The status of the "independent investor" test in reasonable compensation determinations.

• Author: Friske, Karyn Bybee

Recently, the circuit courts have been grappling with the issue of reasonable compensation in the case of small, closely held businesses. So far, the Second, Fifth, Sixth, Seventh and Ninth Circuits have weighed in with decisions. Although most circuits use a variety of factors in determining reasonableness, one factor, the independent investor test, has recently gained added importance. This article examines cases in the various circuits and offers planning guidance.

The issue of reasonable, compensation has long plagued the courts.(1) The IRS rarely questions compensation deductions of public companies. However, for closely held corporations whose shareholders are also employees, the IRS may disallow the compensation paid as unreasonable and treat the disallowed portion as a dividend.

The determination of whether compensation is reasonable depends on the facts and circumstances. However, through the years, the courts have established a number of factors to consider in determining reasonableness. These factors continue to evolve; different courts use them in different ways.

An increasingly important factor considered by the courts is the perspective of a hypothetical independent investor in assessing the reasonableness of compensation. Different courts have varied interpretations of this "independent investor" test. Some courts have applied the test as one of several factors; others have used it as a "lens" through which the other factors are viewed.

Recently, the Seventh Circuit used the independent investor test in lieu of the multi-factor test. In Exacto Spring Corp.,(2) the Seventh Circuit rejected the Tax Court's determination that compensation was unreasonable. Reversing the Tax Court's decision, the appellate court claimed that the multi-factor test the Tax Court used was "redundant, incomplete, and unclear" and that it should have used the independent investor test. Using that test, the Seventh Circuit concluded that the compensation paid to Exacto's chief executive and majority stockholder was reasonable.

Exacto Spring

Exacto Spring Corp. was a closely held corporation that manufactured precision springs. At issue was the salary paid in 1993 and 1994 to William Heitz, its co-founder, chief executive and principal owner. Exacto paid Heitz $1.3 million in 1993 and $1 million in 1994, which the IRS deemed excessive. According to the IRS, only salaries of $381,000 for 1993 and $400,000 for 1994 were reasonable and deductible. Exacto challenged the IRS's assessment in Tax Court. The Tax Court, relying on a seven-factor test previously used by the Seventh Circuit in Edwin's, Inc.,(3) found that $900,000 for 1993 and $700,000 for 1994 represented reasonable compensation. These amounts were about halfway between the IRS figures and the actual compensation paid.

Exacto appealed to the Seventh Circuit. That court strongly criticized the Tax Court's multi-factor approach, for the following reasons:

1. It was nondirective; some factors were vague and there was no indication of how the factors should be weighed.

2. The factors did not relate to each other or to the primary purpose of Sec. 162(a)(1).

3. The test invited the Tax Court to set itself up as a superpersonnel department for closely held corporations (i.e., judges are not trained to determine corporate executives' salaries).

4. It invited arbitrary decisions, as evidenced by the Tax Court's splitting the difference between the IRS amounts and the actual salaries paid.

5. The unpredictability of the Tax Court's decisions regarding reasonable compensation causes closely held corporations to run unavoidable risks.

   The Seventh Circuit concluded that the Tax Court's reasoning under the multi-factor test failed to support its ruling. The appellate court basically threw out the multi-factor test and, instead, applied the independent investor test, which relies on return to investors. Although it cited other circuits (as discussed below) as initiating the idea of using the independent investor test as the "lens" through which to view the multi-factor test, the Seventh Circuit proclaimed that the independent investor test actually "dissolves the old [test] and returns the inquiry to basics." The court concluded that the Exacto compensation was reasonable based on the return a hypothetical investor would expect to earn. Because Heitz generated a sufficiently high rate of return on equity (ROE) to satisfy an independent investor, the salary paid to him was "presumptively" reasonable.

   Although the court's approach seems to put a new spin on the independent investor test, some of the Exacto facts may have warranted such a decision. There were two other 20% owners who approved Heitz's salary; neither had incentive to disguise a dividend as salary. Thus, the compensation expense was bona fide.

   Tax Planning Strategies

   Because Exacto represents a new use of the independent investor test, tax. advisers in the Seventh Circuit should plan with caution. Although that court appeared to rely solely on ROE to a hypothetical independent investor and criticized the Tax Court's multi-factor test, a prudent taxpayer should consider the latter test when determining compensation. The Tax Court seemed particularly interested in the employee's contributions to the company in terms of hours worked, specialized expertise and performance of multiple roles. Salary information for comparable positions in similar companies was also important. However, the court disapproved comparing Heitz's salary to the aggregate salary of four full-time employees performing all of his tasks. The lack of a formal written employment contract with a compensation formula was also a problem. Even at the Tax Court level, the court was most interested in ROE...