## Facts

- Exacto Spring Corporation was a closely held manufacturer of precision springs.
- William Heitz, a cofounder, chief executive, and principal owner, provided services to the corporation.
- For tax years 1993 and 1994, Exacto paid Heitz compensation of $1.3 million and $1.0 million, respectively.
- The IRS determined the compensation was excessive and allowed deductions only up to $381,000 (1993) and $400,000 (1994), assessing deficiencies.
- The Tax Court applied a seven-factor reasonableness test and set “maximum reasonable compensation” at $900,000 (1993) and $700,000 (1994), disallowing the remainder.
- Exacto appealed, challenging both the reduced deductions and the analytic method used to evaluate reasonableness.

## Issues

1. Whether Heitz’s 1993 and 1994 compensation was a “reasonable allowance” for services under 26 U.S.C. § 162(a)(1) and therefore fully deductible.
2. What framework should govern the “reasonable compensation” inquiry for a shareholder-executive: a multifactor balancing test or an independent-investor approach.

## Decision

- The Seventh Circuit reversed the Tax Court.
- The court held Heitz’s compensation was not excessive and was fully deductible under § 162(a)(1).
- The court rejected the Tax Court’s open-ended multifactor balancing as an unreliable method for deciding reasonableness.
- The court directed judgment for Exacto.

## Legal Principles

- Under 26 U.S.C. § 162(a)(1), deductible compensation must be (1) for services actually rendered and (2) reasonable in amount, rather than a disguised distribution of corporate earnings.
- A court may evaluate reasonableness by asking whether an independent equity investor would be satisfied with the corporation’s return after payment of the challenged compensation.
- If the post-compensation return to shareholders exceeds what comparable investors would ordinarily expect, that performance supports a presumption that the compensation is reasonable.
- Multifactor “reasonableness” tests can be “redundant, incomplete, and unclear” and risk substituting judicial judgment for ordinary business decisions about pay.
- Absent evidence that compensation is being used to conceal dividends, strong post-compensation investor returns weigh heavily in favor of deductibility.

## Conclusion

The court held that because the corporation delivered investor returns above expected levels after paying the CEO’s salary and there was no showing that the payments were disguised dividends, the challenged compensation was reasonable under § 162(a)(1) and fully deductible.


Exacto Spring Corp. v. Comm’r, 196 F.3d 833 (7th Cir. 1999)