Exacto Spring Corp. breaks new ground in reasonable compensation.

• Author: Lyden, George

A trend is emerging in reasonable-compensation decisions that should please executives of closely held corporations and clear up some of the murkiness that has clouded this area for years. In Exacto Spring Corp., the Seventh Circuit relied on an independent investor test in its finding that the salary paid to the CEO of a closely held business was reasonable. Although independent-investor analysis is nothing new, the extent to which the court emphasized it in Exacto plies previously uncharted waters.

In brief, the independent-investor test looks at a company's return on equity (ROE) to justify the compensation paid to a closely held business executive. A finding of reasonable compensation is supported if the ROE exceeds a level that would satisfy an independent investor. Alternatively, if ROE is low, the court may disallow compensation deductions to restore it to a more reasonable level. Use of the independent-investor test requires convincing evidence that the executive exercised a high degree of control over the company's success.

The subject of reasonableness is most frequently an issue for closely held businesses, in which executive compensation is normally determined by owners, rather than at arm's length by a board of directors. This lack of independence on the part of closely held business owners gives the IRS leverage to argue that such owners have the incentive to avoid tax by disguising dividends as compensation.

Traditionally, courts have employed various multi-factor tests to determine the reasonableness of compensation. These tests have varied significantly in size and scope from case to case. A classic example is the Sixth Circuit's decision in Mayson Mfg. Co., 178 F2d 115 (1949), which used the following nine factors: (1) the employee's qualifications, (2) the nature, extent and scope of the employee's work, (3) the size and complexities of the business, (4) a comparison of salaries paid relative to the company's gross and net income, (5) the prevailing general economic conditions, (6) a comparison of salaries with distributions to stockholders, (7) the prevailing rates of compensation for comparable positions, (8) the salary policy of the employer as to all employees and (9) the employee's salary history.

The independent-investor test emerged as one of the elements included in a traditional multi-factor analysis. In Elliotts, Inc., 9th Cir., 9/26/83, the court stated "if the bulk of the corporation's earnings are being paid...