Excessive Compensation: What to do when the co-owners of your business pay themselves excessively

Transcript

This is the Good Guys’ Guide to the dark art of ripping off your business partners. And today we’re going to talk about one of the most prevalent and basic ways that a controlling owner can rip off the passive or minority owners in a closely held business: excessive compensation. We’re gonna talk about what it is, how you can recognize it, and what you can do to stop it.

[0:17] In particular, I spend a lot of time representing business owners in disputes with their business partners. As part of my job, I see a variety of ways in which one business owner tries to rip off another business owner and I want to share some of those with you not so that you can use them on your business partners so that you are better able to recognize them when they’re happening and hopefully prevent them before they do.

One that often happens is using excessive compensation to rip off your business partners. And the typical situation goes something like this: You have a majority owner who controls the company legally and can set his salary and those of other employees. He sets the salary for himself at an excessively high level, and as a result there’s no profits left at the end of the year to be distributed out to the owners of the business. In other words, he takes it all out as an expense line, and nothing hits the retained earnings on your Profit & Loss at the end.

[1:53] So how do you know if compensation is excessive? There’s no bright-line rule, but in the context of litigation, what we would typically do is we would hire a forensic accountant or business valuation specialist who has access to databases on compensation structures for employees or officers in various industries. So for example, our expert witnesses typically have access to a database that aggregates information from tax returns showing officer compensation. So their database might show something like a manufacturing company that manufactures plastic in New York state with gross revenues of 10 million dollars and 20 employees, the CEO of such a company makes $150,000 a year. If you are in a similar business to the one in the database, and the CEO of your company who’s the controlling shareholder, and the controlling owner is paying themselves half a million dollars a year, you have a pretty good argument that he or she is paying themselves excess compensation to the tune of $350,000 per year.

[3:16] Now what if you are a controlling owner and you want to pay yourself a reasonable salary, and you’re not trying to rip off your business partners, you just want some certainty that whatever you’re paying yourself isn’t going to comeback and bite you later in the form of a lawsuit claiming that you’re ripping off your business partners? Well, it’s really very easy: Disclose your compensation to the other owners, and have them sign off on it. Have them approve it in writing, and once they’ve done that they can’t turn around and later claim that it’s excessive compensation.