Seven-factor test for reasonable compensation was not valid.

• Author: Fiore, Nicholas J.

H was the cofounder, chief executive officer (CEO) and principal owner of the T Corporation. In 1993 and 1994, T paid H$1.3 and $1 million, respectively, in salary. The IRS found these amounts excessive and assessed a deficiency based on the disallowance of the excess compensation. Based on the traditional seven-factor test, the Tax Court found H's reasonable compensation to be roughly midway between his actual compensation and the Service's determination.

The Court of Appeals (opinion Posner, Chief Judge) reverses; the seven-factor test applied by the Tax Court was unclear and incomplete.

The Tax Court applied a test that requires the consideration of seven factors, none entitled to any specified weight relative to another:

1. Type and extent of the services rendered;

2. Scarcity of qualified employees;

3. Qualifications and prior earning capacity of the employee;

4. Contributions of the employee to the business venture;

5. Net earnings of the employer;

6. Prevailing compensation paid to employees with comparable jobs; and

7. Peculiar characteristics of the employer's business.

This test leaves much to be desired. To begin with, it is nondirective. No indication is given of how the factors are to be weighted in the event they do not all line up on one side. And many of the factors (such as the type and extent of services rendered, the scarcity of qualified employees and the peculiar characteristics of the employer's business) are vague.

Second, the factors do not bear a clear relationship either to each other or to the primary purpose of Sec. 162(a)(1), which is to prevent dividends (or in some cases gifts) that are not deductible from corporate income from being

disguised as salary, which is.

Suppose that an employee, like H, a founder and the CEO and principal owner of T, rendered no services at all but received a huge salary. It would be absurd to allow the whole (or, for that matter, any part of his salary) to be deducted as an ordinary and necessary business expense, even if he were well qualified to be the company's CEO, the company had substantial net earnings, CEOs of similar companies were paid a lot and it was a business in which high salaries were common. The multi-factor test would not prevent the Tax Court from allowing a deduction in such a case, even though T obviously was seeking to reduce its taxable income by disguising earnings as salary. The court would not allow the deduction, but this had nothing to do with the...