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Exacto Spring Corporation v. Commissioner

    Brief Fact Summary. William Heitz was the cofounder, chief executive officer, and principal owner of the Exacto Spring Corporation. The corporation paid him $1.3 million and $1.0 million for tax years 1993 and 1994 as compensation. The corporation sought to deduct this from its income.

    Synopsis of Rule of Law. A business may deduct from its income ordinary and necessary business expenses including a reasonable allowance for salaries or other compensation for personal services.

    Facts. William Heitz was cofounder, chief executive officer, and principal owner of Exacto Spring Corporation. He was paid $1.3 million and $1.0 million in salary in 1993 and 1994. The IRS found this excessive and thought he should not have been paid more than $381,000 in 1993 or $400,000 in 1994. The difference was added to the corporation’s income and a deficiency assessed. The Tax Court found that the maximum reasonable compensation should have been $900,000 and $700,000.

    Issue. Was the salary paid to Heitz excessive and should the excess be included on the corporation’s income?

    Held. Chief Judge Posner issued the opinion for the United States Seventh Circuit Court of Appeals in reversing the Tax Court and holding that the salary was not excessive.

    Discussion. The Court of Appeals overruled the seven factor test applied by the Tax Court. The Court wanted to craft a simple test that would allow for a definitive and reasonable conclusion. The Court said it should determine whether investors are obtaining a higher return than should be expected. In this case, investors could have expected a return of 13% but they were getting are return of 20%. This creates a presumption of reasonableness for the salary paid. However, the Court left open exceptions to this presumption such as a salary concealed as a dividend.



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