Exacto Spring Corporation v. Commissioner
196 F.3d 833 (7th Cir. 1999)

  • Exacto paid Heitz (their CEO and founder) very well by the standards of the day.
    • They paid him $2.3M per year.
  • Exacto deducted Heitz salary as a business expense on their taxes.
    • In general, payments to employees as salary are a legitimate business expense under 26 U.S.C. 162(a).
  • The IRS denied the deduction. Exacto appealed.
    • The IRS argued that under 162(a)(1) Exacto could only deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered."
    • The IRS argued that Heitz's salary wasn't reasonable, and that he should only be earning $381k a year. The rest was not deductible.
  • The Tax Court split the difference. Exacto appealed.
    • The Tax Court found that it was reasonable for Hietz to make $900k, and the rest was not deductible.
    • The Tax Court applied a complicated 7-factor analysis to come to their decision.
      • The Tax Court used this analysis based on a number of other judicial decisions that used a similar multi-factor approach.
  • The Appellate Court reversed and allowed the entire deduction.
    • The Appellate Court found that the 7-factor analysis was unworkable and hopelessly vague.
    • Instead, the Court applied a new independent investor test, which basically asks the question, "would an independent investor be satisfied with the company's rate of return?"
      • In this case Exacto was making higher profits than other companies in their field, so presumably Heitz's services were worth what they were paying him, so his salary was reasonable and therefore deductible under 162(a)(1).
  • While the 7th Circuit now applies this independent investor test, most other courts still use the multi-factor standard used by the Tax Court in this case.
  • The basic reason for 162(a)(1) is that compensation payments made to employees for salary are deductible as a business expense, while payments made to shareholders as a dividend are not deductible. Sometimes, a company will try to call something salary when it is really a dividend just to get the deduction, and 162(a)(1) is an attempt to stop that.