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4. Conflict of Interest
This factor focuses on whether a relationship exists between
the corporation and its employee which might allow the
corporation to disguise nondeductible dividends as deductible
salary. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246. Such
an exploitation of a relationship may exist where, as here, the
employee is the corporate employer’s sole shareholder. Id.
The mere existence of such a relationship, however,
when coupled with the absence of dividend payments,
does not necessarily lead to the conclusion that the
amount of compensation is unreasonably high. * * *
In such a situation, * * * it is appropriate to
evaluate the compensation payments from the perspective
of a hypothetical independent investor. If the bulk of
the corporation’s earnings are being paid out in the
form of compensation, so that the corporate profits,
after payment of the compensation, do not represent a
reasonable return on the shareholder’s equity in the
corporation, then an independent shareholder would
probably not approve of the compensation arrangement.
If, however, that is not the case and the company’s
earnings on equity remain at a level that would satisfy
an independent investor, there is a strong indication
that management is providing compensable services and
that profits are not being siphoned out of the company
disguised as salary. [Id. at 1246-1247.]
Accord LabelGraphics, Inc. v. Commissioner, 221 F.3d at 1099. In
Elliotts, Inc. v. Commissioner, supra at 1247, the Court of
Appeals for the Ninth Circuit concluded that the 20-percent
average rate of return on equity for the 2 years at issue there
would satisfy a hypothetical inactive independent investor and
indicate that the corporate employer and its shareholder/employee
were not exploiting their relationship.
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