A recent Seventh Circuit opinion may have opened the door for more aggressive compensation planning, particularly for key employees of closely held businesses.

Many businesses organized as C corporations pay owners and other key employees the highest "reasonable" compensation possible, in order to maximize corporate level deductions and minimize the "double tax" effect of being a C corporation. In response, the IRS often challenges the "reasonableness" of the deduction for compensation paid to owners and key employees, particularly in the case of closely held businesses. The Tax Court has developed a seven-factor test for determining whether compensation is reasonable, which generally considers the following factors:

1. the type and extent of the services rendered;
   
2. the scarcity of qualified employees;
   
3. the qualifications and prior earning capacity of the employee;
   
4. the contributions of the employee to the business venture;
   
5. the net earnings of the employer;
   
6. the prevailing compensation paid to employees with comparable jobs; and
   
7. the peculiar characteristics of the employer's business.
   

Some courts have also considered an "independent investor test" when evaluating the reasonableness of compensation, usually as part of, or in addition to, the seven-factor test. The independent investor test considers the return on investment indicated by the increase in value of the corporation's stock along with dividends paid during the time periods in question. If a reasonable return is indicated by the increase in value and the dividends paid, an "independent" investor should be happy with the return on investment and would not object to the compensation paid to key employees. Historically, this independent investor test has only been applied as an additional factor to consider, rather than a substitute for, the factual seven-factor test.

In reversing the Tax Court, the Seventh Circuit recently rejected the traditional seven-factor test and relied solely on an independent investor analysis. See Exacto Spring Corp. v. Comm'r., 84 AFTR 2d ¶ 99-6977 (7th Cir. Nov. 16, 1999). In Exacto, the principal owner and CEO of a precision spring manufacturer was paid salary of $1.3 million in 1993 and $1 million in 1994. The IRS argued that only $381,000 and $400,000, respectively, would be reasonable for these years. Upon review, the Tax Court used the seven-factor test to "split-the-difference," determining that $900,000 for 1993 and $700,000 for 1994 were reasonable amounts.

The Seventh Circuit analyzed and expressly rejected the seven-factor test, specifically noting that the factors are vague, the application of the test is vague (how are the factors weighed if they indicate conflicting results?), and the factors do not clearly relate to each other or the purpose of Code Section 162 (avoiding dividends disguised as salary). In addition, the Seventh Circuit challenged the concept of the Tax Court substituting its judgment for the decision makers of a given corporation. Finally, the Court noted that the seven-factor test invites arbitrary decisions and creates unavoidable legal risks for corporations in attempting to determine compensation for employees who may be indispensable to the success of the business.

The Seventh Circuit then applied the independent investor test to determine that the compensation paid was reasonable. The Court noted that if a high rate of return is generated, it would be difficult to pove that a key employee is being overpaid because it is not plausible that the owner would be better off replacing the effective (generated a high return) employee with a lower-paid employee. In this case, the IRS's own expert had testified that a 13% return would be expected by investors in a company like Exacto. The Tax Court had determined that Exacto's investors obtained a 20% return. The Seventh Circuit determined that, notwithstanding the CEO's "exorbitant" salary, the Exacto investors received a far higher return than expected. As a result, the court found the CEO's salary to be "presumptively reasonable".

The Seventh Circuit decision supports the reasonableness of compensation in situations where strong returns for the hypothetical "independent investor" can be demonstrated. Practically, dividends are the most obvious demonstration of investor returns, so they should be considered annually in addition to compensation planning. However, growth in company value for investors, while possibly more difficult to establish, should also satisfy the investor return requirement.

The Second and Ninth Circuits have also considered independent investor analysis in reasonable compensation cases. With this strong and critical decision from the Seventh Circuit, the Tax Court may be feeling the pressure to abandon, or at least refocus, the 7-factor test. This "new trend" in analysis should certainly be considered in any reasonable compensation disputes with the IRS, as well as ongoing compensation planning.