approaches include market benchmark data (salary surveys and labor market data), a replacement-cost “many hats” analysis for multi-role owners, and reasonableness checks against business performance and returns.

Should payroll taxes and benefits be adjusted too?

Yes, when those costs move with compensation and the valuation benefit stream includes them. The adjustment should be recorded consistently and the math should be shown.

Why is compensation normalization frequently challenged in litigation?

Because it is often one of the largest adjustments affecting earnings and value. Challenges usually focus on comparability of benchmarks, completeness of perks identified, and whether the adjustment is consistent with the valuation method used.

Sources

• AICPA — Statement on Standards for Valuation Services (SSVS No. 1 / VS Section 100)
• IRS — Fringe Benefits Audit Technique Guide
• U.S. Bureau of Labor Statistics — Occupational Employment and Wage Statistics (OEWS)
• Robert Half — Salary Guide (Accounting & Finance benchmarks)
• IRS — Reasonable Compensation (various IRS guidance and training materials for closely held entities)

Contact the team at Joey Friedman CPA PA to discuss your business valuation needs.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. Outcomes depend on specific facts and circumstances.