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
Exacto deducted Heitz salary
as a business expense on their
In general, payments to
employees as salary are a legitimate business expense under 26 U.S.C. §162(a).
The IRS denied the deduction.
The IRS argued that under §162(a)(1) Exacto could only deduct "a reasonable
allowance for salaries or other compensation for personal services
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.
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.