- 25 -
perspective of a hypothetical independent investor. The prime
indicator is the return on the investor’s equity. Id. at 1247.
If the company’s earnings on equity after payment of the
compensation remain at a level that would satisfy an independent
investor, there is a strong indication that the employee is
providing compensable services and that profits are not being
siphoned out of the company disguised as salary.31 Id. The
Court of Appeals in Elliotts calculated the return on equity
using the yearend shareholders equity. Id. Dividing
petitioner’s net income book value by the yearend shareholders
equity results in the following:
FYE June 30 Percent return on equity
1995 93 percent
1996 25 percent
Petitioner’s return on equity substantially exceeded the
guideline companies’ average return on equity of 5.9 percent and
-54.4 percent during the fiscal years at issue, respectively, and
exceeded each specific company’s return on equity.32 Mr. Reeves
was solely responsible for petitioner’s success and performed the
31 The Court of Appeals for the Ninth Circuit found that a
20-percent average rate of return on equity would satisfy a
hypothetical inactive independent investor and indicated the
corporate employer and its shareholder/employee were not
exploiting their relationship. Elliotts, Inc. v. Commissioner,
716 F.2d 1241, 1247 (9th Cir. 1983), revg. T.C. Memo. 1980-282.
32 See the table showing each guideline company’s return on
equity supra p. 21.
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