Exacto Spring Corp. v. Comm'r of Internal Revenue

• Decision Date: 16 November 1999
• Docket Number: No. 99-1011,99-1011
• Citation: 196 F.3d 833
• Parties: (7th Cir. 1999) Exacto Spring Corporation, Petitioner-Appellant, v. Commissioner of Internal Revenue, Respondent-Appellee
• Court: U.S. Court of Appeals — Seventh Circuit

Page 833

196 F.3d 833 (7th Cir. 1999)

Exacto Spring Corporation, Petitioner-Appellant, v. Commissioner of Internal Revenue, Respondent-Appellee.

No. 99-1011

United States Court of Appeals, Seventh Circuit

Argued September 8, 1999

Decided November 16, 1999

Appeal from the United States Tax Court.

Before Posner, Chief Judge, and Bauer and Ripple, Circuit Judges.

Posner, Chief Judge.

This appeal from a judgment by the Tax Court, 75 T.C.M. (CCH) 2522 (June 24, 1998), requires us to interpret and apply 26 U.S.C. sec. 162(a)(1), which allows a business to deduct from its income its "ordinary and necessary" business expenses, including a "reasonable allowance for salaries or other compensation for personal services actually rendered." In 1993 and 1994, Exacto Spring Corporation, a closely held corporation engaged in the manufacture of precision springs, paid its cofounder, chief executive, and principal owner, William Heitz, $1.3 and $1.0 million, respectively, in salary. The Internal Revenue Service thought this amount excessive, that Heitz should not have been paid more than $381,000 in 1993 or $400,000 in 1994, with the difference added to the corporation's income, and it assessed a deficiency accordingly, which Exacto challenged in the Tax Court. That court found that the maximum reasonable compensation for Heitz would have been $900,000 in the earlier year and $700,000 in the later one--figures roughly midway between his actual compensation and the IRS's determination--and Heitz has appealed.

In reaching its conclusion, the Tax Court applied a test that requires the consideration of seven factors, none entitled to any specified weight relative to another. The factors are, in the court's words, "(1) the type and extent of the services rendered; (2) the scarcity of qualified employees; (3) the qualifications and prior earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer's business." 75 T.C.M. at 2525. It is apparent that this test, though it or variants of it (one of which has the astonishing total of 21 factors, Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-79 (1981)), are encountered in many cases, see, e.g., Edwin's Inc. v. United States, 501 F.2d 675, 677 (7th Cir. 1974); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987); Mayson Mfg. Co. v. Commissioner 178 F.2d 115, 119 (6th Cir. 1949); 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts para. 22.2.2, p. 22-21 (3d ed. 1999), leaves much to be desired--being, like many other multi-factor tests, "redundant, incomplete, and unclear." Palmer v. City of Chicago, 806 F.2d 1316, 1318 (7th Cir. 1986).

To begin with, it is nondirective. No indication is given of how the factors are to be weighed in the event they don't all line up on one side. And many of the factors, such as the type and extent of services rendered, the scarcity of qualified employees, and the peculiar characteristics of the employer's business, are vague.

Second, the factors do not bear a clear relation either to each other or to the primary purpose of section 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. E.g., Rapco, Inc. v. Commissioner, 85 F.3d 950, 954 n. 2 (2d Cir. 1996). Suppose that an employee who let us say was, like Heitz, a founder and the chief executive officer and principal owner of the taxpayer rendered no services at all but received a huge salary. It would be absurd to allow the whole or for that matter any part of his salary to be deducted as an ordinary and necessary business expense even if he were well qualified to be CEO of the company, the company had substantial net earnings, CEOs of similar companies were paid a lot, and it was a business in which high salaries are common. The multi- factor test would not prevent the Tax Court from allowing a deduction in such a case even though the corporation obviously was seeking to reduce its taxable income by disguising earnings as salary. The court would not allow the deduction, but not because of anything in the multi-factor test; rather because it would be apparent that the payment to the employee was not in fact for his services to the company. Treas. Reg. sec. 1.162-7(a); 1 Bittker & Lokken, supra, para. 22.2.1, p. 22-19.

Third, the seven-factor test invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts, as we have repeatedly noted in the Title VII context, e.g., Jackson v. E.J. Brach Corp., 176 F.3d 971, 984 (7th Cir. 1999), and as the Delaware Chancery Court has noted in the more germane context of derivative suits alleging excessive compensation of corporate employees. Gagliardi v. TriFoods Int'l, Inc., 683 A.2d 1049, 1051 (Del. Ch. 1996). The test--the irruption of "comparable worth" thinking (see, e.g., American Nurses' Ass'n v. Illinois, 783 F.2d 716 (7th Cir. 1986)) in a new context--invites the court to decide what the taxpayer's employees should be paid on the basis of the judges' own ideas of what jobs are comparable, what relation an employee's salary should bear to the corporation's net earnings, what types of business should pay abnormally high (or low) salaries, and so forth. The judges of the Tax Court are not equipped by training or experience to determine the salaries of corporate officers; no judges are.

Fourth, since the test cannot itself determine the outcome of a dispute because of its nondirective character, it invites the making of arbitrary decisions based on uncanalized discretion or unprincipled rules of thumb. The Tax Court in this case essentially added the IRS's determination of the maximum that Mr. Heitz should have been paid in 1993 and 1994 to what he was in fact paid, and divided the sum by two. It cut the baby in half. One would have to be awfully naive to believe that the seven-factor test generated this pleasing symmetry.

Fifth, 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 drawbacks of the multi-factor test are well illustrated by its purported application by the Tax Court in this case. With regard to factor (1), the court found that Heitz was "indispensable to Exacto's business" and "essential to Exacto's success." 75 T.C.M. at 2525. Heitz is not only Exacto's CEO; he is also the company's chief salesman and marketing man plus the head of its research and development efforts and its principal inventor. The company's entire success appears to be due on the one hand to the research and development conducted by him and on the other hand to his marketing of these innovations (though he receives some additional compensation for his marketing efforts from a subsidiary of Exacto). The court decided that factor (1) favored Exacto.

Likewise factor (2), for, as the court pointed out, the design of precision springs, which is Heitz's specialty, is "an extremely specialized branch of mechanical engineering, and there are very few engineers who have made careers specializing in this area," let alone engineers like Heitz who have "the ability to identify and attract clients and to develop springs to perform a specific function for that client. . . . It would have been very difficult to replace Mr. Heitz." Id. Notice how factors (1) and (2) turn out to be nearly identical.

Factors (3) and (4) also supported Exacto, the court found. "Mr Heitz is highly qualified to run Exacto as a result of his education, training, experience, and motivation. Mr. Heitz has over 40 years of highly successful experience in the field of spring design." Id. And his "efforts were of great value to the corporation." Id. at 2526. So factor (4) duplicated (2), and so the first four factors turn out to be really only two.

With regard to the fifth factor--the employer's (Exacto's) net earnings--the Tax Court was noncommittal. Exacto had reported a loss in 1993 and very little taxable income in 1994. But it conceded having taken some improper deductions in those years unrelated to Heitz's salary. After adjusting Exacto's income to remove these deductions, the court found that Exacto had earned more than $1 million in each of the years at issue net of Heitz's supposedly inflated salary.

The court was noncommital with regard to the sixth factor--earnings of comparable employees-- as well. The evidence bearing on this factor had been presented by expert witnesses, one on each side, and the court was critical of both. The taxpayer's witness had arrived at his estimate of Heitz's maximum reasonable compensation in part by aggregating the salaries that Exacto would have had to pay to hire four people each to wear one of Heitz's "hats," as chief executive officer, chief manufacturing executive, chief research and development officer, and chief sales and marketing executive. Although the more roles or functions an employee performs the more valuable his services are likely to be, Dexsil Corp. v. Commissioner, 147 F.3d 96, 102-03 (2d Cir. 1998); Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-46 (9th Cir. 1983), an employee who performs four jobs, each on a part-time basis, is not necessarily worth as much to a company as four employees each working full time at one of those jobs. It is therefore arbitrary to multiply the normal full-time salary for one of the jobs by four to compute the reasonable compensation of the employee who fills all four of them. Anyway salaries are determined not by the method of comparable worth but, like other prices, by the market,...