In Search of a Standard

BY PAUL BONNER
June 1, 2009

Editor's note: This is a sidebar to "Executive Compensation: What's Reasonable?"

 

A seminal case employing the independent investor test for reasonable compensation is the 1983 decision by the Ninth Circuit Court of Appeals in Elliotts Inc. v. Commissioner (716 F.2d 1241). In it, the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington) said an average return on equity (ROE) over two years of 20% clearly would satisfy an investor and was an indication that the company and its CEO were not exploiting their relationship. The court noted that, according to an expert witness, the company’s market value increased many-fold during the period a bonus pay formula was in effect, yielding a hypothetical annual compounded ROE for the period of 56%.

 

The court considered a company’s profitability to be persuasive when it can be attributed to the proven capability and efforts of an owner/employee. The court considered five factors in determining the nature and quality of that person’s services: his or her role in the company (position, duties, hours worked and general importance to the company’s success); an external comparison (what similarly situated corporations pay for similar services); the character and condition of the company (sales, net income and capital value in light of complexities of the business and general economic conditions); conflicts of interest (whether the relationship between the company and the owner/employee might bias the salary level); and internal consistency (comparing the owner/employee’s pay to that of other employees).

 

However, as Judge Richard Posner, writing for the Seventh Circuit, would complain later in Exacto Spring (196 F.3d 833 (7th Cir. 1999)) and still later in Menard Inc. (see sidebar, “‘Workaholic’ CEO Worth $20 Million a Year”), none of the factors are weighted. Courts have generally held that no single factor is dispositive, and all are to be considered in light of all facts and circumstances. The taxpayer generally bears the burden of proving that the IRS’ determination of reasonable compensation is incorrect; the burden is particularly heavy where the compensation is paid to an owner/employee (Rapco Inc. v. Commissioner, 85 F.3d 950 (2nd Cir. 1996), citing Welch v. Helvering, 290 U.S. 111 (1933), and Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d 176 (10th Cir. 1975)).

 

A year after Elliotts was decided, the U.S. District Court for the District of Nebraska (in the Eighth Circuit), finding for the taxpayer and citing Elliotts, applied an independent investor test as one of 15 factors in Trucks Inc. v. U.S. (588 F. Supp. 638). The court noted that ROE for the company for the three years at issue ranged from 29% to 59%—well above industry averages. In 1986, the U.S. District Court for the Southern District of Indiana (Seventh Circuit) also applied the Elliotts investor test in Shaffstall Corp. v. U.S. (639 F. Supp. 1041), this time as the principal factor.

 

Other circuit courts that have used the independent investor test as an important factor include the Sixth (Ohio, Michigan, Kentucky and Tennessee) in Alpha Medical Inc. v. Commissioner (172 F.3d 942 (1999)) and the Second (New York, Connecticut and Vermont) in Rapco Inc. v. Commissioner (cited earlier) and Dexsil Corp. v. Commissioner (147 F.3d 96 (1998)). In both of the latter cases, moreover, the Second Circuit said that “the entire tableau” of the five Elliotts factors should be applied and assessed from the perspective of an independent investor. In Rapco, however, the court upheld the Tax Court’s reduced deductions for the company president’s pay, saying an impressive ROE failed to make up for evidence the pay amounts were arbitrary and biased. The company ignored its own formula for the bonuses, which far exceeded base salary. The court also deemed the president’s 95% stake in the company, coupled with his being the “ultimate decision-maker as to his own salary,” to constitute a conflict of interest. Another relevant factor, the court held, was that the company paid no dividends in the years at issue.

 

The Fifth Circuit (Texas, Louisiana and Mississippi) also has held an impressive ROE to be outweighed by other considerations, primarily comparison to peer companies and pay of the company’s nonshareholder employees, in Owensby & Kritikos Inc. v. Commissioner (819 F.2d 1315 (1987)). On the other hand, the Fifth Circuit recognized the independent investor test as a primary factor weighing against the taxpayer in Donald Palmer Co. Inc. v. Commissioner (84 F.3d 431 (1996)). In that case, a bonus was large enough in relation to the company’s profits to result in a negative ROE.

 

More subtly, the First Circuit (Massachusetts, Rhode Island, New Hampshire and Maine) found a failure to meet the independent investor test in Haffner’s Service Stations v. Commissioner (326 F.3d 1 (2003)) even though ROE averaged 24.6% over the years in question—higher than the 17.4% return for peer companies. But the court considered the data underlying Haffner’s ROE suspect, reflecting an average over 16 years rather than the three years in question, when ROE declined significantly.

 

The Tenth Circuit (Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming) called relying predominantly on an independent investor test “attractive” but said in Eberl’s Claim Service Inc. v. Commissioner (249 F.3d 994 (2001)) that it was bound by precedent to use a multifactor test.

 

Other tests employed by various circuits look at pay for comparable positions and the nature and scope of the work performed.

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