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Exacto Spring Corp. breaks new ground in reasonable compensation.

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 out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder's equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement." The Elliotts court found that the taxpayer's average 20% ROE would be sufficient to satisfy a hypothetical independent investor, and that this was one factor (among others) that pointed in the taxpayer's favor.

The next step in the evolution of the independent-investor test is reflected in two decisions from the Second Circuit. In both RAPCO, Inc., 85 F3d 954 (1996) and Dexsil Corp., 6/3/98, the court rejected the view that the test should be regarded as merely one component of the traditional multi-factor analysis. As stated in Dexsil, "the independent investor test is not a separate autonomous factor; rather, it provides a lens through which the entire analysis should be viewed." The appellate Dexsil decision also recognized the emergence of the independent-investor test as a required part of the reasonable compensation analysis, stating that the "Tax Court's apparent failure to consider [the taxpayer's] compensation from the perspective of an independent investor was legal error."

Exacto takes reasonable compensation litigation to a new level, disregarding entirely the Tax Court's traditional multi-factor analysis in favor of a "much simpler and more purposive test, the `independent investor' test." Referring to RAPCO and Dexsil, Exacto states "the cases we have just cited prefer to say ... that the `independent investor' test is the `lens' through which they view the seven (or however many) factors of the orthodox test. But that is a formality. The [independent investor] test dissolves the old and returns the inquiry to basics." There was no dispute in Exacto as to whether the CEO exercised a high degree of control over the company's destiny. This, together with the court's finding that the company's ROE exceeded 20% in both of the years at issue, led the court to conclude that the CEO's pay was reasonable.

The beauty of the independent-investor test is that it is far more objective than the traditional multi-factor approach, which has yielded some extremely arbitrary and inconsistent decisions. The issue of what constitutes "reasonableness" will never be an exact science, but the emergence of the independent-investor test, as employed in Exacto, is a step in the right direction.

FROM GEORGE LYDEN, NEW YORK, NY
COPYRIGHT 2000 American Institute of CPA's
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Author:Lyden, George
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 2000
Words:785
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