Posner on Tax: The Independent Investor Test

Abstract

Few precedents drew Judge Posner's ire like multifactor tests. As he said in one opinion: multifactor tests leave "much to be desired-being .. . redundant, incomplete, and unclear."'

In this Essay, I endorse Posner's devastating rejection of a tax law multifactor test in Exacto Spring Corp v Commissioner of Internal Revenue. This prototypical tax multifactor test governed the deductibility of salaries paid by corporations to their controlling shareholders by comparing the salaries with a list of factors that indicated deductibility or nondeductibility. Simply put, the test stunk. I also explain why the Posner critique applies to similar multifactor tests in corporate tax law.

I then describe and critique Posner's replacement for the multifactor test-the "independent investor" test. In a nutshell, Posner proposed to evaluate the deductibility of the salaries in question by reference to investment returns of equity investors in the firm paying the allegedly high salaries. If the salaries leave investment returns that would be adequate for "independent investors" in the firm, then the salaries in question are presumptively deductible. Characteristically, Posner's independent investor test shifts the judicial focus from a muddled list to the economic substance of a transaction.