Exacto Spring Corp. v. Commissioner of Internal Revenue, 196 F.3d 833 (7th Cir. 1999)
Exacto Spring Corp. v.
Under IRC § 162(a)(1), is compensation paid to a shareholder-employee deductible as a reasonable allowance for services actually rendered when, after paying that compensation, the corporation delivers robust returns to equity that would satisfy an independent investor?
IRC § 162(a)(1) allows a deduction for ordinary and necessary business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered. In determining reasonableness for compensation paid to a shareholder-employee, the Seventh Circuit adopts the independent-investor test: if, after paying the challenged compensation, the corporation's return on equity would satisfy an independent investor, the compensation is presumptively reasonable and deductible. This presumption can be rebutted by evidence that the payments were not purely for services rendered, were a disguised distribution of profits, or otherwise fail the statutory requirement.
Reversing the Tax Court, the Seventh Circuit held that the compensation paid to the shareholder-CEO was reasonable and deductible under § 162(a)(1) because, after paying that compensation, Exacto Spring delivered returns to equity that would have satisfied an independent investor.
Exacto Spring is the seminal case formalizing the independent-investor test for reasonable compensation under § 162(a)(1). It reshaped the analytic terrain by steering courts away from amorphous multifactor balancing and toward an empirical, results-oriented inquiry tied to return on equity. The decision has influenced subsequent cases within and beyond the Seventh Circuit and provides clearer guidance for closely held corporations paying substantial compensation to shareholder-employees. For law students, it illustrates the intersection of tax law, corporate finance, and law-and-economics, and it highlights how doctrinal tests evolve toward administrability and market coherence.