The Hypothetical Independent Investor Test

In determining reasonable compensation, the courts (and the IRS) have looked to a number of factors and have used various approaches over the years.  Typically, the approach has been to apply from 5 to 12 (or more) factors to determine whether compensation amounts were reasonable.  In recent years, the courts continue to use these factors; however, some courts, beginning with Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), have used the “independent” or “hypothetical” independent investor test as an important, if not prime, consideration in determining whether compensation is reasonable.

Under this test, compensation is, in varying degrees (depending on the court), presumed to be reasonable in amount if an independent investor in the company would still be receiving a reasonable return on his/her investment after the compensation was paid.  If the return was reasonable in light of returns achieved by peer companies, then this suggests that the officer had not drained company profits as disguised compensation.

The independent investor test has been applied in different ways by the courts that have adopted the test.  Calculating the company’s return on equity is a prime consideration.  However, in any version of this test it is always important to determine what the hypothetical independent investor is looking for, i.e., dividends and immediate return or future growth of the company, or both.  See Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 837 (7th Cir. 1999).

Regardless of the degree to which the test is applied, the independent investor test is, at a minimum, an additional consideration to be taken into account in applying the multi-factor approach.  See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5th Cir. 1987).

For example, in evaluating the traditional factors involving the employee’s long hours, experience, effectiveness, and his/her responsibility for the success of the business, an independent investor would pay a higher salary to an employee where the factors were favorable and a lower salary where the factors were not.  The courts that cite Elliotts for reliance on the independent investor test still recite the factors set forth in Elliotts and other cases in their analyses.  See Labelgraphics, Inc. v. Commissioner, 221 F.3d 1091 (9th Cir. 2000).  In fact, the Court of Appeals in Labelgraphics, in upholding the opinion of the Tax Court, stated that “the Tax Court carefully applied the five-factor Elliotts analysis” in relation to what an independent investor would expect.

The 7th and 2nd Circuits have joined the 5th and 9th Circuits in endorsing and enhancing the role of the independent investor test.  See Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999); and Dexsil Corp. v. Commissioner, 147 F.3d 96 (2nd Cir. 1998).  Earlier, the 5th Circuit had indicated its approval of the independent investor test.  See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5th Cir. 1987).

In Exacto Spring, Judge Posner, writing for the 7th Circuit, adopted the “pure” independent investor test and strongly criticized the use of “factors” in determining reasonable compensation.  He stated that the multi-factor approach leaves “much to be desired -- being, like many other multifactor tests, redundant, incomplete, and unclear.”  Judge Posner went on to say that analyzing the factors test “invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts.”