Chapman Law Review
COURTS DON’T FOLLOW: REASONABLE COMPENSATION RULINGS AND THE EXACTO SPRING APPROACH
Copyright (c) 2011 Chapman Law Review; Beth Stetson; Alexis Downs; Evan Shough; Dana Blake
The “reasonable compensation” issue is among the most frequently litigated tax issues. Its genesis is the Internal Revenue Service’s (“Service”) concern that, to avoid double taxation, closely-held corporations may unreasonably increase salaries to shareholder-employees rather than distributing dividends to them. The relevant statute, section 162 of the Internal Revenue Code (“Code”), allows taxpayers to deduct “ordinary and necessary expenses . . . including . . . a reasonable allowance for salaries or other compensation for personal services actually rendered.” Regulation 1.162-7(a) provides that deductible compensation payments must be both “reasonable” (“amount” test) and “purely for services” (“intent” test).
The “amount” test is the usual battleground between taxpayers and the Service. Relevant thereto, Regulation 1.162-7(b)(3) prescribes “[i]n any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances” and “[i]t is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”
Prior to Exacto Spring in 1999, courts generally used a “facts and circumstances” test with multiple objective factors to determine the amount of reasonable compensation, an approach consonant with section 162 and its regulations. In Exacto Spring, the Seventh Circuit alludes to the section 162 regulations only with respect to the “intent” test; and the court harshly criticizes the multiple objective factors analysis used by the Tax Court with respect to the “amount” test. The Seventh Circuit then turns to economic theory, opining that if a given amount of compensation leaves return on equity sufficient to satisfy an independent investor, then it is presumptively reasonable.
We believe Exacto Spring represents a legally improper and practically unwise departure from other reasonable compensation jurisprudence. Below, we first explain that Exacto Spring overstates the judicial trend regarding use of an independent investor perspective and return on equity in reasonable compensation cases. We then discuss Exacto Spring and other courts’ reluctance to follow its approach. We then explicate the opinion’s (1) inconsonance with section 162, its regulations, and its other case law, (2) questionable behavioral assumptions, and (3) creation of more fodder for confusion than using multiple objective factors. Finally, we offer a few of our own thoughts and suggestions.
Whether courts supplant current reasonable compensation jurisprudence with the Exacto Spring approach can be dispositive. Exacto Spring thus gives rise to a potentially outcome determinative split in approach between the circuits regarding one of the most frequently litigated tax issues. Supreme Court intervention would not be surprising, and additional discussion remains warranted.
Except for the Seventh Circuit in Exacto Spring and Menard, Inc. v. Commissioner, courts have used multiple objective factors to determine reasonable compensation. Although the sets of factors vary from circuit to circuit, they are similar. Courts view no single factor as dispositive and weigh the totality of facts and circumstances.
The two most commonly used sets of factors are those set forth in Mayson Manufacturing Company v. Commissioner and Elliotts, Inc. v. Commissioner. Mayson Manufacturing set forth nine factors: (1) officer qualifications; (2) nature, extent, and scope of the officer’s work; (3) business size and complexity; (4) comparison of officer salary to business gross income and net income; (5) prevailing general economic conditions; (6) comparison of officer salary with distributions to stockholders; (7) prevailing rates of compensation for comparable positions and comparable businesses; (8) taxpayer salary policy for all employees; and (9) prior compensation paid to the officer. Elliotts set forth five factors: (1) officer role in the company, including position held, hours worked, and duties performed, as well as general importance of the officer to company success; (2) comparison of the officer’s salary with those paid by similar companies for similar services; (3) character and condition of the company, including its sales, net income, and capital value, as well as business complexity and general economic conditions; (4) potential conflicts of interest, including the independent investor standard; and (5) internal inconsistency in a company’s treatment of payments to employees.
In the 1949 Mayson Manufacturing case, one factor is comparison of officer salary with distributions to stockholders. In the 1950s and 1960s, when addressing both the “intent” and “amount” tests, courts often looked to whether dividends had been paid. In 1970, the Court of Claims decided Charles McCandless Tile Service v. United States, which gave rise to the “automatic dividend” rule. Despite being generally profitable, the McCandless taxpayer had paid no dividends since its inception. The Court of Claims found that, even though the compensation was reasonable in amount (satisfied the “amount” test), the failure to pay dividends indicated “any return on equity capital is so conspicuous by its absence as to indicate . . . the purported compensation payments necessarily contained a distribution of corporate earnings” (failed the “intent” test) and, therefore, disallowed the compensation deduction in the amount needed to leave a fifteen percent return on equity. In essence, McCandless imposed a “substance over form” analysis into the “intent” test.
With respect to the “amount” test, in the 1970s courts began to speak occasionally in terms of the independent investor and return on equity, not just in terms of dividend payments. For example, in 1974 in Edwin’s, Inc. v. United States, the Seventh Circuit noted the taxpayer’s profit exceeded twenty percent of invested capital. The previous year, in Charles Schneider & Company v. Commissioner and in Carole Accessories, Inc. v. Commissioner, and in 1980 in Cromer v. Commissioner, the Tax Court viewed failure to pay dividends as evidencing unreasonable compensation because independent investors would demand a return on their capital. In 1981, in Foos v. Commissioner, the Tax Court viewed return on equity as one of twenty-one factors to be weighed in the “amount” test.
In Exacto Spring, to justify abandoning multiple objective factors, the Seventh Circuit characterized three previous circuit opinions as “moving toward a much simpler and more purposive test, the ‘independent investor’ test.” The first opinion, Elliotts, was issued by the Ninth Circuit in 1983. The second and third opinions, RAPCO, Inc. v. Commissioner and Dexsil Corporation v. Commissioner, were issued by the Second Circuit in the 1990s. All three opinions merely called for an examination as to whether return on equity would satisfy an independent investor as one of the “amount” test multiple objective factors.
In Elliotts, the Ninth Circuit rejected the McCandless “automatic dividend” rule. The Court noted that dividend payment is not legally mandated and it may be in the best interests of the company and shareholders for funds to be retained and reinvested in the company. The Ninth Circuit looked at each of the Elliotts factors. With respect to the “independent investor standard,” it stated as follows:
[I]t is appropriate to evaluate the compensation payments from the perspective of a hypothetical independent shareholder. If the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement. If, however, that is not the case, and the company’s earnings on equity remain at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary.
The Ninth Circuit viewed the taxpayer’s average return on equity of twenty percent for the two years at issue as likely sufficient to satisfy an independent investor and held that the Tax Court erred by limiting its analysis to the taxpayer’s failure to pay dividends and remanded the case.
Since Elliotts, courts generally look to the viewpoint of the independent investor in reasonable compensation cases, but do so only with respect to the “amount” test. As long as the formalities of calling payments compensation are observed, courts hold the “intent” test to be met. After migration to the “amount” test, the viewpoint of the independent investor became just one of several factors and lost its potential trump power exercised in McCandless via the “intent” test.
In RAPCO, even though the taxpayer’s return on equity for the years at issue compared favorably to that of the Standard & Poor’s 500, the Tax Court sustained most of the compensation disallowance. The Second Circuit looked to the Elliotts factors and affirmed. In response to the taxpayer’s argument that the Tax Court gave too little consideration to the effect its “impressive” return on equity would have on a “disinterested shareholder,” the Second Circuit noted that the Tax Court “explicitly conceded that [the taxpayer] had a substantial return on equity” but “correctly acknowledged . . . return on equity is only one factor”; and “the [Tax Court] appropriately discounted this factor, in the absence of evidence comparing [the taxpayer’s] return on equity to that of similar companies.” In Dexsil, although the Second Circuit held the Tax Court erroneously failed to consider the compensation at issue “from the perspective of an independent investor,” it clearly viewed all of the Elliotts factors as relevant.
After Elliotts, but prior to Exacto Spring, if reliable evidence regarding return on equity was available, the Tax Court generally viewed such evidence as indicative of reasonable compensation, while in a few cases, it viewed such evidence as indicating compensation was unreasonable. However, no court other than the Seventh Circuit has interpreted Elliotts, RAPCO, or Dexsil as calling for abandoning the use of multiple objective factors.
II. Exacto Spring and Other Courts’ Reluctance to Follow Its Approach
A. Exacto Spring
In Exacto Spring, the taxpayer, a manufacturer of precision springs, paid its chief executive (also cofounder and principal owner) $1.3 million in 1993 and $1 million in 1994. The Service contended that the proper compensation for these years was $381,000 and $400,000, respectively. Using a seven-factor objective test, the Tax Court held the proper compensation for the years at issue was $900,000 and $700,000, respectively. The Seventh Circuit reversed and held that all of the compensation paid to the chief executive was reasonable.
The Seventh Circuit opined that using multiple objective factors “leaves much to be desired–being like many other multi-factor tests, ‘redundant, incomplete, and unclear.”’ The Seventh Circuit held this based on the following reasons: (1) “it is nondirective . . . [with] no indication . . . of how the factors are to be weighed . . . and many of the factors . . . are vague”; (2) “the factors do not bear a clear relation either to each other or to the primary purpose of section 162(a)(1)”; (3) it “invites the Tax Court to set itself up as a superpersonnel department for closely-held corporations, a role unsuitable for courts”; (4) “it invites the making of arbitrary decisions based on uncanalized discretion or unprincipled rules of thumb”; and (5) “because the reaction of the Tax Court to a challenge to the deduction of executive compensation is unpredictable, corporations run unavoidable legal risks in determining a level of compensation that may be indispensable to the success of their business.” The Seventh Circuit used Exacto Spring to exemplify its views regarding the use of multiple objective factors, abandoning it in favor of an “indirect market test,” which is stated as follows:
A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner’s investment. 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 [because] 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 Service’s expert believed that investors in a firm like Exacto would expect a 13 percent return on their investment. Presumably they would be delighted with more. They would be overjoyed to receive a return more than 50 percent greater than they expected–and 20 percent, the return that the Tax Court found that investors in Exacto had obtained, is more than 50 percent greater than the benchmark return of 13 percent.
When, notwithstanding the CEO’s “exorbitant” salary (as it might appear to a judge or other modestly paid official), the investors in his company are obtaining a far higher return than they had any reason to expect, his salary is presumptively reasonable. We say “presumptively” because we can imagine cases in which the return, though very high, is not due to the CEO’s exertions. Suppose Exacto had been an unprofitable company that suddenly learned that its factory was sitting on an oil field, and when oil revenues started to pour in its owner raised his salary from $50,000 a year to $1.3 million. The presumption of reasonableness would be rebutted. There is no suggestion of anything of that sort here and likewise no suggestion that Mr. Heitz was merely the titular chief executive and the company was actually run by someone else, which would be another basis for rebuttal.
B. Other Circuits and the Tax Court Decline to Follow Exacto Spring
Between Exacto Spring and Menard, the Tax Court decided several reasonable compensation cases. It did not adopt the Exacto Spring approach in any of these cases, despite considerable taxpayer prodding to do so. During the period, several circuits also declined to adopt the Exacto Spring approach despite considerable taxpayer prodding to do so.
In 2000, in Normandie Metal Fabricators, Inc. v. Commissioner, the Tax Court distinguished the case from Exacto Spring and looked to the RAPCO, Inc. factors from the perspective of an independent investor; the Second Circuit affirmed. In 2001, in Eberl’s Claim Service, Inc. v. Commissioner, the Tenth Circuit declined to abandon its “traditional multi-factor test of reasonableness outlined in Pepsi-Cola Bottling” under which “the situation must be considered as a whole, with no one factor being decisive.” In 2003, the Tax Court used the Owensby & Kritikos factors to decide Brewer Quality Homes, Inc. v. Commissioner; the Fifth Circuit affirmed. In 2003, in E.J. Harrison & Sons, Inc. v. Commissioner, the Tax Court rejected the taxpayer’s argument grounded in Exacto Spring that its favorable return on equity rendered compensation “presumptively reasonable”; the Ninth Circuit affirmed in relevant part. In 2003, in Haffner’s Service Stations, Inc. v. Commissioner, the First Circuit stated that the section 162 regulations require reasonableness to be based on “all circumstances” and rejected the taxpayer’s urging to adopt the Exacto Spring approach. In 2004, in Metro Leasing and Development Corp. v. Commissioner, the Ninth Circuit again declined to adopt the Exacto Spring approach and stated that courts should examine the “nature and quality of the services” an officer provides “as well as the effect of those services on the return the investor is seeing on his investment.”
Menards is a retailer of hardware, building supplies, paint, garden equipment, and similar items. During the year at issue, the company had approximately 160 stores in nine Midwestern states and was one of the nation’s top retail home improvement chains (third only to Home Depot and Lowe’s). That year, it paid its CEO $20,642,485. Because the case was appealable to the Seventh Circuit, the Tax Court was obligated to follow Exacto Spring or explain why it did not do so.
In its post-trial Tax Court brief, the Service conceded that the taxpayer’s return on equity for the year at issue would have satisfied an independent investor, and thus, the compensation passed the Exacto Spring “amount” test. The Tax Court refused to accept the concession on its terms, instead treating it as a concession that a presumption of reasonableness arose; a presumption rebuttable by evidence demonstrating the compensation “substantially exceeded . . . [that] paid by comparable publicly traded corporations to their CEO.” The Tax Court viewed the ability of such evidence to rebut the presumption of reasonableness as flowing from Regulation 1.162-7(b)(3), which requires courts to consider “evidence of how the marketplace values the services of comparably situated executives” including “evidence of compensation paid to CEOs in comparable companies.”
Both parties’ experts accepted the Black-Scholes model as appropriate and agreed five publicly traded companies were comparable to the taxpayer: Home Depot, Kohl’s, Lowe’s, Staples, and Target. Because the taxpayer CEO’s compensation was multiple times higher than that of the comparable CEOs (two times the Target CEO, three times the Staples and Lowe’s CEO, four times the Kohl’s CEO, and seven times the Home Depot CEO), the Tax Court held that any presumption that the taxpayer CEO’s compensation was reasonable was rebutted. It then looked to the record as a whole to determine the amount of reasonable compensation.
The Tax Court viewed Home Depot and Lowe’s as most “directly comparable” to the taxpayer. It started with Home Depot CEO’s compensation of $2,841,307. It multiplied this amount by 18.8% divided by 16.1%, because the taxpayer’s return on equity (18.8%) was higher than Home Depot’s (16.1%). This yielded $3,317,799. The Tax Court then multiplied that amount by 213%, because Lowe’s CEO’s compensation was 2.13 times higher than Home Depot’s CEO’s. This yielded $7,066,912, which the Tax Court held to be the amount of reasonable compensation.
The Seventh Circuit reversed and held reasonable the entire amount the taxpayer characterized as compensation, $20,642,485. Specifically, the Seventh Circuit held the Tax Court committed clear error by holding that the reasonableness presumption was rebutted by evidence of comparable companies’ CEO compensation.
In the one Tax Court reasonable compensation case appealable to the Seventh Circuit since Menard, the Tax Court acknowledged that a sufficiently high rate of return could give rise to a rebuttable presumption of reasonableness (although the rate of return therein did not suffice), while in the only other reasonable compensation case decided subsequent to Menard the Tax Court did not follow Exacto Spring and Menard. No circuit has addressed the reasonable compensation issue since Menard.
III. Exacto Spring Is Inconsonant with Section 162, Its Regulations and Its Other Case Law
A. Exacto Spring Is Inconsonant with Section 162
Scholars have identified four methods of statutory interpretation used by courts: intentionalism, purposivism, textualism, and the dynamic method. According to intentionalism, even if statutory language appears clear, courts should examine legislative history to discern what the enacting legislature intended the statute to mean. That is, courts should essentially act as agents of the enacting legislature. According to purposivism, courts should discern a statute’s original purpose by examining legislative history in the context of enactment circumstances. According to textualism, courts should not look to a statute’s legislative history but rather to its text in the context of surrounding law. According to the dynamic method, courts should look not only to a statute’s text and historical background but also to society’s contemporary needs and goals.
In 1934 in Gregory v. Helvering, the Second Circuit refused to give tax recognition to a transaction that literally complied with the Code but in its view was not what the statute intended; the Supreme Court affirmed. Since then, courts construing the Code most often speak in terms of intentionalism and purposivism. However, there are a few cases which best fit into the dynamic method mold, and recently some judges, including Supreme Court Justice Antonin Scalia, have argued for and applied textualism.
No matter which method of statutory interpretation courts employ, the starting point is the statute’s text. Section 162 provides: “[T]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including . . . a reasonable allowance for salaries or other compensation for personal services actually rendered.”
i. Intentionalism and Purposivism
Intentionalism and purposivism look to legislative history and historical background. The Revenue Acts of 1913 and 1916 contained only the general “ordinary and necessary” provision of section 162’s predecessor. However, underlying regulations warned of the need to analyze carefully purported compensation payments to officers to ensure such payments were not out of proportion to business volume or excessive when compared to similarly situated employees in other companies; the regulations prescribed “the amount so paid in excess of reasonable compensation for the services will not be deductible from gross income, but will be treated as a distribution of profits.”
The Revenue Act of 1918 added the “reasonable allowance for salaries or other compensation” provision. Its legislative history is unclear. According to some commentators, the provision “permit closely held enterprises to deduct an allowance for services rendered by officers and proprietors in computing the World War I excess profits tax even if no salary was actually paid.” In any event, after the excess profits tax expired, the provision came to be interpreted as a disallowance of unreasonable amounts if paid, rather than as an allowance for reasonable amounts that were not paid. By 1930, the Supreme Court implicitly acknowledged such a view in Lucas v. Ox Fibre Brush Co., and since then the “reasonable allowance” provision has functioned as a limitation rather than an enlargement of compensation deductibility.
While little in the way of intent or purpose can be gleaned from the unusual history of the “reasonable allowance” provision, eighty years of Congressional silence since Lucas evidences its assent to the facts and circumstances analysis of Regulation 1.162-7 and multiple objective factors case law. When Congress re-enacts a statute with administrative or judicial interpretative guidance in place, Congress is deemed to give assent to such guidance. The “reasonable allowance” provision with underlying regulations and multiple objective factors case law was in place during the 1954 and 1986 Code re-codifications, and if Congress had been unhappy with these interpretations, presumably it would not have implicitly blessed them by re-enacting the provision verbatim.
In sum, while legislative history and historical background are murky, Congressional re-enactment of section 162 while Regulation 1.162-7 and multiple objective factors case law were in place evidence Congressional approval of these interpretations.
Textualism looks to a statute’s text and surrounding law. With respect to text, the amorphous phrase “reasonable allowance” evidences Congressional intent to sentence taxpayers, the Service, and courts to messy facts and circumstances analysis in reasonable compensation controversies. Congress imposes many such sentences in the Code: for example, determining whether an activity is engaged in for profit (section 183); determining whether related party transactions are at arm’s length (section 482); and computing reasonable capital needs of a business for purposes of the accumulated earnings tax (section 531). When Congress wants to have a characterization question settled by a bright line test, it knows how to do so: for example, the material participation test under the passive loss rules (section 469); the definition of alimony (section 71); and the definition of passive gains under subchapter S (section 1375). But in section 162 Congress decided against a bright line for reasonable compensation.
With respect to context, courts have held a “reasonable in amount” limitation inherent in the section 162 “ordinary and necessary” provision, and section 482 grants the Service discretion to reallocate income and deductions among related parties to reflect an arm’s length standard. These provisions reflect the recurrent tax law theme of ensuring related party transactions are treated for tax purposes as if they had occurred between unrelated parties. Determining the amount a taxpayer would have paid an unrelated party for the same goods and services entails a facts and circumstances test very akin to the reasonable compensation determination approach of Regulation 1.162-7 and multiple objective factors case law.
In sum, the amorphous language of section 162 coupled with the contextual tax law theme regarding related party transactions evidences that Regulation 1.162-7 and multiple objective factors case law are proper interpretations of section 162.
iii. Dynamic Method
The dynamic interpretative approach looks to society’s contemporary needs and goals. According to the Seventh Circuit, a simpler, bright line test is needed to determine reasonable compensation. As discussed below, the Exacto Spring approach increases rather than decreases the complexity of reasonable compensation controversies.
Even if the Exacto Spring approach did reduce complexity, such simplicity might come at too high a price. To some extent, the “rules” approach of Exacto Spring versus the “principles” approach of multiple objective factors reflects the “rules versus principles” debate now ongoing with respect to both tax law and financial accounting. It is perhaps overly simple, but not inaccurate, to summarize this debate as revealing there are advantages and disadvantages for both rules and principles for most applications. Policymakers must pick their poison.
To recap, intentionalism, purposivism, textualism, and dynamic statutory interpretation all indicate courts should not abandon using multiple objective factors in favor of the Exacto Spring approach in reasonable compensation cases.
Furthermore, in the absence of statutory language to the contrary or a compelling public policy reason, tax statutes should be construed without presumption. In Exacto Spring, the Seventh Circuit attempts to coin a presumption that compensation is reasonable if it leaves sufficient return on equity. As is apparent herein, neither the text of section 162 nor its related policy concerns warrant such a presumption.
B. Exacto Spring is Inconsonant with Section 162 Regulations
The relevant section 162 regulations were promulgated pursuant to section 7805(a), which authorizes the Treasury Department to promulgate regulations interpreting the Code. In Mayo Foundation for Medical Education and Research v. United States, the Supreme Court recently held that such regulations must be followed if they represent a “reasonable interpretation” of the relevant Code section.
Again, Regulation 1.162-7(b)(3) prescribes that “[i]n any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances” and that “[i]t is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” The Seventh Circuit does not mention the regulation in Exacto Spring. In Menard, it dismisses the regulation as “not an operational standard,” but cites no authority to justify ignoring regulations for such a reason. We are aware of no case in which a party (or a court) challenged Regulation 1.162-7 as not representing reasonable statutory interpretation or as inconsonant with Congressional intent. Even if the Exacto Spring approach is a “better” or even the “best” approach to determining reasonable compensation, it is legally improper for the Seventh Circuit to substitute such approach for that of Regulation 1.162-7.
One can view Exacto Spring as consonant with Regulation 1.162-7 if one believes company owners actually determine officer compensation by looking solely to return on equity. Empirical studies indicate company owners consider much more than return on equity. For example, one survey of 587 firms indicates that only four percent of firms relied exclusively on return on equity. To reduce the myopic behavior that specific metrics may cause, most firms use multiple metrics, including various ratios, income and revenue targets, and non-financial measures such as quality and innovation. Further, many reputable scholars question the behavioral assumptions of Law and Economics theory, upon which Exacto Spring is based.
In sum, the Seventh Circuit’s lack of deference to Regulation 1.162-7 in favor of Law and Economics theory is not legally proper. Because taxpayers’ trust in and deference to Treasury Regulations is grounded in the expectation that courts will follow them, such judicial refusal to follow Treasury regulations may have negative consequences.
C. Exacto Spring Is Inconsonant with Other Section 162 Case Law
Judge Posner, author of Exacto Spring and Menard, has criticized use of multiple factors and reversed trial courts’ use of such analysis in a number of legal contexts; he has imposed standards derived from his economic theory in lieu of established legal standards in several cases across varied areas of the law. Discussion of the propriety of this practice by Judge Posner, in general, is beyond the scope of this article. However, in our opinion, even if such practice might be appropriate in some areas of the law, it is not appropriate with respect to reasonable compensation jurisprudence.
Stare decisis, Latin for “let the decision stand,” is a bedrock principle of common law. It provides that, absent powerful justification, courts should follow previous precedent. In Edwin’s, Inc. v. United States, the Seventh Circuit had previously determined reasonable compensation using multiple objective factors. Thus, Exacto Spring deviates from stare decisis.
Stare decisis reflects two key policy concerns. First, judicial decisions only provide guidance to citizens structuring their affairs and to litigants preparing for trial if courts follow them. Second, respecting previous judicial decisions allows law to develop incrementally. Once Exacto Spring was on the books, the first policy concern was ameliorated in the Seventh Circuit, but remains germane for other courts.
Regarding the second policy concern, when the Seventh Circuit issued Exacto Spring, courts had been wrestling with reasonable compensation for around seventy years. The Tax Court had penned several dozen opinions regarding the issue, and most Circuits had dealt with the issue a number of times. While courts may have differed slightly regarding the factors they applied, they had reached a consensus that (1) section 162 and its underlying regulations give rise to a dual subjective “intent” test and objective “amount” test, and (2) the “amount” test should be implemented using multiple objective factors.
Judge Posner is quite knowledgeable regarding tax law. However, no amount of technical knowledge can replace the collective practical wisdom of Tax Court judges. They typically practice tax law for decades in private practice, government service, or both prior to their court appointment. Upon appointment, they serve fifteen year terms, during which they typically preside over several cases involving reasonable compensation and other valuation issues. Tax Court expertise is so well recognized that many scholars argue its legal tax interpretations should be afforded a heightened standard of review.
In sum, when the Seventh Circuit issued Exacto Spring, adequate reasons were not extant to abandon multiple objective factors analysis, which reflected the collective practical wisdom of dozens of Tax Court judges and had been uniformly followed in all circuits (including the Seventh).
IV. Exacto Spring Is Grounded Upon Questionable Behavioral Assumptions
Exacto Spring ignores a multitude of social science theories that potentially are as equally applicable as Law and Economics. In Menard, Judge Posner focused on the risk inherent in Mr. Menard’s compensation, and clearly, an economic theoretical framework informed Posner’s perspective. In a recent article in the Journal of Institutional Economics, Posner explains this perspective. He states: “[O]rganization economics emphasizes the relation between organizational structure and compensation systems, on the one hand, and innovation, the management of information flows, agency costs, and efficiency in general, on the other hand.” The Journal article articulates Posner’s keen endorsement of organization economics and his support for the Law and Economics interface.
In Posner’s view, the law and economics interface is pragmatic. Posner writes:
[W]hile pragmatist philosophers do not think that scientific theories can be shown to embody final truths about the structure of the universe, they do not doubt the utility of such theories. It is no more unpragmatic for judges to use economics to help them reach a decision than it is for them to use chemistry, the findings of cognitive psychology, or actuarial computation.
He goes on to say that his support for the Law and Economics interface is pragmatic and empiricist and that economic tools of analysis promote efficiency. Despite Posner’s disavowal of final truths and his focus on economics as merely one theory that informs the law, we think that Posner uses organization economics to the exclusion of other available organizational theories. Alternatives to organization economics are available.
What are these alternatives, and where might we find them? As an expert of new institutional economics and transaction cost economics, Oliver Williamson is mentioned in Posner’s organization economics article. Williamson himself, a 2009 winner of the Nobel Memorial Prize in economics, provides a survey of organization theory alternatives. Alternatives include resource dependence theory and the anthropological and symbolic perspectives.
The first alternative is resource dependence theory as advocated by Jeffrey Pfeffer. In many ways, the predictions of resource dependence theory are similar to those of transaction cost economics. However, as explained by Pfeffer, resource dependence theory emphasizes that (1) organizations and people within them are interdependent with other organizations and with other people; and (2) due to interdependence, understanding social context is critical. Hence, organizations and the people within them will seek relationships with others and be dependent upon others in order to obtain needed resources. More specifically, a compensation structure results from a social comparison process. According to Pfeffer, seniority has been shown to be more related to compensation than performance. Furthermore, according to Pfeffer, “individuals prefer more equal distributions of wages or other organizational rewards than a principle of equity or proportionality implies, in which individuals are compensated strictly in proportion to their performance . . . .” Resource dependence theory would probably de-emphasize a single test, such as the independent investor test, and instead emphasize the multiple factors of Mayson Manufacturing or Elliotts because such factors recognize interdependence and context. Moreover, the emphasis upon interdependence and social context points to the importance of stare decisis. As Posner himself explains, “the constraining effect of precedent comes not from the fact that stare decisis is a sound policy but from the fact that a judge’s influence is dependent to a significant degree on his decisions being treated as precedent by other judges.” In other words, the policy of stare decisis recognizes that organizations or institutions and the people within them are interdependent.
More broadly, resource dependence theory points to the needs of the whole: the whole organization and the whole society. Consideration of the needs of the whole contrasts with “methodological individualism.” As described by Mary Douglas, whose work is included among the organization theory alternatives, methodological individualism starts with the rational actor who is “sovereign over his own choices”; this contrasts with an anthropological perspective. As Douglas explains, methodological individualism ignores social influence. Douglas acknowledges Williamson’s theory of the firm, which is a “whole,” but Douglas points out that Williamson “has the same representative rational individual marching into one kind of contract or refusing to renew it . . . .” As an alternative to methodological individualism, Douglas proposes an anthropological argument: “What the individual is going to want is not entirely his own idea, but consists largely of a set of desires that the social environment inspires in him.” Douglas urges that dimensions of culture be included in theories of organizations and their actors. The point is that, as an alternative to organization economics, Douglas’ anthropological perspective suggests that a single test, such as the independent investor test, is inappropriate as it ignores a possible set of culturally influenced desires and constraints.
Organization economics can be critiqued from yet another perspective: the non-rational, symbolic perspective. Richard Scott, whose work is included in Williamson’s text, recognizes the “importance of economic incentives,” but he argues that stronger incentives are symbolic incentives. Briefly, he means that leadership is its own reward and that leaders manipulate symbols. Referring to the work of Chester Barnard, Scott says that symbols elicit commitment of organizational actors; organizational leaders, such as Mr. Menard, are rewarded by the commitment of the organizational actors. In addition, from Scott’s perspective, the independent investor test could be considered symbolic in this sense: “[S]ymbols also function in organizations to provide an externally devised cognitive framework, allowing conforming organizations to constitute themselves as rational actors, borrowing meaning and garnering legitimacy and support from their environment.” In the sense of an “externally devised cognitive framework,” return on equity becomes symbolic because a return on equity legitimizes compensation, even though return on equity would not necessarily justify compensation.
In sum, the preceding paragraphs have provided some examples of alternative organization theories. More examples are possible. The point is this: organization economics is merely one organization theory.
The general formula for return on equity is income divided by equity. While application of return on equity may have appeared straightforward in Exacto Spring, in actuality the formula is laden with questions ripe for argument. Several cases have wrestled with these questions and arrived at no settled answers.
After Exacto Spring, parties in the Seventh Circuit have apparently perceived that their case will hinge upon return on equity. In other circuits, parties have apparently perceived a material possibility their court will adopt the Exacto Spring approach and their case will hinge upon return on equity. Consequently, cases have often veered into arcane economic questions with extensive, highly technical, and quite partisan expert testimony. For example, in Brewer Quality Homes the Tax Court and the Fifth Circuit wrestled with the merits of the Capital Asset Pricing Model and weighted average cost of capital; the Tax Court also grappled with whether an equity risk adjustment, size adjustment, and company-specific risk adjustment should be made to the risk-free rate of return. In Wechsler & Co., Inc. v. Commissioner, the Tax Court considered adjusting cost of common stock equity using a beta (measure of risk comparing a stock’s volatility to that of the general market) representing the median beta for six “smaller” publicly traded broker-dealers. In Menard, the Tax Court waded into issues of comparative proxy statement compensation, periodicity, transfer restrictions, vesting periods, risk of forfeiture, discount for aversion risk, Financial Accounting Standard 123, etc.
Among the issues that commonly arise when applying return on equity are the following:
First, which year(s)’ return on equity is relevant? Return on equity for the year(s) at issue, the recent past, the officer’s tenure, or the corporation’s entire life? The answer is not clear and may differ among cases. A related question is whether to examine return on equity for each year separately or in the aggregate?
Second, what is “income?” Should the parties use financial income per Generally Accepted Accounting Principles, taxable income, or income adjusted to better reflect economic reality? Subtract taxes, interest cost, or cost of equity? Use consolidated or unconsolidated income? Use income per se or dividends plus stock appreciation?
Third, what is “equity?” Should the parties use accounting book equity? If yes, use initial capital contribution, beginning equity, ending equity, average equity, or equity otherwise determined? Include funds in form “borrowed” from the officer that are in substance capital contributions? What should be done if equity is negative?
Or should the parties use fair market value of company stock (beginning, ending, or average)? This value would better represent the opportunity cost of investment. However, it would render relevant everything from the macroeconomic environment to office furniture value, and would import an abundance of technical finance and economic questions. For example, in Brewer Quality Homes, the Tax Court valued equity using fair market value; it wrestled for pages and pages with (1) whether to use three times “owners’ discretionary cash flow . . .” or five times “earnings before interest (net of interest income and interest expense) and taxes (Federal income taxes), or EBIT [Earnings Before Interest and Taxes],” and (2) how to determine the “cost of capital.”
Fourth, what is an acceptable return on equity? In Brewer Quality Homes, the Tax Court looked to the “rate of return that an investor would expect to realize from an investment in a company such as the taxpayer, taking into account the appropriate risk and performance characteristics of the taxpayer.” This definition makes relevant everything about the taxpayer and its operational environment. It also requires identification of comparable companies and raises many technical questions.
Fifth, do the parties adjust for the taxpayer’s leverage? Companies with high debt-to-equity ratios will experience heightened return on equity vis à vis companies with lower debt-to-equity ratios when times are good, but the reverse is also true.
Although return on equity often enters into multiple objective factors analysis and so these issues could arise anyway, the Exacto Spring approach transmutes the issues into the crux of the case. This transmutation makes parties more likely to bring out the heavy artillery of partisan experts who render highly technical and arcane testimony. While parties often introduce expert testimony regarding multiple objective factors analysis, such testimony is typically less technical and is related to matters more within the typical judge’s realm of knowledge.
Currently, parties have to address both approaches. In circuits other than the Seventh, in the event the court follows Exacto Spring, parties must address return on equity. In the Seventh Circuit, parties must address multiple objective factors analysis in case the court holds the taxpayer’s return on equity was unsatisfactory or was not attributable solely to officer(s).
Finally, the Service has other weapons available to disallow unreasonable compensation. For example, the Service could use the section 162 “ordinary and necessary” provision, section 482, or the substance over form doctrine. All of these generate messy facts and circumstances battles. What is to prevent the Service from using these weapons if courts adopt the Exacto Spring approach?
VI. Our Thoughts and Suggestions
A. Appellate Courts Should Review Trial Courts’ Selection of Relevant Reasonable Compensation Factors Using a Clearly Erroneous Standard
At the appellate level, trial courts’ factual findings are properly overturned only if “clearly erroneous”; their legal conclusions are properly reviewed without deference (that is, de novo). However, there is not simply a continuum of issues ranging from purely factual to purely legal. For example, “evaluative determinations” have no home in such a continuum.
“Reasonable” issues, including the reasonable compensation issue, are evaluative determinations; such issues are not properly always reviewed deferentially or de novo. Rather, their standard of review is based on a policy choice concerning the judicial actor better positioned to decide the particular issue.
Appellate courts have treated composition of the factors used to determine reasonable compensation as a legal question reviewable de novo. Nevertheless, they have treated determination of the ultimate fact of the amount of reasonable compensation as a factual question reviewable only for clear error. This disparate treatment seems logically inconsistent. By deferring to trial courts’ determination of the amount of reasonable compensation, appellate courts implicitly acknowledge that trial courts are better positioned to make this evaluative determination. If trial courts are better positioned to determine the amount of reasonable compensation, surely they are also better positioned to select the factors relevant to such determination.
Further, appellate courts already show deference to trial courts’ weighting of reasonable compensation factors differently in different cases, but there is no logical distinction between determining that a given factor will receive a very high or very low weight in different cases and determining that the factor is relevant in some cases and irrelevant in other cases.
In sum, trial courts are better positioned to select relevant reasonable compensation factors. Such selection is integral to determining the amount of reasonable compensation, an inherently factual determination that appellate courts concede is properly the province of trial courts. Thus, appellate courts should overrule trial courts’ selection of relevant reasonable compensation factors only if it leads to clearly erroneous determination of ultimate fact (the amount of reasonable compensation).
B. A Few Additional Thoughts
We believe it unlikely that an independent company owner would agree to a contract embodying the Exacto Spring approach. Such a contract would allow the officer to draw out any amount of compensation, no matter how high, as long as return on equity is left at a certain minimal level.
More likely, an officer and independent company owner would agree as follows. First, the officer will receive minimal fixed compensation, even if pre-compensation net income is negative. Next, if net income (after officer minimal fixed compensation) is positive, the company owner will receive a minimal return on their invested capital. If net income exceeds that needed to provide the minimal return on owner invested capital, the officer and company owner will share the “bounty.” Under the Exacto Spring approach, all the bounty would be allocated to the officer. While profit sharing plans entitling management to a share of the bounty are common, we are aware of no independent company owner agreeing to a compensation plan granting management most, much less all, of it.
Allocating all the bounty to the officer implicitly presumes that only the officer could have steered the taxpayer to a bountiful performance. We believe this is an erroneous presumption of bilateral monopoly. Occasionally, the officer may have technical expertise, supplier and customer relationships, or the like, without which the taxpayer simply could not function. But usually the taxpayer could function without the officer. Pre-compensation net income might be lower without the officer, but such diminution could potentially be more than offset by reduced salary cost.
If the bounty is attributable to intangibles (on or off the balance sheet), its division would depend upon who owns or controls the intangibles. For example, if certain customers would cease purchasing from the company if the officer left, this “customer list” intangible would provide the officer with bargaining leverage to obtain a larger share of the bounty.
Courts have occasionally allowed compensation to be increased for the value of intangibles such as customer lists, unique processes, etc. Issues frequently skipped include: (1) who owns or controls the intangibles, and (2) whether the intangibles would have value if the officer left the corporation. In our view, if a corporation uses intangibles owned or controlled by an officer, the officer should receive more of the bounty. However, if the corporation owns or controls intangibles that would remain valuable if the officer were absent, the corporation should receive more of the bounty.
C. A Few Suggestions
Additional regulatory guidance would better protect closely-held corporations from uncertainty regarding reasonable compensation than would adoption of the Exacto Spring approach. Such regulations could prescribe, inter alia, methodological guidance similar to the section 482 regulations, mandatory documentation regarding the taxpayer’s method of determining compensation, and procedures for pre-filing agreements regarding reasonable compensation.
The impact of intangibles on reasonable compensation also warrants additional regulatory guidance. We believe courts should more deliberately identify and address the impact of intangibles on reasonable compensation. However, valuing intangibles entails thorny measurement questions. For example, many intangibles are inextricably tied to other intangible or tangible assets, making disaggregated valuation exceedingly difficult. This valuation issue is likely one reason firms with high amounts of intangibles are more likely to use bonus structures with earnings rather than return based benchmarks. However, crafting of useful intangible valuation guidance is possible.
Courts have been reluctant to follow Exacto Spring’s return on equity approach in reasonable compensation cases. We agree with their reluctance. Multiple objective factors analysis better accords with section 162, better implements applicable regulations, is more consonant with collective judicial wisdom, and is more attuned to the manner in which unrelated parties actually determine compensation. A likely more efficacious approach to lessening taxpayer uncertainty regarding reasonable compensation would be issuance of additional regulatory guidance, including methodological guidance (especially regarding intangibles), documentation guidance, and pre-filing agreement procedures.
Without question, the federal tax code is the most technical and complex of all federal statutory schemes. Given this level of complexity, the Treasury Department, as the agency charged with administering the tax laws, must provide seemingly endless guidance to the public on how to comply with these laws. Because they are often regarded as equivalent to statutory law, valid Treasury regulations are the most important form of Treasury guidance. Treasury regulations–both legislative and interpretive–are the most formal type of Treasury guidance and are clothed with congressional delegatory authority. To the extent that these regulations are respected by reviewing courts, the public is assured that compliance with them is the same as complying with the related federal statute. However, if reviewing courts refuse to defer to Treasury regulatory interpretations of tax statutes, public confidence in the Treasury is damaged, as is its ability to administer the tax laws. Conceivably, this increases the likelihood that taxpayers will challenge Treasury regulations in court.
For example, in a negligence case involving stipulated historical facts–that is, the parties agree about what happened, but disagree about whether the defendant’s conduct was reasonable–the jury’s reasonableness determination is neither factual nor legal. It is not deciding what happened, since that is stipulated. And it is not deciding rules that apply for all similarly situated people. It is just deciding whether one person’s conduct was reasonable in a specific circumstance.
Similarly, a jury’s decision to award $1 million in damages for pain and suffering is neither fact nor law, nor anything in between. It is a different kind of decision altogether, one in which the jury is neither determining what happened (a question of fact) nor fixing a generally applicable rule (a question of law), but is prescribing the appropriate result in one specific case.
Id. at 108. As noted by the article, evaluative determinations are found everywhere in the law (for example, negligence in tort law and probable cause in criminal procedure).
While it might theoretically be reasonable for an investor to pay 100 percent of profits above his expected return to an executive if he has no other means of obtaining his expected return, the market drives down the price an investor has to pay. It would be unreasonable for an investor seeking to maximize his wealth to pay 100 percent of those excess profits to one executive, if another would agree to take only fifty percent. Even if this second executive were to generate a smaller gross return than the first, if his share of the profits is small enough, the investor will still be better off by hiring the second executive. Thus, the premise that a hypothetical reasonable investor would agree to pay an above-market salary may be faulty, and the conclusion that an employee/owner’s salary was reasonable because it fell within the range predicted by a model that eliminates the market may not be warranted.
The Tax Court noted in Guy Schoenecker, Inc. v. Commissioner, 70 T.C.M. (CCH) 1303, 1312 (1995), that while “it is difficult to determine what an independent investor would expect from the risk of his funds in a business such as [the taxpayer’s]…it is reasonable to assume that an independent investor would be unwilling for an officer to realize compensation out of line with compensation paid by similar businesses, thus unnecessarily reducing the income produced by the business in which he had invested.”