An owner salary so large the deduction was never safe

The situation

A family-run commercial landscaping and snow-removal company came to market with reported EBITDA of $610,000 on $4,200,000 of revenue. Unlike the parent file this one forks from, where the founder drew nothing for five years, this founder paid himself a $340,000 discretionary bonus every December — roughly 56% of reported EBITDA in a single line item, on top of a modest base salary already reflected in cost of labour.

The buyer's quality-of-earnings team treated the bonus the way SDE and EBITDA normalization ordinarily treats an owner's discretionary compensation: not as a real operating cost, but as a number a new owner would set differently. A hired general manager doing the same job, benchmarked against comparable roles for a business of this size, came in around $130,000 — a deal-specific estimate the diligence file treated as a scenario input, not a published benchmark. The proposed add-back was $210,000: normalized EBITDA of $820,000, applied against the same multiple already under discussion.

The problem

Three weeks into diligence, the seller's accountant disclosed what the corporation's own books already showed: the Canada Revenue Agency had opened a reasonableness audit on the same bonus, covering the three most recent taxation years, after the founder's operating role had visibly narrowed once an outside general manager took over daily supervision two years earlier. CRA's working position was that $150,000 of each year's bonus — $450,000 across the three open years — exceeded what the founder's actual, reduced duties could support, and proposed to deny the deduction for the excess.

The buyer's model and CRA's audit were not asking the same question, and treating them as one issue would have understated the risk. The buyer's add-back asks what a rational new owner would pay someone to do this job going forward — a commercial, forward-looking judgment with no statutory test behind it at all, the same as the DSCR normalization in the parent file. CRA's audit asks whether the corporation's historical deduction for what it actually paid was reasonable in the circumstances — a backward-looking question with a real statute behind it, and one that does not care what a buyer's model assumes about future compensation.

The numbers

Reported EBITDA $610,000; oversized bonus $340,000; benchmarked replacement-manager cost $130,000; proposed add-back $210,000; normalized EBITDA $820,000 — a 34% increase feeding directly into the purchase-price multiple before a single dollar of tax exposure was discussed.

CRA's audit position covered three open taxation years at roughly $150,000 of disputed bonus each, $450,000 in total previously-deducted expense at risk of denial. If the corporation loses that deduction for those years, its taxable income for each of those years rises by the denied amount, and it owes additional corporate tax plus arrears interest on the shortfall — a liability that belongs to the corporation being purchased, not to the founder personally, because the founder already reported and paid personal tax on the full $340,000 received each year regardless of what the corporation can deduct.

The rule that decided it

There is no statute behind the buyer's add-back, exactly as there is none behind the lender's imputed-salary deduction in the parent file. There is a statute behind CRA's audit, and it is short: Income Tax Act s.67, marginal note “General limitation re expenses”: “In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.” Read the unit: the test does not ask whether the shareholder-employee was overpaid in some general sense. It asks whether the outlay is deductible to the corporation, and only to the extent reasonable.

That produces a mismatch, not a wash. Where CRA denies part of a salary deduction under s.67, the corporation's taxable income rises by the denied amount and it owes additional tax on it — while the shareholder-employee has already been taxed personally on the full amount received as employment income, with no corresponding relief. The same dollar is taxed twice, once to each party, and s.67 does nothing to prevent that; it simply decides what the corporation may deduct.

This is the axis the parent file's own compensation problem does not touch at all. There, no statute governs whether a lender's imputed replacement-manager salary is the right normalization — it is lending judgment, full stop. Here, whether $450,000 of what the corporation actually paid and actually deducted was reasonable is a question of law with a real answer, decided by comparable compensation, the value and scope of services actually performed, the corporation's profitability, and whether the payment served a genuine business purpose rather than simply shifting income — the CRA reasonableness factors, none of which the buyer's forward-looking add-back needs to satisfy and none of which it does satisfy.

The outcome

The parties kept the two questions separate rather than letting the audit contaminate the valuation discussion. The purchase price was built on the normalized $820,000 EBITDA — a commercially reasonable adjustment on its own terms, unaffected by whether CRA's audit ultimately succeeds. Separately, the buyer's tax advisors sized an escrow of $180,000, calibrated to cover the additional corporate tax and arrears interest if CRA's reassessment holds for the full $450,000, released to the seller once the audit closed with the seller retaining the right to contest CRA's position at its own cost.

What it would have cost otherwise

A buyer pricing the deal on the normalized $820,000 EBITDA without separately pricing the audit risk would have acquired a corporation carrying an unrecorded contingent tax liability of up to $450,000 in denied deductions, discovered only once CRA's reassessment landed after closing, with no seller left on the hook. Valuation and tax exposure look like one conversation — both start from the same $340,000 — and treating them as one would leave the risk sitting silently on the buyer's side of the table.

The tell

A large, irregular, year-end-only bonus to a working owner, paid at a size that has grown while the owner's actual day-to-day role has visibly shrunk, with no board resolution or documented rationale tying the amount to the work performed. That pattern is a live s.67 exposure sitting inside the target's own prior-year filings, not merely a normalization question for the buyer's model. Ask whether compensation has been reviewed against the role currently being performed, not just against what the role used to be.

Takeaways

• • ITA s.67 denies a corporation's deduction for an outlay or expense “except to the extent that the outlay or expense was reasonable in the circumstances” — it governs the corporation's own past deduction, not a buyer's forward-looking valuation judgment.
• • A s.67 denial creates a mismatch, not a wash: the corporation loses the deduction and owes more tax, while the shareholder-employee has already been taxed personally on the full amount received.
• • A buyer's positive EBITDA add-back for an oversized owner salary is a separate, statute-free commercial judgment from whether the corporation's own historical deduction for that salary was reasonable — treat them as two different questions, priced with two different tools.
• • A live CRA reasonableness audit on owner compensation is a contingent tax liability that belongs to the corporation being purchased — escrow or indemnify it separately from the valuation adjustment.
• • A multi-year pattern of large, irregular, year-end bonuses with no documented rationale is an s.67 flag in its own right, distinct from the nil-compensation flag the parent file describes.

Sources

• • Income Tax Act s.67 — “General limitation re expenses”, quoted in full above.
• • See the parent file this one forks from, which states plainly that no statute governs the buyer's own SDE/EBITDA normalization judgment — the contrast this file turns on.
• • Treadstone Law — reasonable salary for a shareholder-employee (CRA, Ontario) — on point here, unlike its citation in the parent file: it sets out the comparable-compensation, scope-of-services, profitability and business-purpose factors CRA weighs, though it does not cite s.67 by section number, which is quoted from the Act above.
• • The $130,000 replacement-manager benchmark, the $150,000-per-year audit position, and the $180,000 escrow are deal-specific figures agreed by the parties' own advisors, not published standards.