Eberl's Independent Investors, and the Incoherence of the Reasonable Compensation Rule

Posted: 19 Jul 2001

See all articles by Edward A. Zelinsky

Edward A. Zelinsky

Yeshiva University - Benjamin N. Cardozo School of Law

Abstract

In this article, Professor Zelinsky discusses the recent decision of the Court of Appeals for the Tenth Circuit in Eberl's Claim Services, Inc. v. Commissioner. In Eberl's, the Tenth Circuit, affirming the Tax Court, held that substantial amounts paid to the sole shareholder of an incorporated claims adjusting company were not reasonable compensation, properly deductible by the corporation. These amounts, the Tenth Circuit held, were instead disguised dividends, subject to the double tax regime for corporate earnings.

Professor Zelinsky contends that Eberl's reflects the doctrinal disarray of the law of unreasonable compensation as well as the incoherence of that law in terms of policy. As a matter of doctrine, in Eberl's, the Tenth Circuit refused to align itself with the other courts of appeals that have embraced the "hypothetical independent investor" test for reasonable compensation inquiries. Eberl's thus presents the kind of inter-circuit split that only the Supreme Court can resolve.

Moreover, the hypothetical independent investor test is itself no panacea for the conundrum that is the reasonable compensation rule. Indeed, the circuits embracing the hypothetical independent investor standard so disagree among themselves that there are effectively two versions of that standard.

As a matter of policy, Professor Zelinsky concludes, the reasonable compensation test of section 162(a) is an anomaly in a world where federal tax policy permits the income of closely held businesses to be taxed only once. In practice, the reasonable compensation rule is little more than a randomly imposed penalty on entrepreneurial success. For the long run, Professor Zelinsky suggests, the best solution to the problem posed by cases like Eberl's is the legislative abolition of the reasonable compensation doctrine.

Suggested Citation

Zelinsky, Edward A., Eberl's Independent Investors, and the Incoherence of the Reasonable Compensation Rule. Available at SSRN: https://ssrn.com/abstract=277249

Edward A. Zelinsky (Contact Author)

Yeshiva University - Benjamin N. Cardozo School of Law ( email )

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