Corporations can deduct salaries paid to executives. Shareholders who work for their corporation are happy to take high salaries because salaries are deductible to the corporation (reducing corporate tax) and taxable to the executive (one level of tax). Dividends are not deductible (two levels of tax). So there’s a natural incentive to recharacterize dividends as salary.
The IRS pushes back, arguing that “unreasonable” compensation is really a disguised dividend. For decades, courts applied a multi-factor test that was famously criticized as leaving “much to be desired.” In 1999, the Seventh Circuit offered a better way – the “independent investor” test – in Exacto Spring Corp. v. Commissioner, 196 F.3d 833.
The Seven-Factor Test and Its Problems
Judge Posner, writing for the court, cataloged the deficiencies of the traditional multi-factor test (which included factors like “type and extent of services rendered,” “scarcity of qualified employees,” “net earnings of the employer,” and “prevailing compensation paid to employees with comparable jobs”):
- The factors are vague and nondirective.
- No indication is given of how to weigh the factors.
- The factors invite the Tax Court to “set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts.”
- The test “invites the making of arbitrary decisions based on uncanalized discretion or unprincipled rules of thumb.”
- Because the reaction of the Tax Court is unpredictable, “corporations run unavoidable legal risks in determining a level of compensation that may be indispensable to the success of their business.”
The case before the court illustrated the problem: the Tax Court had run through all seven factors, found that most favored the taxpayer, and then concluded that the compensation was unreasonable anyway – cutting the baby in half.
The Independent Investor Test
The Seventh Circuit adopted the “independent investor” test, which asks: Would an independent investor (a hypothetical shareholder) be satisfied with the return on investment after paying the compensation at issue? If the investor would still earn a reasonable return (adjusted for risk), the compensation is presumptively reasonable.
As the court explained: “A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner’s investment. The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command.”
In Exacto Spring, the taxpayer paid its co-founder and CEO, William Heitz, $1.3 million in 1993 and $1.0 million in 1994. The Tax Court found he should have been paid only $900,000 and $700,000 respectively. The Seventh Circuit reversed, noting that the investors (other shareholders) had approved the compensation and were earning a return of over 20% – far exceeding the 13% benchmark that the IRS’s expert considered reasonable.
The Presumption of Reasonableness
The court established a rebuttable presumption: “When, notwithstanding the CEO’s ‘exorbitant’ salary (as it might appear to a judge or other modestly paid official), the investors in his company are obtaining a far higher return than they had any reason to expect, his salary is presumptively reasonable.” The presumption can be rebutted by showing the return is due to factors other than the CEO’s efforts (e.g., an oil discovery under the factory) or that the company did not genuinely intend to pay the salary (i.e., it was a sham).
The government failed to rebut the presumption in Exacto Spring. The investors were happy, the return was excellent, and there was no evidence of bad faith.
Later Applications
The Seventh Circuit applied the independent investor test again in Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), where John Menard, founder and sole owner of a home improvement chain, paid himself $7.1 million in 1998. The return on equity was 18.8% – far above industry averages. The court found the compensation reasonable, noting that “if the return is extremely high, it will be difficult to prove that the manager is being overpaid.”
But in Mulcahy, Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d 867 (7th Cir. 2012), the court affirmed the Tax Court’s disallowance of deductions for “consulting fees” paid to shareholders of a law firm. The firm had negative return on equity; the independent investor would have earned nothing. The fees were clearly disguised dividends.
The Tax Court’s Resistance
The Tax Court has not uniformly adopted the independent investor test. In Clary Hood, Inc. v. Commissioner, T.C. Memo 2022-15, the Tax Court stated that it would apply the independent investor test only in cases appealable to a circuit that has adopt it. The Second, Third, Fourth, Fifth, Sixth, Seventh, Eighth, Ninth, Tenth, and Eleventh Circuits have not all clearly adopted it – but the trend is growing.
Section 162(m) and Publicly Held Corporations
For publicly held corporations, Section 162(m) imposes a $1 million deduction limit on compensation paid to certain covered employees (CEO, CFO, and the three other highest-paid executives). The Tax Cuts and Jobs Act expanded Section 162(m) to cover more employees and eliminated the “performance-based compensation” exception (except for grandfathered arrangements). For public companies, the independent investor test is largely irrelevant – the statute imposes a hard cap.
Practical Takeaways
For closely held corporations, the independent investor test offers a clear, objective standard. Instead of litigating over comparability studies and vague factors, the focus is on whether the investors are receiving a reasonable return. Documentation is key:
- Board minutes approving the compensation should reflect the director’s consideration of the company’s profitability and return on equity.
- Shareholder approval (especially from non-family shareholders) provides strong evidence of reasonableness.
- Compensation should be consistent over time; large spikes coinciding with profitable years invite scrutiny.
The Exacto Spring decision gave closely held businesses a strong weapon against IRS challenges. As Judge Posner noted, the multi-factor test was a mess – and judges are not qualified to determine what executives are worth. The market, through the return on investment, is a much better guide.
Disclaimer: This article provides general information for educational purposes only and does not constitute legal advice. Tax laws, judicial interpretations, and IRS guidance are subject to change at any time through legislation, regulation, or court decision. Readers should consult Alan Goldstein & Associates for advice regarding their specific factual situations.
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