When, notwithstanding a 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 rate of return than they had any reason to expect, his salary is presumptively reasonable.
In 1993 and 1994, petitioner, a closely held corporation, paid its cofounder, chief executive, and principal owner $ 1.3 million and $ 1.0 million, respectively, in salary. The Internal Revenue Service thought this excessive, reduced it by more than half, adding the difference to the corporation's income, and assessed a deficiency accordingly. The Tax Court found the maximum reasonable compensation roughly midway between his actual compensation and the IRS's determination, applying seven factors, all of which either favored the taxpayer or were neutral. Judgment was reversed with directions to enter judgment for taxpayer.
Did the Tax Court err in its decision holding that the chief executive officer's salary was unreasonably high and assessing a deficiency accordingly?
The appellate court reversed, calling the Tax Court conclusion "stunning," holding that remand was warranted because the Tax Court did not support its result with reasoning and the seven-factor test did not provide guidance to a rational decision. The appellate court applied an "independent investor" test, which petitioner met, resulting in the actual salary being held presumptively reasonable.