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The jurisprudence of the Court of Appeals for the Ninth
Circuit is set forth in Elliotts, Inc. v. Commissioner, 716 F.2d
1241, 1244-1245 (9th Cir. 1983), revg. T.C. Memo. 1980-282,
wherein it adopts and applies the two-pronged test set forth in
the regulations as follows:
In determining the deductibility of compensation
payments paid to shareholder-employees, we will
continue to concentrate on the reasonableness of those
payments. In the rare case where there is evidence
that an otherwise reasonable compensation payment
contains a disguised dividend, the inquiry may expand
into compensatory intent apart from reasonableness.
* * * The inquiry into reasonableness is a broad one
and will, in effect, subsume the inquiry into
compensatory intent in most cases.
In evaluating the reasonableness of compensation
paid to a shareholder-employee * * * 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. * * *
In considering the reasonableness of compensation “from the
perspective of a hypothetical independent investor”, the Court of
Appeals for the Ninth Circuit in Elliotts, Inc. applies a five-
factor test: (1) The employee’s role in the company; (2) a
comparison of the compensation paid to the employee with the
compensation paid to similarly situated employees in similar
companies (external comparison); (3) the character and condition
of the company; (4) whether a conflict of interest exists that
might permit the company to disguise dividend payments as
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