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The Status of the “Independent Investor” Test in Reasonable Compensation Determinations 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. Karyn
Bybee Friske, Ph.D., CPA Darlene
Pulliam Smith, Ph.D., CPA For more information about this article, contact Dr. Smith at (806) 651-2525. Executive Summary
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 information. Presumably, the Tax Court will eventually follow the Seventh Circuit's lead. However, until then, taxpayers should maintain good supporting documentation as to the seven factors, in addition to strong support for the independent investor test. Primary emphasis should be on the ROE to a hypothetical independent investor. Companies should consider a written compensation formula that allows for an average (or above-average) ROE. Of course, evidence must be gathered as to average return.
Strategies for Other Courts As might be expected, the issue of reasonable compensation has been examined in other circuits. A related issue is whether compensation paid is a bona fide expense and not a dividend. Although there may be some common threads, each case is different, because the facts and circumstances vary. Some courts follow a multi-factor approach; some follow a version of the independent investor test. The trend for circuit courts seems to be the independent investor approach. Presently, as illustrated in Exhibit 1, the Second, Fifth, Sixth, Seventh and Ninth Circuits use some form of the independent investor test in analyzing reasonableness of compensation.
Second Circuit In the Second Circuit, the independent investor test has not been considered a separate autonomous factor, but rather, a lens through which the entire analysis should be considered.4 In Dexsil,5 the court found the Tax Court's failure to assess the reasonableness of an executive's compensation from the perspective of a hypothetical or independent investor erroneous as a matter of law. An important factor in this circuit is the existence of a long-standing, consistently applied compensation formula. In Rapco,6 the company had a bonus formula with a cap, but disregarded it and paid its president a much higher amount. The Second Circuit was troubled by the taxpayer's "cavalier dismissal" of its corporate minutes that established the bonus formula. In Dexsil, the Second Circuit, remanding to the Tax Court, urged it to consider whether an informal, unwritten compensation formula had been consistently followed in both good and bad years. Other important factors for this circuit are payment of dividends, extensive detail on comparable salaries for similar multiple roles performed in comparable companies and demonstration of an extraordinary ROE. In this circuit, high ROE has been deemed an indication that an independent investor might approve of the compensation paid, but it is not determinative by itself. Although Rapco demonstrated a substantial ROE, other factors (e.g., disregard of the formula, the salary-light/bonus-heavy pay scheme and the lack of dividends) led the court to conclude that an independent investor would not approve the salary paid to the president.
Fifth Circuit This circuit's view of the independent investor test differs from that of the Seventh Circuit in Exacto; the Fifth Circuit recognizes that there are limits on reasonable compensation for even the most valuable employees. This contrasts with the Seventh Circuit's view that compensation is presumptively reasonable if investors are earning a higher-than-normal ROE. In contrast to the Second Circuit, the Fifth Circuit views the independent investor test as merely one of the factors to consider, rather than as a lens. The Fifth Circuit has noted that, in some cases, it could be a substantial factor.7 Although the Fifth Circuit has considered a sufficient ROE to be evidence of reasonable compensation, it has not been determinative. In Owensby & Kritikos, Inc.,8 the ROE was "impressive," but the court also considered other factors in determining the compensation that was reasonable. However, in Donald Palmer Co., Inc.,9 a negative ROE caused by a large bonus paid to the president-sole shareholder meant that an independent investor would not have approved such compensation. Strategies for companies in the Fifth Circuit include (1) use of a formal compensation formula, determined early in the business's existence, that allows for an average return; (2) payment of dividends (or valid business reasons why the company is retaining earnings); and (3) avoidance of one-time bonus payments or payments in direct proportion to stockholdings (which might appear to be a distribution of profits). Citing Owensby, the court stated in Donald Palmer that "limits to compensation exist even for the most valuable employees." Supporting data regarding compensation for comparable positions in comparable companies would be of value in this circuit.
Sixth Circuit Historically, the Sixth Circuit has considered the independent investor test as one of several factors to use in reasonableness analysis. Information regarding growth of the business and above-average ROE due to the efforts and expertise of the employee-shareholder have been important in this circuit. An above-average ROE may also help mitigate the problem of few or no dividends. In Alpha Medical Inc.,10 the court noted that use of a long-standing arm's-length compensation formula would have been upheld. Information on prevailing rates of compensation for comparable positions in comparable companies has also been an extremely significant factor in this circuit, but the positions must be truly comparable. Other job offers provide concrete evidence of an employee's value. Prior years' undercompensation has also been perceived as support for reasonableness.
Ninth Circuit In 1983, the Ninth Circuit was the first court to specifically mention the hypothetical independent investor, in Elliotts, Inc.11 The court mentioned that "it is appropriate to evaluate the compensation payments from the perspective of a hypothetical independent shareholder." In a 1998 case, Leonard Pipeline Contractors Ltd.,12 the court noted that "'reasonableness' of compensation seems to depend to a degree on the eye of the beholder." Is this similar to the Second Circuit's lens concept? Generally, the Ninth Circuit has followed the Elliotts factors, including the independent investor test. The taxpayer's demonstration of undercompensation in prior years and the lack of employee benefits (e.g., a retirement plan) have been important in this circuit. As in other circuits, an above-average ROE has been considered more important than a lack of dividends. Another influential factor has been the employee's contribution to the business's success in terms of hours worked, specialized expertise and multiple roles. Salary data for comparable positions in similar companies is accepted only if it is truly comparable. The lack of a long-standing, consistent compensation formula has been considered a negative factor. In addition, the court has looked unfavorably on salary-light/bonus-heavy compensation plans.13
Tax Court In many cases, the Tax Court has allowed larger deductions for compensation than has the IRS. Nevertheless, the Tax Court has been inconsistent in applying the independent investor test in cases involving reasonable compensation. At times, in circuits in which the appellate court has used the independent investor concept, the Tax Court has subsequently failed to use it. For example, in Ashare,14 the Tax Court recently determined that a sole shareholder's salary was deductible in full, because it was reasonable in amount and paid for services actually rendered. There was no mention of the independent investor test. The taxpayer's principal place of business is Michigan. The Sixth Circuit, which includes Michigan, has used the independent investor test. However, in Normandie Metal Fabricators, Inc.,15 the Tax Court followed the Second Circuit's factors and carefully considered them from the independent investor perspective. With more circuits considering the independent investor test in some manner, the Tax Court should follow this lead. Meanwhile, closely held companies must grapple with the uncertainty of the amount of compensation that is reasonable.
Documentation and Planning Although reasonableness of compensation depends on the facts and circumstances, some basic strategies may help establish the reasonableness of a corporation's compensation deduction. Most of the suggestions mentioned here are derived from the cases discussed above and other cases that have addressed the reasonableness issue. Because the burden of proving that compensation is reasonable is on the taxpayer, it is sensible to take some legitimizing precautions. 1. A compensation formula should be established early in the corporation's life and followed consistently in both good and bad years. A compensation plan that benefits only shareholders should be avoided, particularly if the bonus is proportional to stockholdings. 2. Corporate minutes should document the reasons for the compensation paid (including pay for prior years' services, incentive compensation arrangements or formulas) and for paying few or no dividends. The board of directors should be independent and include nonshareholders.16 3. Compensation for comparable positions in comparable organizations should be researched. The reasons why employees should earn more than those in similar companies should be documented, as should the details of job offers from similar companies, to help substantiate the compensation paid. 4. Compensation should not be paid to shareholder-employees in proportion to their stockholdings. This is a "red flag" to the IRS that this is actually a dividend (i.e., a distribution of earnings, rather than compensation). The corporation will lose the deduction; the income will be subject to double taxation. 5. If the corporation is profitable, some dividends should be paid, unless there is justification to retain earnings in the business (and those reasons should be documented in the corporate minutes). 6. The payment of compensation should be spread throughout the year, rather than paid at year-end. Although incentive compensation arrangements may be dependent on end-of-year results, some compensation should be paid during the year. A single large payment at the end of the year may appear to be a distribution of earnings (and, thus, a dividend), rather than deductible compensation. 7. Given the courts' recent interest in ROE to a hypothetical independent investor, a closely held company should keep track of its ROE as compared to similar businesses and compensate executives accordingly. If the company uses a compensation formula, it should allow for a reasonable ROE. 8. The factors deemed important by the court in the relevant circuit should be reviewed. 9. Court decisions involving reasonable compensation should be monitored. 10. Compensation should be reasonable and substantiated. If the IRS challenges compensation and the corporation decides to take the issue to court, zealousness should be restrained. In O.S.C. & Associates, Inc.,17 although decided on other issues, a dissenting opinion states, in footnote 2:
The key is advance planning and recognizing that the IRS may question the reasonableness of compensation. It is easier to maintain current documentation as to reasonableness than to have to establish it three or four years after the fact.
Conclusion The issue of reasonable compensation is uncertain for closely held companies. Each situation turns on the facts and circumstances and jurisdiction. The best advice is to plan, follow the suggestions mentioned and be reasonable. |
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