SEVENTH CIRCUIT ADOPTS NEW TEST FOR REASONABLE COMPENSATION

By Peter C. Barton

Arecent case in the Seventh Circuit dealt with the complex issue of reasonable compensation in a clearheaded way, and it will be interesting to see how other courts apply the results.

In Exacto Spring Corp. v. Comm'r [1999 US App. LEXIS 29988 (Nov. 16, 1999)], the Seventh Circuit, reversing the Tax Court, became the first court to abandon the decades-old multifactor test for determining reasonable compensation. Instead, the Seventh Circuit adopted the independent investor test. Chief Judge Richard Posner wrote the opinion.

IRC section 162(a)(1) allows a business to deduct "reasonable ... compensation for personal services actually rendered." Classification of payments as deductible compensation or nondeductible dividends is often problematic in closely held corporations, where ownership and management frequently coincide. Courts have used a multifactor test to determine reasonable compensation.

In Exacto Spring, the Tax Court used the following factors:

* Type and extent of services the employee performed,
* Scarcity of qualified employees,
* Qualifications and prior earnings of the employee,
* Employee's contribution to the business,
* Employer's net earnings,
* Compensation paid to employees with comparable jobs at similar companies, and
* Peculiar characteristics of the employer's business.

Exacto Spring Corporation manufactured precision springs; its CEO (also 55% owner) was responsible for every phase of Exacto's success. In 1993­1994, his compensation averaged $1.15 million per year, but the IRS allowed approximately $390,000. The Tax Court found that the factors either favored the CEO or were neutral, yet ruled that compensation approximately midway between these numbers was reasonable. In reversing this decision, the Seventh Circuit ruled that the multifactor test "does not provide adequate guidance to a rational decision" due to the following four problems:

* The test does not specify how the factors should be weighed, and some of the factors are vague.
* The factors do not clearly relate to each other or the purpose of IRC section 162(a)(1), which is to prevent dividends from being disguised as salary.
* The test invites the Tax Court to inappropriately become a super-personnel department.
* Consequently, the test leads to arbitrary decisions.

The Seventh Circuit then adopted the independent investor test: The higher the risk-adjusted rate of return on investment (equity) that a manager generates, the greater the reasonable compensation can be. In Exacto Spring, the industry benchmark was 13%, and Exacto Spring earned 20%. The CEO's salary was therefore "presumptively reasonable."

On different facts, the IRS could rebut this presumption by showing, for example, that the CEO was merely a figurehead, that Exacto Spring's return was due to passive income, or that the company intended that the CEO's salary include a concealed dividend. However, approval of the salary by Exacto Spring's 40% minority nonemployee shareholders indicates no dividend was intended.

Although the reasoning in Exacto Spring is persuasive, how courts will apply the independent investor test in future cases is uncertain. Will the courts need information to apply the test that reintroduces the factors? Finally, will the second and other circuits adopt the test? *

Peter C. Barton, MBA, JD, CPA, is a professor of accounting at University of Wisconsin­Whitewater.

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