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As we have mentioned, the independent investor test measures
whether a corporation’s shareholders received a fair return on
their investment. Return on equity measures the appreciation of
the stockholders’ investments through the corporation’s
retainment of earnings. See Owensby & Kritikos, Inc. v.
Commissioner, 819 F.2d at 1326-1327; Home Interiors & Gifts, Inc.
v. Commissioner, 73 T.C. 1142, 1161 (1980); see also Rev. Rul.
79-8, 1979-1 C.B. 92 (stating compensation may be reasonable even
when the corporation never paid a substantial portion of its
earnings and profits as a dividend).
Each party’s expert analyzed whether an independent investor
would consider the amount of compensation paid by petitioner
reasonable in light of the return on equity (ROE) petitioner’s
shareholders received. To do this, the experts first determined
the appropriate assumed rate of return on equity that an
independent investor would find acceptable for each year in
issue. The parties do not agree on the assumed equity rate of
return. The second step is to determine the appropriate period
in which to compare the ROE received by petitioner’s shareholders
with the assumed rates. The parties do not agree on the
appropriate period.
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