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Independent Investor Test
The tests used to determine reasonable compensation leave something to be desired. The IRS uses its judgment to make the determination, so the corporation may always doubt whether it's in compliance. All the various tests tend to combine tips drawn from IRS internal procedures and the accumulated wisdom extracted from decades of tax court decisions.
Here are some of the problems with the tests:
- There's no indication given as to how the factors should be weighted.
- The relationships between the factors are unclear.
- The factors appear to have no relation to the purpose of IRC 162 (a), which contains the principle of reasonable compensation as it applies to closely held corporations.
- Judges aren't trained to determine proper compensation for executives.
- There's a lack of consensus among tax courts on the issue of reasonable compensation.
- Appeals Courts can issue rulings that change IRS practices and interpretations.
The tax court has employed an additional approach to the reasonable-compensation issue. The court has chosen to apply the independent investor test as an additional factor. The independent investor test is applied to the whole company, whereas the multi-factor test is applied to each key employee.
Here's what the independent investor test does…
The independent investor test considers the return on investment indicated by the increase in the value of the corporation's stock along with dividends paid during the period in question. This perspective is analogous to the now prevalent Total Shareholder Return (TSR) used to measure shareholder alignment by most publicly traded corporations.
In other words…
The test evaluates the company's performance throughout the year to determine whether the compensation to key employees is reasonable as a whole.
Practically speaking, an "independent" investor should be happy with the return on his or her investment and would not object to the compensation paid to key employees if the rate of return is acceptable.
Exacto Spring Corp. vs. Commissioner
In this case brought before the Seventh District Court, the Court abandoned the factor approach to reasonable compensation and replaced it with the independent investor test. The stockholder-employee of the company was paid $1.3 million in 1993 and $1 million in 1994. The IRS had contended that, based upon the reasonable factors test, the stockholder-employee should have been paid $381,000 in 1993 and $400,000 in 1994.
The argument made by the Appellate Court is that a corporation can be thought of as a contract between the owners of assets and the person hired to manage those assets. This contract is an exchange. The manager receives compensation for providing the owners with an increasing value of their assets. This can be expressed as a return on assets or equity. The Court rationalized that the higher the rate of return generated by the manager, the higher the compensation the manager can be reasonably paid. This is true even if the manager is paid an "unreasonable" compensation if the rate of return is above expectations. However, this is only true if it's the manager's efforts that led to the positive results. In this case, a rate of return of 13% in the industry would be perceived as normal, while the CEO of Exacto Springs achieved 20%.
Return on equity
Return on equity measures a corporation's profit by disclosing how much profit a company generates with the money shareholders have invested. The use of return on equity has some problems of its own. Corporations vary in the amount of equity required for operation, so it may be possible to have a very high rate of return in a company that requires a low amount of equity. This has led tax courts to use a number of other financial measures in varying circumstances.
Return on assets
In addition, the rate of return on assets needs to have some base average, as noted in the Exacto Springs case. This requires expert testimony on what is normal or average. Even if the case is made that the return is high, there are some questions that must be answered:
- What should be the relationship between the level of compensation and the level of return?
- To what extent are these business results due to the Executive or other factors not directly within the Executive's influence?
- How much more is each percentage increase worth in increased compensation?
- Could the IRS examine corporations in terms of rate of return on assets and decide that reasonable compensation of executives in low performing companies is substantially lower than in average performing companies?
Paying executives high compensation based on a single financial measure can have a negative effect on other financial measures. In this case, paying high compensation can (and will) negatively affect cash flow in the corporation, and probably retained earnings too. So the choice of financial measure can determine if the executive is doing well or poorly.
Status of the independent investor test
The seventh district court has used the independent investor test on its own to determine reasonable compensation, but other district courts have not. Some courts range from not accepting the test at all to including it with more traditional tests. Even in the Exacto Springs case, the court looked at the nature of the CEO's job and how well it was being performed. It's likely that the independent investor test will be used to validate decisions made on other criteria.
Memory Jogger
In the Exacto Springs case, the judge decided that a rate of return of what percent exceeded the industry average?