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The Court of Appeals for the Seventh Circuit, on the other
hand, treats a corporation’s enjoyment of a higher than average
return on shareholder equity as presumptively establishing the
reasonableness of a shareholder-officer’s compensation, without
regard to the multifactor analysis. Exacto Spring Corp. v.
Commissioner, 196 F.3d 833, 838-839 (7th Cir. 1999), revg. T.C.
Memo. 1998-220.
Central to both variants of the independent investor test is
the need to examine the return on equity of the taxpayer-
corporation (where the employee-shareholder receiving the
compensation in issue also controls that taxpayer) from the
perspective of a hypothetical independent investor. As the Court
of Appeals for the Ninth Circuit explained in Elliotts, Inc. v.
Commissioner, supra at 1245-1247:
In evaluating the reasonableness of compensation
paid to a shareholder-employee, particularly a sole
shareholder, it is helpful to consider the matter from
the perspective of a hypothetical independent investor.
A relevant inquiry is whether an inactive, independent
investor would be willing to compensate the employee as
he was compensated. The nature and quality of the
services should be considered, as well as the effect of
those services on the return the investor is seeing on
his investment. The corporation’s rate of return on
equity would be relevant to the independent investor in
assessing the reasonableness of compensation in a small
corporation where excessive compensation would
noticeably decrease the rate of return.
* * * * * * *
In this case, where * * * [the employee
receiving the compensation in issue] was the sole
shareholder, the sort of relationship existed that
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