Exacto Spring Corporation v.

Commissioner
196 F.3d 833 (7th Cir. 1999)
Posner, Chief Judge. This appeal from a judgment by the Tax Court, requires us to
interpret and apply 26 U..C. se!tion "62#a$#"$, %hi!h allo%s a business to dedu!t from
its in!ome its &ordinary and ne!essary& business expenses, in!luding a &reasonable
allo%an!e for salaries or other !ompensation for personal ser'i!es a!tually rendered.& (n
"))* and "))+, ,xa!to pring Corporation, a !losely held !orporation engaged in the
manufa!ture of pre!ision springs, paid its !ofounder, !hief exe!uti'e, and prin!ipal
o%ner, -illiam .eit/, 0".* and 0".1 million, respe!ti'ely, in salary. The (nternal 2e'enue
er'i!e thought this amount ex!essi'e, that .eit/ should not ha'e been paid more than 0
*3",111 in "))* or 0 +11,111 in "))+, %ith the differen!e added to the !orporation4s
in!ome, and it assessed a defi!ien!y a!!ordingly, %hi!h ,xa!to !hallenged in the Tax
Court. That !ourt found that the maximum reasonable !ompensation for .eit/ %ould
ha'e been 0 )11,111 in the earlier year and 0 511,111 in the later one 66 figures roughly
mid%ay bet%een his a!tual !ompensation and the (24s determination 66 and .eit/ has
appealed.
(n rea!hing its !on!lusion, the Tax Court applied a test that requires the !onsideration of
se'en fa!tors, none entitled to any spe!ified %eight relati'e to another. The fa!tors are, in
the !ourt4s %ords,
#"$ the type and extent of the ser'i!es rendered7
#2$ the s!ar!ity of qualified employees7
#*$ the qualifi!ations and prior earning !apa!ity of the employee7
#+$ the !ontributions of the employee to the business 'enture7
#8$ the net earnings of the employer7
#6$ the pre'ailing !ompensation paid to employees %ith !omparable jobs7 and
#5$ the pe!uliar !hara!teristi!s of the employer4s business.
(t is apparent that this test, though it or 'ariants of it #one of %hi!h has the astonishing
total of 2" fa!tors$, are en!ountered in many !ases$, lea'es mu!h to be desired 66 being,
li9e many other multifa!tor tests, &redundant, in!omplete, and un!lear.&
To begin %ith, it is nondire!ti'e. :o indi!ation is gi'en of ho% the fa!tors are to be
%eighed in the e'ent they don4t all line up on one side. ;nd many of the fa!tors, su!h as
the type and extent of ser'i!es rendered, the s!ar!ity of qualified employees, and the
pe!uliar !hara!teristi!s of the employer4s business, are 'ague.
e!ond, the fa!tors do not bear a !lear relation either to ea!h other or to the primary
purpose of se!tion "62#a$#"$, %hi!h is to pre'ent di'idends #or in some !ases gifts$,
%hi!h are not dedu!tible from !orporate in!ome, from being disguised as salary, %hi!h is.
uppose that an employee %ho let us say %as, li9e .eit/, a founder and the !hief
exe!uti'e offi!er and prin!ipal o%ner of the taxpayer rendered no ser'i!es at all but
re!ei'ed a huge salary. (t %ould be absurd to allo% the %hole or for that matter any part
of his salary to be dedu!ted as an ordinary and ne!essary business expense e'en if he
%ere %ell qualified to be C,< of the !ompany, the !ompany had substantial net earnings,
C,<s of similar !ompanies %ere paid a lot, and it %as a business in %hi!h high salaries
are !ommon. The multi6fa!tor test %ould not pre'ent the Tax Court from allo%ing a
dedu!tion in su!h a !ase e'en though the !orporation ob'iously %as see9ing to redu!e its
taxable in!ome by disguising earnings as salary. The !ourt %ould not allo% the dedu!tion,
but not be!ause of anything in the multi6fa!tor test7 rather be!ause it %ould be apparent
that the payment to the employee %as not in fa!t for his ser'i!es to the !ompany.
Third, the se'en6fa!tor test in'ites the Tax Court to set itself up as a super personnel
department for !losely held !orporations, a role unsuitable for !ourts, as %e ha'e
repeatedly noted in the Title =(( !ontext, and as the >ela%are Chan!ery Court has noted
in the more germane !ontext of deri'ati'e suits alleging ex!essi'e !ompensation of
!orporate employees. The test 66 the irruption of &!omparable %orth& thin9ing #see, e.g.,
;meri!an :urses4 ;ss4n '. (llinois, 53* ?.2d 5"6 #5th Cir. ")36$$ in a ne% !ontext 66
in'ites the !ourt to de!ide %hat the taxpayer4s employees should be paid on the basis of
the judges4 o%n ideas of %hat jobs are !omparable, %hat relation an employee4s salary
should bear to the !orporation4s net earnings, %hat types of business should pay
abnormally high #or lo%$ salaries, and so forth. The judges of the Tax Court are not
equipped by training or experien!e to determine the salaries of !orporate offi!ers7 no
judges are. @Ed. Note: Contrary to Judge Posners intimation, it seems unlikely that there
are strong links between Acomparable worth@ thinking and the Serice=s litigation
position with respect to unreasonable compensation. !he regulations hae long proided
that "#t is, in general, $ust to assume that reasonable and true compensation is only such
amount as would ordinarily be paid %or like serices by like enterprises under like
circumstances." Sec. &.&'() *+b,+-, !he issue is not solely one o% determining how much
serices proided are worth, but also o% whether the return to the serice proiders is in
line with the return being proided to the other %actors including capital that contribute
to corporate pro%its. A
?ourth, sin!e the test !annot itself determine the out!ome of a dispute be!ause of its
nondire!ti'e !hara!ter, it in'ites the ma9ing of arbitrary de!isions based on un!anali/ed
dis!retion or unprin!ipled rules of thumb. The Tax Court in this !ase essentially added the
(24s determination of the maximum that Br. .eit/ should ha'e been paid in "))* and
"))+ to %hat he %as in fa!t paid, and di'ided the sum by t%o. (t !ut the baby in half. <ne
%ould ha'e to be a%fully nai'e to belie'e that the se'en6fa!tor test generated this
pleasing symmetry.
?ifth, be!ause the rea!tion of the Tax Court to a !hallenge to the dedu!tion of exe!uti'e
!ompensation is unpredi!table, !orporations run una'oidable legal ris9s in determining a
le'el of !ompensation that may be indispensable to the su!!ess of their business.
The dra%ba!9s of the multi6fa!tor test are %ell illustrated by its purported appli!ation by
the Tax Court in this !ase. -ith regard to fa!tor #"$, the !ourt found that .eit/ %as
&indispensable to ,xa!to4s business& and &essential to ,xa!to4s su!!ess. .eit/ is not only
,xa!to4s C,<7 he is also the !ompany4s !hief salesman and mar9eting man plus the head
of its resear!h and de'elopment efforts and its prin!ipal in'entor. The !ompany4s entire
su!!ess appears to be due on the one hand to the resear!h and de'elopment !ondu!ted by
him and on the other hand to his mar9eting of these inno'ations #though he re!ei'es some
additional !ompensation for his mar9eting efforts from a subsidiary of ,xa!to$. The !ourt
de!ided that fa!tor #"$ fa'ored ,xa!to.
Ci9e%ise fa!tor #2$, for, as the !ourt pointed out, the design of pre!ision springs, %hi!h is
.eit/4s spe!ialty, is &an extremely spe!iali/ed bran!h of me!hani!al engineering, and
there are 'ery fe% engineers %ho ha'e made !areers spe!iali/ed in this area,& let alone
engineers li9e .eit/ %ho ha'e &the ability to identify and attra!t !lients and to de'elop
springs to perform a spe!ifi! fun!tion for that !lient. . . (t %ould ha'e been 'ery diffi!ult
to repla!e Br. .eit/.&
:oti!e ho% fa!tors #"$ and #2$ turn out to be nearly identi!al.
?a!tors #*$ and #+$ also supported ,xa!to, the !ourt found. &Br. .eit/ is highly qualified
to run ,xa!to as a result of his edu!ation, training, experien!e, and moti'ation. Br. .eit/
has o'er +1 years of highly su!!essful experien!e in the field of spring design.& (d. ;nd
his &efforts %ere of great 'alue to the !orporation.& o fa!tor #+$ dupli!ated #2$, and so
the first four fa!tors turn out to be really only t%o.
-ith regard to the fifth fa!tor 66 the employer4s #,xa!to4s$ net earnings 66 the Tax Court
%as non!ommittal. ,xa!to had reported a loss in "))* and 'ery little taxable in!ome in
"))+. Dut it !on!eded ha'ing ta9en some improper dedu!tions in those years unrelated to
.eit/4s salary. ;fter adjusting ,xa!to4s in!ome to remo'e these dedu!tions, the !ourt
found that ,xa!to had earned more than 0 " million in ea!h of the years at issue net of
.eit/4s supposedly inflated salary.
The !ourt %as non!ommital %ith regard to the sixth fa!tor 66 earnings of !omparable
employees 66 as %ell. The e'iden!e bearing on this fa!tor had been presented by expert
%itnesses, one on ea!h side, and the !ourt %as !riti!al of both. The taxpayer4s %itness had
arri'ed at his estimate of .eit/4s maximum reasonable !ompensation in part by
aggregating the salaries that ,xa!to %ould ha'e had to pay to hire four people ea!h to
%ear one of .eit/4s &hats,& as !hief exe!uti'e offi!er, !hief manufa!turing exe!uti'e,
!hief resear!h and de'elopment offi!er, and !hief sales and mar9eting exe!uti'e.
;lthough the more roles or fun!tions an employee performs the more 'aluable his
ser'i!es are li9ely to be, an employee %ho performs four jobs, ea!h on a part6time basis,
is not ne!essarily %orth as mu!h to a !ompany as four employees ea!h %or9ing full time
at one of those jobs. (t is therefore arbitrary to multiply the normal full 6time salary for
one of the jobs by four to !ompute the reasonable !ompensation of the employee %ho
fills all four of them. ;ny%ay salaries are determined not by the method of !omparable
%orth but, li9e other pri!es, by the mar9et, %hi!h is to say by !onditions of demand and
supply. ,spe!ially in the short run, salaries may 'ary by more than any differen!e in the
&obje!ti'e& !hara!teristi!s of jobs. ;n indi'idual %ho has 'aluable s9ills that are in
parti!ularly short supply at the moment may !ommand a higher salary than a more
'ersatile, better6trained, and more loyal employee %hose s9ills are, ho%e'er, less s!ar!e.
The (nternal 2e'enue er'i!e4s expert %itness sensibly !onsidered %hether .eit/4s
!ompensation %as !onsistent %ith ,xa!to4s in'estors4 earning a reasonable return
#adjusted for the ris9 of ,xa!to4s business$, %hi!h he !al!ulated to be "* per!ent. Dut in
!on!luding that .eit/4s !ompensation had pushed the return belo% that le'el, he
negle!ted to !onsider the !on!essions of improper dedu!tions, %hi!h led to adjustments
to ,xa!to4s taxable in!ome. The Tax Court determined that %ith those adjustments the
in'estors4 annual return %as more than 21 per!ent despite .eit/4s large salary. The
go'ernment argues that the !ourt should not ha'e !al!ulated the in'estors4 return on the
basis of the !on!essions of improper dedu!tions, be!ause %hen .eit/4s !ompensation %as
determined the !orporation %as una%are that the dedu!tions %ould be disallo%ed. (n
other %ords, the !orporation thought that its after6tax in!ome %as larger than it turned out
to be. Dut if the ex ante perspe!ti'e is the proper one, as the go'ernment !ontends, it
fa'ors the !orporation if %hen it fixed .eit/4s salary it thought there %as more money in
the till for the in'estors than has turned out to be the !ase.
-hat is pu//ling is ho% disallo%ing dedu!tions and thus in!reasing the taxpayer4s tax bill
!ould in!rease the in'estors4 return. -hat in'estors !are about is the !orporate in!ome
a'ailable to pay di'idends or be rein'ested7 ob'iously money paid in taxes to the (nternal
2e'enue er'i!e is not a'ailable for either purpose. The reasonableness of .eit/4s
!ompensation thus depends not on ,xa!to4s taxable in!ome but on the !orporation4s
profitability to the in'estors, %hi!h is redu!ed by the disallo%an!e of dedu!tions 66 if a
!orporation su!!eeds in ta9ing phantom dedu!tions, shareholders are better off be!ause
the !orporation4s tax bill is lo%er. Dut the go'ernment ma9es nothing of this. (ts only
obje!tion is to the Tax Court4s ha'ing ta9en a!!ount of adjustments made after .eit/4s
salary %as fixed. Doth parties, plus the Tax Court, based their estimates of in'estors4
returns on the after6tax in!ome sho%n on ,xa!to4s tax returns, %hi!h
jumped after the dedu!tions %ere disallo%ed, rather than on ,xa!to4s real profits, %hi!h
de!lined. The approa!h is in!onsistent %ith a realisti! assessment of the in'estors4 rate of
return, but as no one in the !ase questions it %e shall not ma9e an issue of it. @Ed Note:
!his discussion suggests that E.acto, like many other businesses, makes no other
accounting o% pro%it and loss besides that made %or income ta. purposes. #% this is true,
what else might the court hae tried to consider in determining the proper way to take
into account the disallowed deductions in determining whether the shareholders should
be happy with the corporations per%ormance/A
?inally, under fa!tor #5$ #&pe!uliar !hara!teristi!s&$, the !ourt first and rightly brushed
aside the (24s argument that the lo% le'el of di'idends paid by ,xa!to #/ero in the t%o
years at issue, but ne'er 'ery high$ %as e'iden!e that the !orporation %as paying .eit/
di'idends in the form of salary. The !ourt pointed out that shareholders may not %ant
di'idends. They may prefer the !orporation to retain its earnings, !ausing the 'alue of the
!orporation to rise and thus enabling the shareholders to obtain !orporate earnings in the
form of !apital gains taxed at a lo%er rate than ordinary in!ome. The !ourt also noted that
%hile .eit/, as the o%ner of 88 per!ent of ,xa!to4s !ommon sto!9, ob'iously %as in a
position to influen!e his salary, the !orporation4s t%o other major shareholders, ea!h %ith
21 per!ent of the sto!9, had appro'ed it. They had not themsel'es been paid a salary or
other !ompensation, and are not relati'es of .eit/7 they had no finan!ial or other
in!enti'e to allo% .eit/ to siphon off di'idends in the form of salary.
.a'ing run through the se'en fa!tors, all of %hi!h either fa'ored the taxpayer or %ere
neutral, the !ourt rea!hed a stunning !on!lusionE &-e ha'e !onsidered the fa!tors
rele'ant in de!iding reasonable !ompensation for Br. .eit/. <n the basis of all the
e'iden!e, %e hold that reasonable !ompensation for Br. .eit/& %as mu!h less than
,xa!to paid him. The !ourt4s only effort at explaining this result %hen .eit/ had passed
the se'en6fa!tor test %ith flying !olors %as that &%e ha'e balan!ed Br. .eit/4 unique
selling and te!hni!al ability, his years of experien!e, and the diffi!ulty of repla!ing Br.
.eit/ %ith the fa!t that the !orporate entity %ould ha'e sho%n a reasonable return for the
equity holders, after !onsidering petitioners4 !on!essions.& Dut &the fa!t that the
!orporate entity %ould ha'e sho%n a reasonable return for the equity holders& after the
!on!essions is on the same side of the balan!e as the other fa!tors7 it does not fa'or the
(nternal 2e'enue er'i!e4s position. The go'ernment4s la%yer %as for!ed to !on!ede at
the argument of the appeal that she !ould not deny the possibility that the Tax Court had
pulled its figures for .eit/4s allo%able !ompensation out of a hat.
The failure of the Tax Court4s reasoning to support its result %ould alone require a
remand. Dut
the problem %ith the !ourt4s opinion goes deeper. The test it applied does not pro'ide
adequate guidan!e to a rational de!ision. -e o%e no deferen!e to the Tax Court4s
statutory interpretations, its relation to us being that of a distri!t !ourt to a !ourt of
appeals, not that of an administrati'e agen!y to a !ourt of appeals. 26 U..C. e!tion
5+32#a$#"$.
De!ause judges tend to do%nplay the element of judi!ial !reati'ity in adapting la% to
fresh insights and !hanged !ir!umstan!es, the other !ourts of appeals that ha'e adopted
an &independent in'estor& test to say that the &independent in'estor& test is the &lens&
through %hi!h they 'ie% the se'en #or ho%e'er many$ fa!tors of the orthodox test. Dut
that is a formality. The ne% test dissol'es the old and returns the inquiry to basi!s. The
(nternal 2e'enue Code limits the amount of salary that a !orporation !an dedu!t from its
in!ome primarily in order to pre'ent the !orporation from eluding the !orporate in!ome
tax by paying di'idends but !alling them salary be!ause salary is dedu!tible and
di'idends are not. #Perhaps they should be, to a'oid double taxation of !orporate
earnings, but that is not the la%.$ (n the !ase of a publi!ly held !ompany, %here the
salaries of the highest exe!uti'es are fixed by a board of dire!tors that those exe!uti'es
do not !ontrol, the danger of siphoning !orporate earnings to exe!uti'es in the form of
salary is not a!ute. The danger is mu!h greater in the !ase of a !losely held !orporation,
in %hi!h o%nership and management tend to !oin!ide7 unfortunately, as the opinion of
the Tax Court in this !ase illustrates, judges are not !ompetent to de!ide %hat business
exe!uti'es are %orth.
There is, fortunately, an indire!t mar9et test, as re!ogni/ed by the (nternal 2e'enue
er'i!e4s expert %itness. ; !orporation !an be !on!eptuali/ed as a !ontra!t in %hi!h the
o%ner of assets hires a person to manage them. The o%ner pays the manager a salary and
in ex!hange the manager %or9s to in!rease the 'alue of the assets that ha'e been
entrusted to his management7 that in!rease !an be expressed as a rate of return to the
o%ner4s in'estment. The higher the rate of return #adjusted for ris9$ that a manager !an
generate, the greater the salary he !an !ommand. (f the rate of return is extremely high, it
%ill be diffi!ult to pro'e that the manager is being o'erpaid, for it %ill be implausible that
if he quit if his salary %as !ut, and he %as repla!ed by a lo%er6paid manager, the o%ner
%ould be better off7 it %ould be 9illing the goose that lays the golden egg. The er'i!e4s
expert belie'ed that in'estors in a firm li9e ,xa!to %ould expe!t a "* per!ent return on
their in'estment. Presumably they %ould be delighted %ith more. They %ould be
o'erjoyed to re!ei'e a return more than 81 per!ent greater than they expe!ted 66 and 21
per!ent, the return that the Tax Court found that in'estors in ,xa!to had obtained, is more
than 81 per!ent greater than the ben!hmar9 return of "* per!ent.
-hen, not%ithstanding the C,<4s &exorbitant& salary #as it might appear to a judge or
other modestly paid offi!ial$, the in'estors in his !ompany are obtaining a far higher
return than they had any reason to expe!t, his salary is presumpti'ely reasonable. -e say
&presumpti'ely& be!ause %e !an imagine !ases in %hi!h the return, though 'ery high, is
not due to the C,<4s exertions. uppose ,xa!to had been an unprofitable !ompany that
suddenly learned that its fa!tory %as sitting on an oil field, and %hen oil re'enues started
to pour in its o%ner raised his salary from 081,111 a year to 0".* million. The
presumption of reasonableness %ould be
rebutted. There is no suggestion of anything of that sort here and li9e%ise no suggestion
that Br. .eit/ %as merely the titular !hief exe!uti'e and the !ompany %as a!tually run by
someone
else, %hi!h %ould be another basis for rebuttal.
The go'ernment !ould still ha'e pre'ailed by sho%ing that %hile .eit/4s salary may ha'e
been no greater than %ould be reasonable in the !ir!umstan!es, the !ompany did not in
fa!t intend to pay him that amount as salary, that his salary really did in!lude a !on!ealed
di'idend though it need not ha'e. This is material #and the &independent in'estor& test,
li9e the multi6fa!tor test that it repla!es, thus in!omplete, though in'aluable$ be!ause any
business expense to be dedu!tible must be, as %e noted earlier, a bona fide expense as
%ell as reasonable in amount. The fa!t that .eit/4s salary %as appro'ed by the other
o%ners of the !orporation, %ho had no in!enti'e to disguise a di'idend as salary, goes far
to rebut any inferen!e of bad faith here, %hi!h in any e'ent the Tax Court did not dra%
and the go'ernment does not as9 us to dra%.
0Ed. Note: #n the early &1123s, E.acto had an appraised alue o% at least 45 million6 the
original capital contributed by 7eit8 and his partners in &1'2 was 41,222. Neither court
opinion indicates how much o% this alue is attributable to what kind o% asset: land,
building, manu%acturing e9uipment, patents and other trade secrets, customer relations,
or more amorphous goodwill. Should it matter %or the purposes o% determining
reasonable compensation to the o%%icers o% the company/
Should it matter whether these assets were created by the corporations employees or
were purchased %rom third parties %or the purposes o% determining reasonable
compensation/ #% the bulk o% the alue is in sel%)constructed assets held within the
corporation, should it matter whether 7eit8 was the primary deeloper o% this alue, and
the e.tent to which he continues to be the source o% this alue/ :hat i% it could be
shown that hal% the alue o% E.acto was deried %rom the relationships that 7eit8 had
with his customers/ :hat i% one o% the (2; owners had purchased a competing business
in the late eighties %or 4<22,222, and contributed its assets to E.acto/ 7int: =nder
which circumstances would the presence o% these assets be taken into account in
determining the capital inested in the corporation, and there%ore the ade9uacy o% the
return to capital being proided by such diidends as may hae been paid/ =nder what
circumstances might there be assets desering a return, but that are not held within the
corporation/
Judge Posner assumes that the oil) well)under) the) %actory e.ample would be a clear
case in which e.ecutie>owner compensation would be unreasonable. :hat i% the owner
was an amateur rock collector who happened to notice some geological %ormations that
suggested that looking %or oil would be worthwhile/ ?oes Judge Posner3s approach
really aoid $udges making determinations about the alue o% corporate e.ecuties to
their %irms/
!he salary paid to 7eit8 and challenged by the #@S was in the same range as the total o%
the salaries paid to 7eit8 and his two co) owners immediately be%ore their retirement in
the early &1123s. Should that %act hae any signi%icance/ Should the terms o% the
retirement o% the co)owners +not mentioned in the opinion, be releant/ :hat i% the co)
owners had already agreed to hae their stock redeemed %rom them by the corporation
+%or instance, at their death,, at a price that did not depend upon income o% the
corporation a%ter taking into account salaries/ =nder such circumstances would they
still be Aindependent inestors/B
Judge Posner critici8es the way the !a. Court and the parties handled the e%%ect o% ta.es
on the rate o% return calculations. !he only numbers o%%ered in the opinion appear to be
based on E.acto=s ta. books. Should the ade9uacy o% return to shareholders be
calculated based on book or ta. earnings/ #n either eent, should it be calculated be%ore
or a%ter the ta. e%%ect o% the challenged compensation/ Ce%ore or a%ter any ta. that might
be owing i% diidend distributions were made instead/
!he #@S also brought to the !a. Court=s attention two other aspects o% E.acto=s
operations that indicated some attention had been gien to ta. planning. Dirst, E.acto
owed 7eit8 more than 4(,222,222 and, although E.acto regularly accrued the deduction
%or interest due on this loan, it neer paid on the loan and thus 7eit8 did not include the
amount in income, until a year later. See section ('*+a,+(, %or the ta. accounting
treatment o% some such circumstances. Second, two employees o% E.acto owned all o% the
stock in a corporation that engaged in sales actiities %or E.acto. 7eit8 did not own any
stock, but he was the sole employee and was paid more than 4&22,222 %or his actiities as
an employee o% this separate sales company. !hese %acts make no appearance in Judge
Posner3s opinion. :hat impact, i% any, should these %acts hae on the outcome o% the
reasonable compensation issue/