Most reasonable compensation opinions live and die by multifactor tests — the employee’s role, external comparisons, the company’s condition, internal consistency, and the rest. But in the Seventh Circuit, and increasingly as a cross-check everywhere, one question dominates: would an independent investor be satisfied with their return after the executive was paid? That is the legacy of Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999).

Posner’s impatience with factor lists

Exacto Spring’s cofounder and chief engineer was paid over a million dollars a year; the IRS said roughly half of it was a disguised dividend. The Tax Court applied a seven-factor test and — as Judge Posner observed on appeal — landed on a number between the parties’ positions with no principled anchor. The Seventh Circuit rejected the factor list as vague, redundant, and directionless, and reversed for the taxpayer outright.

The independent investor test

The court’s replacement lens is elegantly simple: investors pay executives to grow the value entrusted to them. If, after the executive’s compensation, the owners’ return on equity comfortably exceeds what an independent investor would demand, the compensation is presumptively reasonable — the pay demonstrably did not come at the investors’ expense. In Exacto, the company generated returns around twenty percent against an expected return in the low teens, and the presumption carried the day.

The presumption is rebuttable — and that’s where the work is

The test is not a free pass. The presumption can be rebutted where the company’s success is attributable to something other than the executive, or where the executive effectively set his own pay and the return figures mask self-dealing. And applying the test properly is analytical work: it requires a supportable fair market value of the company for each year examined, a defensible expected-return benchmark, and honest treatment of what actually drove performance. A version of the test built on soft valuations persuades no one — the same hired-gun discount we describe in our Clary Hood commentary applies.

How it’s used in practice

Outside the Seventh Circuit, most courts still walk the multifactor frameworks — the Ninth Circuit’s Elliotts factors expressly incorporate an independent-investor perspective — so the sound approach treats the test as one of the convergent methods in a complete analysis: market comparability, composite-role (“Many Hats”) pricing, and the independent investor cross-check. That convergence is how Grahall builds compensation opinions for tax controversy and litigation engagements: no single lens, and no number that cannot survive all three.

This article is general commentary on a published decision, not legal or tax advice for any specific matter.