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Tax Court Finds Compensation Paid to Shareholder-Employees Reasonable

Published: July 28th, 2016

Stephen R. Looney

In Johnson, Inc.,[1] the Tax Court held that the amounts paid to the shareholder-employees of a C corporation constituted reasonable compensation deductible under Section 162 and that amounts paid by the taxpayer-corporation to an entity controlled by two of its shareholders was deductible as an ordinary and necessary business expense under Section 162.

Facts of Case

During the years in issue, the taxpayer operated a concrete contracting business, which was one of the largest curb, gutter and sidewalk contractors in the State of Arizona. The taxpayer had over 200 employees and contract revenues of $23,754,182 and $38,022,612 in 2003 and 2004, respectively.

The taxpayer was incorporated in 1974 by H.W. Johnson and Margaret Johnson. Two of their sons, Bruce Johnson and Donald Johnson, began working part-time for the taxpayer as teenagers in the 1970s, and gradually assumed increasing responsibilities and took over the taxpayer’s daily operations in 1993. When H.W. Johnson retired, Bruce and Donald each acquired 24.5% of the shares of the taxpayer, with Margaret retaining the remaining 51%.

The taxpayer’s contract revenues grew rapidly after Bruce and Donald assumed control of the taxpayer’s daily operations in 1993 and climbed steadily every year thereafter including the years in issue, when revenues increased dramatically between 2003 and 2004. The taxpayer was profitable and experienced significant revenue and asset growth during 2003 and 2004, with gross profit margins before payment of officer bonuses of 38.3% and 38.2%, respectively.

During the years at issue, Bruce and Donald personally guaranteed loans made to the taxpayer and managed all operational aspects of the taxpayer’s business. Bruce and Donald each supervised over 100 employees in their respective divisions, and worked 10-12 hours a day, 5 to 6 days a week. The taxpayer had an excellent reputation with developers, inspectors and other contractors and was known for its timely performance and quality product.

A reliable supply of concrete was critical to the taxpayer’s business. Starting in late 2002 and throughout the years at issue there were shortages of concrete in the taxpayer’s market due to the housing boom in Arizona. Bruce and Donald suggested to Margaret that the taxpayer invest in a concrete supplier so as to have a reasonable supply of concrete. As the controlling shareholder in the taxpayer, Margaret refused to involve the company in such a venture because she judged it was too risky. Consequently, Bruce and Donald, acting through D.B.J. Enterprises, LLC (“DBJ”), partnered with other investors, including a former executive of a local concrete supplier that had been acquired by a large multi-national firm, to form Arizona Materials, LLC to conduct a concrete supply business. DBJ owned a controlling interest (52%) in Arizona Materials. Bruce and Donald, through DBJ, invested sums in, and guaranteed the indebtedness of, Arizona Materials.

Although the taxpayer was unable to procure concrete from its other suppliers, the taxpayer was able to obtain a substantial amount of concrete from Arizona Materials during 2004 and was able to procure concrete even when other contractors could not (and were therefore forced to suspend operations). The taxpayer also received bulk discounts for large concrete purchases from Arizona Materials, obtaining concrete at a price lower than it paid other suppliers. DBJ exercised its influence as the majority shareholder of Arizona Materials to ensure that the taxpayer received a steady supply of concrete. At the end of 2004, the taxpayer paid DBJ $500,000 as payment for a “guaranteed supply of concrete at market prices for the year ended June 30, 2004.” The taxpayer’s board minutes reflected the payment, although there was no written agreement between the taxpayer and DBJ regarding the $500,000 payment.

Bruce’s total compensation for 2003 was $2,013,250, of which $1,750,000 constituted a bonus paid to him under the taxpayer’s bonus formula, and received total compensation of $3,651,177 in 2004, of which $3,400,000 was received as a bonus under the taxpayer’s bonus formula. Donald received total compensation of $2,011,789 in 2003, of which $1,750,000 constituted a bonus paid to him under the taxpayer’s bonus formula, and received total compensation of $3,649,739 in 2004, of which $3,400,000 was received as a bonus under the taxpayer’s bonus formula.

Under the taxpayer’s officer bonus formula, adopted by the taxpayer’s board in 1991 and amended in 1999, total potential bonuses were calculated in proportion to the company’s annual contract revenue and added to a “bonus pool.” Under the 1999 amended bonus formula, the bonus pool was calculated as follows: 20% of contract revenue up to $15,000,000; 18% of contract revenue between $15,000,000 and $30,000,000; and 16% of contract revenue between $30,000,000 and $45,000,000. At year end, upon advice of the taxpayer’s accountant, the board of directors issued bonuses out of the bonus pool based on officer performance and the taxpayer’s ability to pay.

During the years at issue, the taxpayer also had a dividend plan, adopted in 1991 and amended in 1999. The plan called for dividend payments when the company’s retained earnings exceeded $2,000,000. The board determined the amount of the dividend on the basis of the taxpayer’s financial condition, profitability, and capitalization, following the advice of the taxpayer’s accountant. The taxpayer paid modest annual dividends to its shareholders between 1996 and 2004. For most of those years, the dividend amount was $25,000. In 2002 and 2003, the dividend amount was $50,000, and in 2004, the dividend amount was $100,000.

The IRS issued a notice of deficiency to the taxpayer determining that $2,607,517 and $5,616,771 of the amounts the taxpayer deducted for 2003 and 2004, respectively, as officer compensation exceeded reasonable compensation and disallowed in its entirety the $500,000 deduction the taxpayer claimed for 2004 with respect to the fee paid to DBJ. Prior to trial, the IRS conceded that deductions of $3,214,000 and $6,532,000 for compensation were reasonable in 2003 and 2004, respectively, leaving $811,039 and $768,916 in dispute for 2003 and 2004, respectively.

Statutes and Regulations

The relevant authority in this area is Section 162(a)(1), which allows a deduction for ordinary and necessary expenses paid or incurred during a taxable year in carrying on a trade or business, including a “reasonable allowance” for salaries or other compensation for personal services actually rendered.

Reg. 1.162-7(a) provides that the test of deductibility in the case of compensation payments is whether such payments are reasonable and are, in fact, payments purely for services. Consequently, there is a two-prong test for the deductibility of compensation payments: (1) whether the amount of the payment is reasonable in relation to the services performed, and (2) whether the payment was, in fact, intended to be compensation for services rendered.

Reasonableness of Compensation: The Multi-Factor Test

In determining the reasonableness of compensation, the courts have traditionally applied the so-called “multi-factor” test. The leading case in the unreasonable compensation area is Mayson Manufacturing Co.,[2] which sets forth nine factors to be used in evaluating the reasonableness of the amount of an employee’s compensation.[3] These factors have generally been used in one form or another in almost all subsequent cases analyzing the reasonableness of compensation.

Another significant case utilizing the multi-factor test is Elliotts Inc.[4] Elliotts involved a corporation that sold and serviced equipment manufactured by John Deere Company and other manufacturers. Although significant for a number of reasons, Elliotts is probably most important for categorizing the nine Mayson factors into five categories, the fourth category of which is the genesis for the so-called “independent investor test” as follows:

“Whether some relationship exists between the corporation and its shareholder-employee which might permit the company to disguise nondeductible corporate distributions of income as salary expenditures deductible under Section 162(a)(1). This category employs the independent investor standard, which provides that if the company’s return on equity remains at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company as disguised salary.”

Reasonableness of Compensation: The Independent Investor Test

In the Elliotts case, the five categories used by the court in determining the reasonableness of compensation paid by the corporation to its shareholder-employees employed the independent investor standard discussed above. That standard provides that if the corporation’s return on equity remains at a level that would satisfy an independent investor, that is a strong indication that the compensation being paid to the shareholder-employees is reasonable.

In Dexsil Corp.,[5] the Second Circuit vacated and remanded a decision of the Tax Court finding unreasonable employee compensation in the context of a closely held corporation. In reaching its decision, the court quoted its opinion in Rapco Inc.,[6] in stating that “in this circuit the independent investor test is not a separate autonomous factor; rather, it provides a lens through which the entire analysis should be viewed.”[7] The court thus articulated the notion that the independent investor test is more than a mere factor in determining the reasonableness of compensation and provides the very basis for assessing reasonableness.

Other circuits have adopted the independent investor test as set forth by the Second Circuit in Dexsil. In Exacto Spring Corp.,[8] the Seventh Circuit held that the salary paid to a shareholder-employee was reasonable based on the fact that an independent investor would achieve a high rate of return even with the shareholder’s salary. In following the Dexsil court’s reasoning, Chief Judge Posner stated that “[b]ecause judges tend to downplay the element of judicial creativity in adapting law to fresh insights and changed circumstances, the cases we have just cited [Dexsil and Rapco] prefer to say … that the ‘independent investor’ test is the ‘lens’ through which they view the seven … factors of the orthodox test. But that is a formality. The new test dissolves the old and returns the inquiry to basics.”[9]

Another recent case applying the independent investor test is Menard, Inc.,[10] where the Seventh Circuit reversed the holding of the Tax Court and found that the compensation paid by a corporation to its chief executive officer constituted reasonable compensation rather than a non-deductible dividend distribution to him where the rate of return to the corporation’s independent investors was 18.8%, as determined by the IRS’s own expert.

Additionally, in Multi-Pak Corp.,[11] the Tax Court held that the compensation paid by the taxpayer’s wholly owned corporation for one of the year’s in issue (2002) was reasonable, but recharacterized a portion of the compensation paid to the taxpayer in the other year in issue (2003) as a non-deductible dividend distribution because the amount of compensation paid to the taxpayer in that year was unreasonable. Specifically, in determining the rate of return which would be received by the hypothetical independent investor, the Tax Court in Multi-Pak divided the taxpayer’s net profit (after payment of compensation and a provision for income taxes) by the year-end shareholder’s equity as reflected in its financial statements. This yielded a return on equity of 2.9% for 2002 and negative 15.8% for 2003. The court concluded that although an independent investor may prefer to see a higher rate of return than the 2.9% in 2002, they believed that an independent investor would note that the CEO was the sole reason for the company’s significant rise in sales in 2002 and would be satisfied with the 2.9% rate of return. However, the court agreed with the IRS that a negative 15.8% return on equity in 2003 called into question the level of the CEO’s compensation for that year. The court went on to state that when compensation results in a negative return on shareholder’s equity, it cannot conclude, in the absence of a mitigating circumstance, that an independent investor would be pleased. Consequently, the court felt that if the CEO’s salary was reduced to $1,284,104 in 2003, which would result in a return on equity of 10% in 2003, that would be sufficient to satisfy an independent investor.[12] More recent cases applying the independent investor test include Thousand Oaks Residential Care Home I, Inc.,[13] Mulcahy, Pauritsch, Salvador & Co.[14]; and Brinks Gilson & Lione, P.C.[15]

Application of Five Factor Elliotts Test

Because an appeal in the Johnson case would lie with the Court of Appeals for the Ninth Circuit, the Tax Court applied the five factor test set forth in the Elliotts case to determine the reasonableness of compensation, with no factor being determinative: (1) the employee’s role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements. As stated above, in analyzing the fourth factor, the Elliotts case emphasized evaluating the reasonableness of compensation payments from the perspective of a hypothetical investor, focusing on whether the investor would receive a reasonable return on equity after payment of the compensation.

On brief, the IRS effectively conceded four of the five Elliotts factors that tended to support, or at least were neutral with respect to the reasonableness of the compensation the taxpayer paid to Bruce and Donald. Notwithstanding this, the IRS argued that the case hinged on the fourth Elliotts factor; namely whether a hypothetical investor would receive an adequate return on equity after accounting for Bruce’s and Donald’s compensation. In its decision, the Tax Court nevertheless considered each of the Elliotts factors inasmuch as the Court of Appeals for the Ninth Circuit indicated that no one factor is dispositive.

Role in the Company

This factor focuses on the employee’s importance to the success of the business. The Tax Court found that Bruce and Donald were integral to the taxpayer’s success during the years at issue, and found that this factor weighed in favor of the taxpayer.

External Comparison

This factor compares the employee’s compensation with that paid by similar companies for similar services. The IRS’s expert calculated that the taxpayer’s officer’s compensation as a percentage of gross revenues was 18.4% and 20.9% for 2003 and 2004, respectively, whereas the industry average for those years was 2.2%. The taxpayer contended that its performance so exceeded the industry average that the divergence of its compensation from the average was justified. The Tax Court found that it lacked any reliable benchmarks from which to assess the taxpayer’s claim and therefore found it unpersuasive, but in view of this and the IRS’s concession, the Tax Court concluded that this factor was essentially neutral.

Character and Condition of the Company

This factor considers the company’s character and condition, focusing on size as measured by sales, net income, or capital value. The Tax Court found that the taxpayer experienced remarkable revenue, profit margins (before officer compensation), and asset growth during the years at issue and therefore found that this factor weighed in the taxpayer’s favor.

Conflict of Interest

As discussed above, the primary focus of this factor is whether a relationship exists between the company and the employee which may permit the company to disguise nondeductible corporate distributions as deductible compensation payments under Section 162(a)(1). This factor employs the so-called independent investor test. If the company’s earnings on equity after payment of 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 syphoned out of the company as disguised salary. The parties and their experts agreed that the taxpayer had pretax returns on equity of 10.2% and 9% for 2003 and 2004, respectively. The IRS’s expert used return on equity figures from four sources that produced return on equity figures ranging from 13.8% to 18.3%. The Tax Court, however, found that the data on which the IRS expert relied was not as reliable as that used by the taxpayer’s expert (who used financial information of privately held companies falling under SIC Code 1771, Construction — Special Trade Contractors — Concrete Work, with sales ranging from $25,000,000 to $49,999,000), in determining that the average pretax return on equity was 10.5% and 10.9% for calendar years 2003 and 2004.

The Tax Court agreed with the taxpayer that its return on equity for the years at issue was in line with the industry average and therefore would have satisfied an independent investor. The court went on to cite a number of cases that have applied the independent investor test and which have typically found that a return on equity of at least 10% seems to indicate that an independent investor would be satisfied and thus payment of compensation that leaves this rate of return for the investor is reasonable.[16]

Internal Consistency of Cocmpensation

The last factor focuses on whether the compensation was paid pursuant to a structured, formal and consistently applied program. The Tax Court found that the taxpayer consistently adhered to the officer bonus formula from its inception in 1991, as amended in 1999, and therefore this factor also weighed in the taxpayer’s favor.

The Tax Court concluded that the Elliotts factors support the conclusion that the compensation the taxpayer paid to Bruce and Donald in 2003 and 2004 was reasonable, and specifically stated that the return on equity the taxpayer generated each year after payment of Bruce’s and Donald’s compensation was in line with (and indeed closely approximated), the return generated by the companies most comparable to it. As such, the Tax Court concluded that an independent investor would have been satisfied with the return and that the compensation paid was reasonable and therefore deductible under Section 162(a)(1).

DBJ Payment

The last issue to be addressed by the Tax Court was whether the taxpayer’s payment of $500,000 to DBJ was a deductible business expense under Section 162. The IRS contended that the $500,000 payment was not an ordinary and necessary business expense because there was no written agreement or evidence of any oral agreement obligating the taxpayer to compensate DBJ, that DBJ performed no compensable services on behalf of the taxpayer, and that the $500,000 was made not for services that DBJ provided, but for services Bruce and Donald performed in their capacities as officers of the taxpayer. The Tax Court found each of these arguments unpersuasive and found that the $500,000 was an ordinary and necessary expense within the meaning of Section 162(a) because it was normal for a concrete contractor to expend funds in connection with ensuring a reliable supply of concrete in the face of shortages, and the expenditure was helpful to the taxpayer’s business, allowing it to meet customer demand when other companies engaged in the same business were hampered by the shortage.

 

[1] TCM 2016-95.

[2] 178 F.2d 115, 49-2 USTC ¶9467 (CA-6, 1949).

[3] The nine factors set forth in the Mayson case are: (1) the employee’s qualifications, (2) the nature, extent, and scope of the employee’s work, (3) the size and complexities of the business, (4) a comparison of the salaries paid with the gross income and the net income of the business, (5) the prevailing general economic conditions, (6) a comparison of salaries with distributions to stockholders, (7) the prevailing rates of compensation for comparable positions and comparable businesses, (8) the salary policy of the taxpayer for all employees, and (9) the compensation paid to the particular employee in prior years where the business is a closely-held corporation.

[4] 716 F.2d 1241, 83-2 USTC ¶9610 (CA-9, 1983), rev’g TCM 1980-282.

[5] 147 F.3d 96, 98-1 USTC ¶50,471 (CA-2, 1998).

[6] 85 F.3d 950, 96-1 USTC ¶50,297 (CA-2, 1996).

[7] 147 F.3d at 101.

[8] 196 F.3d 833, 99-2 USTC ¶50,964 (CA-7, 1999).

[9] Id.

[10] 560 F.3d 620 (CA-7 2009).

[11] TCM 2010-139.

[12] It is somewhat perplexing why the Tax Court would use a 10% rate of return in determining reasonable compensation in 2003, when it found a 2.9% rate of return adequate for 2002.

[13] TCM 2013-10.

[14] 680 F.3d 867 (CA-7 2012).

[15] TCM 2016-20.

[16] Thousand Oaks Residential Care Home I, Inc., TCM 2013-10; Multi-Pak Corp., TCM 2010-139.

 

About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@deanmead.com.