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Federal Editorial Materials WG&L Journals
Practical Tax Strategies/Taxation for Accountants (WG&L) Practical Tax Strategies
2013
Volume 90, Number 04, April 2013 Articles
EXCESS COMPENSATION AND THE INDEPENDENT INVESTOR TEST, Practical Tax Strategies, Apr 2013
COMPENSATION
EXCESS COMPENSATION AND THE INDEPENDENT INVESTOR TEST
Using the independent investor test to determine reasonable compensation is not a reliable method to avoid IRS scrutiny.Author: DEBRA T. SINCLAIR AND BRITTON A. MCKAY
DEBRA T. SINCLAIR, Ph.D., AVA, CMA, is an assistant professor of accounting at the College of Business of the University of South Florida in St. Petersburg. BRITTON A. MCKAY, Ph.D., is an assistant professor of accounting at the School of Accountancy of Georgia Southern University in Statesboro.
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When a closely held corporation tries to compensate a shareholder-employee, it is possible for the IRS to challenge the compensation paid as excessive. According to Reg. 1.162-7(b)(3), the deduction for compensation must reflect what would “ordinarily be paid for like services by like enterprises under like circumstances.” When the IRS rules that compensation is excessive, it reclassifies a portion of the compensation as dividends, thus making them non-deductible for the business. In the past, courts have been sympathetic to the shareholder-employee. However, given the current political climate, the IRS may be more willing to press excess compensation cases, and the employee-shareholder may be less likely to prevail.
For some time now, the public has been concerned that executive compensation and perquisites are excessive. While much of the media attention has been focused on publicly traded firms, the sentiment that executives are overly compensated seems to be growing in general. The IRS, pressured by the public and Congress, has begun to focus more attention on executive compensation. In February 2005, the IRS issued several Audit Techniques Guides (ATGs) regarding executive compensation.1 These ATGs (which
pertain to the audit of both publicly traded and privately held entities) tell IRS agents what to look for when they are auditing a firm. In June 2005 through June 2006, the IRS conducted a nationwide examination of compensation practices in non-profit organizations. Given the public concern over executive compensation and the current political climate, the timing may be right for the IRS to pursue excess compensation of shareholder-owners.
Within closely held corporations there is some cloudiness regarding compensation and determinations of whether or not it is excessive. While it appears that—especially in the Seventh Circuit—the independent investor test is beginning to gain favor over a multi-factor model, there are some weaknesses in the way the independent investor test has been applied, so far. To use the independent investor test effectively in defense of a client, it is important to understand the weaknesses in prior applications of the method. Outside the Seventh Circuit, relying primarily on the independent investor test in setting a firm's executive compensation—or in defending a client's executive compensation—is, essentially, putting all eggs in one
[pg. 149]
basket. Even in the Seventh Circuit, misapplying the independent investor test could have disastrous results.
For large, publicly traded corporations, executive compensation is rarely questioned by the IRS because the corporation is dealing at arm's length with its employees. However, in closely held corporations, because the owner and executive are often one and the same, the issue arises more frequently. As noted in Eberl's Claim Service Inc.:2
For closely held corporations, the identity between shareholders and employees creates an incentive to distribute earnings in the form of compensation rather than in the form of dividends. Compensation is a deductible expense, while dividend payments are subject to the two-tier system of corporate taxation. Absent a third-party interest in limiting compensation for the sake of profitability, dividends may be disguised as salary and channeled out of the corporation tax-free. Because of the potential for avoiding taxation in this manner, “special scrutiny should be given to compensation paid by a corporation whose stock is closely held.” Pepsi-Cola Bottling, 528 F.2d 179.
In the 1983 seminal case, Elliots Inc.,3 the Ninth Circuit applied a five-factor test in determining “reasonable compensation” under
Section 162(a)(1). These factors included:
(1) The taxpayer's role in the company.
(2) An external comparison of the employee's salary with those paid by similar companies for similar services. (3) The character and condition of the company (which takes into account the company's size and complexity).
(4) Conflicts of interest, i.e., does a relationship exist between the taxpaying company and its employee that might permit the company to disguise nondeductible corporate distributions of income as salary expenditures.
(5) Internal consistency in a company's treatment of payments to employees.
Part of the Ninth Circuit's evaluation of a conflict of interest in Elliots included the independent investor test. The court concluded that an average return on equity (ROE) of 20% over the two years in question would clearly satisfy an investor and was an indication that the company and its CEO were not exploiting their relationship. Additionally, the court noted that the current market value of the initial shareholder investment of $19,000 had climbed to $5 million—resulting in an annual compounded return of 56%.
A year after Elliots, a district court, finding for the taxpayer and citing Elliots, applied an independent investor test as one of eight factors in Trucks, Inc.4 Another district court, in Shaffstall Corp.,5 relied predominately on the independent investor test to determine
reasonable compensation and ruled in favor of the taxpayer. However, it must be noted that, first, the court stated that, to determine whether compensation was reasonable:
[T]he type and extent of services rendered, the availability of qualified employees, the qualifications and prior earnings of the employee, the contributions of the employee to the business venture, the net earnings of the taxpayer, the prevailing compensation paid to comparable employees, and the peculiar character of the business must all be considered.
Because of the uniqueness of the product and the firm's dominant market position under the taxpayer's guidance, the court felt that the reasonableness of the taxpayer's compensation could not be evaluated by comparing it to other companies. Only then did the court rely on the independent investor test. Additionally, the court also seemed to have considered several other factors in reaching its decision, including the fact that the taxpayer was the creator of the product and fulfilled multiple roles in the company's business; that the company's compensation plan was adopted early in the fiscal year before the favorable financial results had occurred; that there was a cap on the bonus portion of the compensation plan; that the taxpayer's percentage salary increase was less than the
company's percentage increase in gross sales; that the taxpayer's compensation was less, as a percentage of sales, than it had been in the previous year; and that, with the exception of the initial $1,000 contribution of capital, all of the equity in the firm was generated through retention of earnings (a fact that the court felt established that profits were not being taken out of the company disguised as salary).
While other courts have since applied the independent investor test as an important factor, including the Sixth Circuit in Alpha
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Medical Inc.6 and the Second Circuit in both Rapco Inc.7 and Dexsil Corp.,8 with the exception of the Seventh Circuit, none have used
the independent investor test exclusively. There have always been other factors weighing in on the decision of each court.
The appellate court stated that, while other courts have typically considered multiple factors in trying to determine reasonable compensation, these tests are too difficult to apply. The Seventh Circuit seems to have favored the independent investor test because it is easy to calculate. However, although as applied by the court the independent investor test may seem easy, there are actually some difficult issues associated with the test that have not yet been considered in the test's application.
Use of independent investor test
First, after sharply criticizing the multi-factor analysis used by previous courts in determining excess compensation cases, the Seventh Circuit went on to say that, if a high rate of return is generated for the firm, it would be difficult to prove that the key employee is being overpaid because it is not plausible that the owner would be better off replacing the effective employee (one who generates a high return) with a lower paid employee. In Exacto, the IRS's own expert had testified that a 13% return would be expected by investors in a company like Exacto. The Tax Court determined that Exacto's investors obtained a 20% return. The Seventh Circuit determined that, despite the CEO's “exorbitant” salary, the Exacto investors received a far higher return than expected. As a result, the court found the CEO's salary to be “presumptively reasonable” and reversed the Tax Court's decision.
In this case, there are several problems with the Seventh Circuit's reasoning. First, while a 20% return may sound like more than an investor would have expected in this case, consider the following illustration:
Example: Aceco is a small, closely held business that needs no assets other than cash and has no liabilities. At the beginning of Year 1, the owners invest $100,000 into the firm. It then has $100,000 in cash and $100,000 in equity. Aceco hires a CEO and, in Year 1, it earns $100,000 before compensating the executive. Because the investors expect a 20% return on their investment, the CEO pays out $20,000 in dividends to the owners and takes home $80,000 in CEO compensation. The investors have earned a 20% return on investment and—according to the court—they are happy. At the end of Year 1, total assets and total equity are still $100,000 (as all earnings have been distributed to the owners and CEO).
In Year 2, Aceco earns $1,000,000. Again, the CEO provides the shareholders with a 20% return on their investment, paying them $20,000, and keeping $980,000 for himself. Again, according to the court, the shareholders are happy. At the end of Year 2, total assets and total equity are still $100,000 (as all earnings have been distributed to the owners and CEO).
In Year 3 Aceco earns $10,000,000. With a 20% return on their investment, the owners again earn $20,000 while the CEO takes home $9.8 million. Clearly at some point the owners would probably not be happy with their 20% return on investment, as the CEO's pay knows no boundaries and owner compensation is continually capped at 20% of the $100,000 investment.
To further illustrate the flaw in applying the independent investor test exclusively, consider the case in which the firm is not performing well. Using the previous example, assume that, in Year 4, the economy takes a turn for the worse and the firm earns only $20,000. The owners expect a 20% return and, therefore, the owners receive $20,000, leaving no compensation for the executive. Following the court's reasoning, any compensation paid to the executive under this scenario should be considered excessive. In fact, the Fifth Circuit recognized the independent investor test as a primary factor weighing against the taxpayer in Donald
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Palmer Co. Inc.10 Supporting the Tax Court, the Fifth Circuit concluded that, because "the large bonus paid to Palmer resulted in
negative retained earnings, a taxable loss, and a negative return on investment for its shareholders for 1990, an independent investor would not have been pleased with his investment if he had to compensate Palmer so handsomely."
Returning to Exacto, in applying the independent investor test, the Seventh Circuit goes on to say,
The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid, for it will be implausible that if he quit if his salary was cut, and he was replaced by a lower-paid manager, the owner would be better off; it would be killing the goose that lays the golden egg.
The court's stance here seems extreme. It presents the situation as an all or nothing proposal in which, if the business owner cuts the manager's salary and the manager quits, the firm would be worse off. However, if the manager is being overcompensated, the manager is taking home profits that belong to the firm—and its owners; so the firm is worse off when they over-compensate a manager. Indeed,
in Palmer it was determined that, even when the corporation would have been rendered virtually worthless without the
overcompensated individual (David Palmer was the sole stockholder, president, officer and sole salesperson in a plastics packaging business), there are limits on how much compensation is deemed to be reasonable. Further, contracting theory suggests that the firm could hire a less-talented manager and still be better off.
Returning to the initial example, consider the following. Assume instead that in Year 3 (the year in which Aceco earned $10 million), the owners decided to limit executive compensation to $1 million per year. Because of the limit on compensation, as the court feared, the talented executive leaves the firm. A less-talented executive accepts the job for the $1 million salary and, in fact, performs much worse than his more-talented counterpart would have, earning only $5 million (half as much as his talented counterpart). The less-talented CEO takes his million-dollar salary and leaves the owners with $4 million—a 4,000% return on investment. Clearly, in this case, the owners of Aceco are better off with the less talented executive.
Hazards of overcompensation
This notion that the firm could actually be worse off by overcompensating the CEO is also supported by research. A recent study examining the distribution of pay among top executives in publicly traded companies in the U.S. found that CEOs receiving higher compensation than average generate lower value for their investors.11 The authors attribute these findings to firms having weak
shareholder rights and more management entrenching provisions. Similarly, another article finds that firms ranking in the top 10% with regard to CEO compensation performed worse than their industry peers.12 Specifically, the authors found that stock returns for these
firms lagged their industry peers by more than 13 percentage points, cumulatively, over the next five years. They attribute their findings to over-confident managers accepting large amounts of incentive pay and investors' overreaction to these pay grants.
Although the court in Exacto seems to attribute firm performance solely to the CEO in its statement, “The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command,” Judge Posner did recognize that there may be circumstances in which the firm's return is not attributed to the executives efforts, “e.g., where the return is based on the company suddenly learning that it was sitting on an oil field, it is unlikely that an independent investor would agree to pay an executive a high salary based on the return.” Unfortunately there are, in fact, many factors responsible for firm performance that are outside of the executive's control, including industry factors, government regulation, and the economy. Therefore, the court's assumption that a high rate of return automatically demands a greater salary (barring some “windfall” event) is unwarranted.
Closely held corporations
The Seventh Circuit has since made a similar ruling in Menard Inc.,13 arguing that a hypothetical investor in Menard Inc. would have
enjoyed an 18.8% return on equity for the year. However, this ruling spent less time on discussion of the independent investor test and, instead, the court discussed risk in the executive compensation package. The court's argument is that an executive should receive higher total compensation when contingent compensation is involved and that shareholders, on the other hand, have less risk because they are able to diversify. In this case, the
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court seems to have forgotten that, unlike the typically diversified shareholders of publicly traded stocks, shareholders in this type of case are not likely to be diversified because the shareholder and manager are one and the same—and substantially all of the taxpayer's wealth is likely tied up in the firm.
Additionally, a compensation package that contains contingent compensation should, in fact, result in higher total compensation (assuming a successful year in which contingent compensation is paid) than a package that contains no contingent compensation (i.e., one that is strictly salary) because the executive has given up part of his “safe” stable return (i.e., salary) for a chance at a bigger reward (the contingent part of the compensation package, i.e., bonus compensation). The purpose of including a bonus in a
compensation package is, in fact, to encourage an executive to “work harder” for the benefit of both the company and the executive. The bulk of the reward for taking risk, however, should go to the owners—as they have invested the initial capital.
It is unlikely that the CEO would receive zero or negative compensation in years when the firm incurred a loss; therefore, the CEO does not share the full extent of the risk of the firm, as the CEO function demands no monetary investment on the part of the CEO and no risk of personal loss. Additionally, the CEO's risk is tempered by at least some guaranteed salary. In contrast, shareholders are
not guaranteed any minimum return—and their initial investment is also at risk (if the firm goes bankrupt, the initial investment is also irretrievable). Therefore, while one may wish to reward the executive in times of good firm performance, there is a limit to the amount the CEO should be compensated.
Again, recognizing that some, but not all, of the firm return is because of executive effort, it is reasonable to assume that owners and managers may share in the spoils of an exceptionally good year; it is unreasonable, however, to assume that the manager, who does not have total control over the outcome of firm performance and who has no invested capital to lose in the case of bankruptcy, would take all of the excess returns.
Finally, the Seventh Circuit's application of the independent investor test has, so far, failed to address some important issues in calculating the return to the investor. In Exacto, the parties had already agreed that a 20% rate of return was acceptable. Although Judge Posner noted that the method of calculating the return seemed odd, the court concluded that, because the parties agreed to this rate, there was no reason to ”make an issue of it.” Of course, going into the agreement, the parties had no idea that the Seventh Circuit would rely exclusively on the independent investor text to decide excess compensation. If they had, they may not have agreed so readily to the calculated rate of return. Similarly, in Menard, the court determined that an 18.8% return was acceptable because there was “no suggestion that any of the shareholders were disappointed” with the return (although Menard himself owned all of the voting shares and 56% of the non-voting shares, the remainder of which were owned by family members).
If more importance is placed on the independent investor test, the issue as to what is the appropriate rate of return on investment will surely become more contentious. The calculation of this rate is one of the most difficult areas of small business valuation. The appropriate rate of return should be based on the amount of risk involved in the investment. For a number of reasons, small closely held firms are inherently more risky than large publicly traded firms.14 The rates of return used in both the Menard and Exacto cases
were probably too low.
The consensus among participants in the marketplace (buyers and sellers, brokers, appraisers, and others) seems to be that the required total rate of return on an equity investment in a small business is in the range of 20 to 40 percent; this depends on the degree of risk, and is higher for unusually risky situations.15
In fact, even the return on investment calculation was overly simplified. In Exacto, the return was calculated by dividing after-tax net income by the balance in the owners' equity account (i.e., the book value of equity).16 However, the relevant rate of return should be
calculated on the market value of equity. The book value of equity is determined by accounting rules and is not a reflection of the “real” (i.e.,
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market) value of the firm. In fact, a firm's book and market values of equity may differ significantly.
The market value of a firm is a reflection of the firm's earnings power and is based on expected cash flows. The book value of a firm is simply a reflection of the original cost of the firm's assets (which may be greater or less than the assets' current values). This value is then affected by accounting decisions (such as the method of depreciation chosen by the firm). Accounting standards vary widely across firms, and book values may not be comparable between similar firms or even across one firm over time.
Calculating the market value of a firm is in itself a complicated process, especially for firms that are privately held because there is no ready market for shares in closely held firms. However, courts often value closely held corporations for gift and estate taxes.17
Applying the same procedures to determine excess compensation cases would require courts to rely on expert testimony from valuation specialists, as they do for gift and estate taxes.
Since Exacto and Menard, the Tax Court in Multi-Pak Corp.18 used Elliot's five-factor method; the court, however, did seem to weigh
the independent investor test heaviest. It found that three of the factors favored the taxpayer, one factor was neutral, and the
independent investor test actually supported the IRS's position. The court determined that, in light of “impressive sales growth” and low company debt, a 2.9% return on investment was acceptable for 2002; however, a negative 15.8% return on equity was deemed unacceptable in 2003. Accordingly, the court reduced the company's deductible compensation in that year.
Currently, the methods used to determine excess compensation vary from the independent investor test to a much more complicated 15-factor test. While use of the independent investor test is gaining momentum due to its objectivity and simplicity, the analysis above suggests that the independent investor test is not as simple as it seems. Mixed results from recent court cases indicate that its use cannot be relied on to keep the shareholder-employee out of trouble with the IRS. Additionally, because recent court rulings have relied more heavily on the independent investor analysis, it is likely that the IRS will be more prepared in defending its position in the future. For the shareholder-employee within a closely held corporation, a more balanced approach to assigning levels of compensation should be followed in order to allay any fears of future problems with the IRS.
Sidebar
PRACTICE TIPS
● When helping clients determine appropriate levels for executive compensation, consult a compensation expert. If that is not an option, consider using other resources such as compensation websites (e.g., www.salary.com), national professional organizations, and even competitors' currently advertised positions. The Economic Research Institute (ERI) is also an excellent source of compensation information.
● When determining compensation plan for a shareholder-employee, put it in writing and put it in place as early as possible in that individual's tenure with the organization. Make sure that compensation is in line with other salaries in the industry as well as others within the company, and that compensation is tied to performance.
● Compensation plans should be discussed at annual board meetings. Advise clients to record these conversations in the minutes and maintain a record of all compensation decisions for all employees. For consistency, a compensation formula should be used for all compensation decisions. Additionally, the minutes should document all reasons for paying, or not paying, dividends. ● When evaluating an existing compensation plan, advise clients that rising compensation within a stagnant organization is a red
flag to the court. Pulling out all or most of the profits from the business in the form of rising salaries is also a red flag to the court. Additionally, the combination of salary and bonus should not cause a net loss or negative retained earnings within the corporation.
1
Topics covered in these ATGs include transfers of compensatory stock options to related persons, non-qualified deferred
compensation plans, stock-based compensation, the Section 162(m) salary deduction limitation, fringe benefits, golden parachutes, and split-dollar life insurance plans.
2
87 AFTR 2d 2001-2075, 249 F3d 994, 2001-1 USTC ¶50396 (CA-10, 2001).
3
52 AFTR 2d 83-5976, 716 F2d 1241, 83-2 USTC ¶9610 (CA-9, 1983).
4
54 AFTR 2d 84-5117, 588 F Supp 638, 84-1 USTC ¶9418 (DC Neb., 1984), aff'd on other grounds 56 AFTR 2d 85-5209, 763 F2d 339, 85-2 USTC ¶9461 (CA-8, 1985).
5
58 AFTR 2d 86-5574, 639 F Supp 1041, 86-2 USTC ¶9566 (DC Ind., 1986).
6
83 AFTR 2d 99-1922, 172 F3d 942, 22 EBC 2885, 99-1 USTC ¶50461 (CA-6, 1999).
7
77 AFTR 2d 96-2405, 85 F3d 950, 96-1 USTC ¶50297 (CA-2, 1996).
81 AFTR 2d 98-2312, 147 F3d 96, 98-1 USTC ¶50471 (CA-2, 1998).
9
196 F3d 893 (CA-7, 1999), rev'g Heitz, TC Memo 1998-220, RIA TC Memo ¶98220, 75 CCH TCM 2522 .
10
84 F.3d 431, 77AFTR2d 96-1808 (CA-5, 1996), aff'g TC Memo 1995-65, RIA TC Memo ¶95065, 69 CCH TCM 1869 .
11
Peyer, Cremers, and Bebchuk. “Pay distribution in the top executive team,” American Law & Economics Association Annual Meeting (2007), see www.law.harvard.edu/programs/olin_center/papers/pdf/Bebchuk_et%20al_574.pdf.
12
Cooper, Gulen, and Rau, “Performance for pay? The relationship between CEO Incentive compensation and future stock price performance,” Working paper, University of Utah and Perdue University (July 2009), www.krannert.purdue.edu/faculty/hgulen/CEO% 20Performance%20for%20Pay_0710.pdf.
13
103 AFTR 2d 2009-1280, 560 F3d 620, 2009-1 USTC ¶50270 (CA-7, 2009).
14
Small businesses tend to have higher degrees of both business and financial risk. These differences are well documented in the finance and valuation literature.
15
Pratt, Valuing Small Businesses and Professional Practices (The University of Michigan: Dow Jones-Irwin, 1986).
16
Menard does not disclose how the IRS calculated the rate of return.
17
Guidance for calculating the market value of equity is found in Regs. 20.2031-1(b) and 25.2512-1, and Rev. Rul. 59-60, 1959-1 CB 237.
18
TC Memo 2010-139, RIA TC Memo ¶2010-139, 99 CCH TCM 1567 .
