Tax Court Finds Compensation Reasonable, Rejects IRS Attempt to Modify Independent-Investor Test

Editor: Mark G. Cook, CPA, MBA, CGMA

In a May 2016 ruling in favor of the taxpayer (H.W. Johnson, Inc., T.C. Memo. 2016-95), the Tax Court held that compensation paid by a closely held corporation was reasonable and therefore deductible. A review of the details of the case and the court’s analysis and findings of facts follow.

The Short Story

The corporate taxpayer, a concrete contractor, deducted as officer compensation $4 million and $7.3 million on its tax returns for fiscal years ending June 30 in 2003 and 2004, respectively. Additionally, the taxpayer deducted $500,000 as an administration fee paid to a related party. The IRS issued a notice of deficiency disallowing $2.6 million and $5.6 million of the compensation, in 2003 and 2004, respectively, and the $500,000 administration fee in its entirety, claiming that the disallowed deductions exceeded what was “reasonable.” The court agreed with the taxpayer that all of the compensation and administrative fees deducted were reasonable and therefore deductible.

Background

The taxpayer is a second-generation, family-owned business, founded in 1974 by H.W. Johnson and his wife, Margaret Johnson. Their sons, Bruce and Donald, worked in the business and eventually took over daily operations in 1993. H.W. and Margaret gifted shares to Bruce and Donald, and each eventually owned 24.5% of the company, with the remaining 51% owned by Margaret. H.W. retired in 1996, and the brothers became co-vice presidents. Margaret was responsible for payroll, finances, accounts receivable, human resources, and other administrative functions.

The Growth Years

Beginning in 1993, when the brothers took control of operations, the company’s revenues grew rapidly, from $4 million in 1993 to $13 million in 1994 and 1995. Annual revenue leveled off at around $17 million between 1996 and 1999 and then consistently increased each year, growing to $23.8 million in 2003 and $38 million in 2004, the years at issue.

It is well-documented that the company’s growth was predominantly a result of the brothers’ hard work and business acumen.

The Related Party

Beginning in 2002 and extending to the years at issue, there were concrete shortages as a result of a housing boom in Arizona, the taxpayer’s market. The brothers planned to prevent a disruption in the supply of concrete by investing in a concrete supplier. Margaret, the majority shareholder, thought the investment was too risky and did not approve of the plan.

Instead, Bruce and Donald formed D.B.J. Enterprises LLC (DBJ) to partner with other investors and industry insiders and formed Arizona Materials LLC to conduct a concrete supply business. DBJ owned 52% of Arizona Materials.

As a result of DBJ’s investment in Arizona Materials, the taxpayer received bulk discounts for large orders of concrete, obtained concrete at prices lower than it paid other suppliers, and was able to secure delivery during shortages.

The taxpayer paid DBJ $500,000 during 2004 for a “guaranteed supply of concrete at market prices for the year ended June 30, 2004. DBJ . . . has negotiated with Arizona Materials . . . on behalf of H.W. Johnson . . . to provide a continuous supply of concrete.”

The Deficiency

The taxpayer, on its timely filed Forms 1120, U.S. Corporation Income Tax Return, claimed deductions for salaries, bonuses, and directors’ fees it paid to Margaret, Bruce, and Donald. It also claimed a deduction for the $500,000 paid to DBJ as “administration fees.”

The IRS issued a notice of deficiency determining that $2.6 million and $5.6 million of officer compensation deducted for 2003 and 2004, respectively, exceeded reasonable compensation and disallowed the entire $500,000 administration fee.

Compensation

The taxpayer argued that the full amounts paid to Bruce and Donald for 2003 and 2004 were reasonable compensation and therefore deductible under Sec. 162(a)(1). The IRS, after originally disallowing $2.6 million and $5.6 million of compensation deductions on the notice of deficiency, conceded some of the disallowed amounts, leaving $811,039 and $768,916 as amounts it claimed exceeded reasonable compensation.

An appeal in this case would be heard by the Ninth Circuit, and therefore the Tax Court applied the five factors used by that court to determine the reasonableness of compensation (the Elliotts factors) as follows (see Elliotts, 716 F.2d 1241 (9th Cir. 1983), rev’g T.C. Memo. 1980-282):

• The employee’s role in the company;
• A comparison of compensation paid by similar companies for similar services;
• The character and condition of the company;
• Potential conflicts of interest (the independent-investor test); and
• The internal consistency of compensation arrangements.

The IRS’s trial briefs conceded all of the above factors except the independent-investor factor, arguing that this case hinged on whether a hypothetical independent investor would receive an adequate return on equity after accounting for the compensation at issue. Although the court considered each of the above factors, its discussion and analysis of the conceded factors are not discussed here.

The independent-investor test says that if the company’s earnings on equity after payment of compensation would satisfy an independent investor, there is a strong indication that the compensation is reasonable and not a disguised payment of dividends.

The IRS and the taxpayer agreed on the calculation of the return on equity for the years in question, 10.2% and 9% for 2003 and 2004, respectively. The disagreement was whether these returns would satisfy an independent investor. The taxpayer’s experts used industry information from Integra Information to calculate an average return on equity for the industry of 10.5% and 10.9% for 2003 and 2004, respectively. The Service’s expert used industry information from four sources and calculated an average return on equity for the industry ranging from 13.8% to 18.3%.

The court reviewed the sources of the data the parties used and determined that the data used by the IRS’s experts were less reliable than those used by the taxpayer’s experts. The court agreed with the taxpayer that the return on equity after deduction of the compensation at issue would satisfy an independent investor and that, although the actual return was less than the average return for similar companies, the difference was not material.

The IRS also argued that since the company was very successful, an independent investor would have required a return that significantly exceeded the industry average. The court dismissed this argument, indicating that there is no case law or other authority for this proposition.

Since this was the only factor in dispute, and the court agreed with the taxpayer, it allowed the entire compensation deduction.

It is noteworthy that the company had a set formula for the bonuses, and the formula did not shift over time. The bonuses were, in all material respects, a product of this revenue-based formula.

Related-Party Payments

The taxpayer argued that the $500,000 expense was ordinary and necessary to compensate DBJ for securing a supply of concrete at preferential prices for bulk purchases. The IRS countered that the payment was not an ordinary and necessary business expense because (1) there was no written agreement or evidence of an oral agreement obligating the taxpayer to compensate DBJ and therefore the payment was voluntary; (2) DBJ performed no compensable services on behalf of taxpayer; and (3) the payment was for services the brothers performed in their capacities as officers of the taxpayer.

The court found the IRS’s arguments “unpersuasive” and listed, in detail, the value-added services performed by the brothers as individuals (and not as officers of the taxpayer) through DBJ. Additionally, the court specifically noted that Margaret, the taxpayer’s majority shareholder, who had no ownership interest in DBJ, approved the payment. Thus, the court allowed the full deduction.

The Takeaway

The taxpayer in this case had good and documented facts. An excellent road map of what the IRS will look for when examining reasonableness of compensation can be found in the IRS publication Reasonable Compensation: Job Aid for IRS Valuation Professionals. This publication and the full facts of H.W. Johnson should be reviewed when the reasonableness of compensation is a potential issue.

EditorNotes

Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.