UNITED STATES TAX COURT
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T.C. Memo. 2001-160
UNITED STATES TAX COURT
WAGNER CONSTRUCTION, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3819-99.
Filed June 29, 2001.
John K. Steffen, Walter A. Pickhardt, and Myron L. Frans,
for petitioner.
Jack Forsberg and Eric W. Johnson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge:
Respondent determined deficiencies in
petitioner's Federal income tax of $370,158 for the taxable year
ending October 31, 1995, and $317,261 for the taxable year ending
October 31, 1996.
- 2 The issue for decision is whether petitioner may deduct as
officer compensation paid to Dennis Wagner (Dennis) and Curtis
Wagner (Curtis) for taxable years ending October 31, 1995 and
1996, the amounts shown below as the parties contend, or some
other amounts:
Year
10/31/95
10/31/96
Petitioner
Dennis
Curtis
$1,048,200
$246,688
699,192
400,573
Total
$1,294,888
1,099,765
Year
10/31/95
10/31/96
Respondent
Dennis
Curtis
$243,000
$192,450
258,600
202,350
Total
$435,450
460,950
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended and in effect for the years
in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
A. General Background
Petitioner is a Minnesota corporation that was incorporated
on November 1, 1985.
When the petition in this case was filed,
petitioner maintained its principal place of business in
International Falls, Minnesota.
- 3 During the years in issue, Dennis and Curtis were
petitioner's sole stockholders.
Dennis and Curtis are the sons
of Clifford Wagner (Clifford) and Evelyn Wagner (Evelyn).
Dennis was born in 1952, and graduated from high school in 1971.
Curtis was born in 1954, and graduated from high school in 1973.
Neither Dennis nor Curtis attended college.
Both began working
with their father when they were young boys.
Petitioner is the successor to a partnership called Clifford
Wagner & Dennis Wagner Construction (Wagner & Wagner).
Clifford
and Dennis formed Wagner & Wagner in 1974 to conduct a logging
business.
In 1976, Wagner & Wagner acquired a construction
business that previously had been owned by Clifford and a third
individual.
Clifford and Dennis each owned a 50-percent interest
in Wagner & Wagner.
On November 1, 1985, Clifford and Dennis incorporated
petitioner.
At that time, the construction business of Wagner &
Wagner was well established; the partnership had approximately 30
employees1 and normally operated four construction crews during
the construction season.
Wagner & Wagner transferred assets of $638,916 and
liabilities of $127,543 to petitioner.
The transfer was treated
as a contribution to capital on petitioner's books.
1
The amount
Wagner & Wagner had seven or eight full-time employees; the
other employees were seasonal.
- 4 of additional paid-in capital reflected on petitioner's balance
sheet dated November 1, 1985, was $332,373.
The $332,373 net
equity on the books included a charge of $179,000 for deferred
income taxes attributable to Wagner & Wagner's being an accrual
basis taxpayer and petitioner's being a cash basis taxpayer.
Additionally, the financial statements show a capital
contribution of $2,000 for the common stock.
Initially, Clifford and Dennis each owned 1,000 shares (50
percent) of petitioner's stock.
Clifford died on April 15, 1986.
In August 1986, petitioner redeemed 1,000 shares of its stock for
$157,883 payable to Evelyn in monthly installments of $2,000 with
interest at a rate of 9 percent per annum.
At the same time,
Dennis transferred 250 of his 1,000 shares of petitioner's stock
(25 percent of the outstanding stock) to Curtis, and Evelyn gave
each son a 25-percent interest in Wagner & Wagner.
From August
1986 through the years at issue, Dennis owned 75 percent of
petitioner and Wagner & Wagner, and Curtis owned 25 percent.
On January 1, 1988, Wagner & Wagner transferred a
substantial portion of its net assets (assets of $703,257 and
liabilities of $207,106) to petitioner, and petitioner issued to
Wagner & Wagner a debenture of $496,151 due January 1, 1993.
debenture bore interest at an annual rate of 8 percent and was
The
recorded as long-term debt on petitioner's books.
- 5 B.
Petitioner's Business Activity
From 1985 through the years at issue, petitioner's primary
business activity was sewer, water, and road construction
(highway and heavy construction).
Because of the seasonal nature
of the construction work performed by the company, petitioner
also performed contract logging in the winter months.
The
logging operation complimented petitioner's construction business
because petitioner could use its trucks and equipment during the
winter months.
This seasonal operation kept many of petitioner's
construction employees working throughout the winter months.
Petitioner also owned and operated property for storage of logs
and construction materials and owned and operated sand and gravel
pits.
Petitioner was required to submit competitive bids for
highway and heavy construction contracts.
Petitioner submitted
detailed information in the bids that included fixed costs for
materials and subcontractors in addition to petitioner's
projected costs for its labor, supplies, and bond costs.
After
the bids were submitted, the requesting agency selected the
lowest bid and awarded the contract.
In order to submit a bid for construction projects,
petitioner was required by law to show that it had obtained the
required performance and payment bonds issued by an approved
bonding company.
Performance and payment bonds protect the owner
- 6 of the construction project by guaranteeing that the contractor
will build the project according to the specifications and make
all required payments to its subcontractors on the project.
Dennis, Curtis, and their wives personally guaranteed all
performance and payment bonds issued on behalf of petitioner.
In addition to Dennis and Curtis, petitioner employed 35
persons during 1995 and 41 persons during 1996.
Petitioner's
office staff consisted of Rodney Olson (Mr. Olson), who was the
office manager, and Jane Wagner (Jane), who was Curtis' wife.
Other than Dennis, Curtis, Jane, and Mr. Olson, petitioner's
remaining employees worked an average of 28.9 weeks in 1995 and
27.3 weeks in 1996.
Petitioner's major construction jobs for 1995 and 1996 were
performed throughout northern Minnesota and included jobs located
in International Falls, Littlefork, Warroad, Roseau, Greenbush,
Crookston, Chisholm, and Ash River.
During the construction
season, which is generally from May through November in northern
Minnesota, petitioner maintained four construction crews.
The Associated General Contractors of Minnesota Highway,
Railroad and Heavy Construction Contractors entered into separate
agreements with the International Union of Operating Engineers
Local No. 49 and the Laborer's District Council of Minnesota and
North Dakota on behalf of its affiliated local unions.
During
the years in issue, petitioner operated under those contracts
- 7 with its laborers and operating engineers.
Petitioner paid its
laborers and operating engineers the highest wage scale in the
State of Minnesota.
C.
Dennis' Responsibilities and Qualifications
By 1995, Dennis had more than 30 years of experience in the
construction and logging industries and had been petitioner's
president for 10 years.
Dennis prepared, approved, and submitted bids for contract
work.
He was responsible for securing contracts at a profit
sufficient to keep petitioner's four construction crews active
throughout the construction season in northern Minnesota.
He
selected bonding companies, consulting engineers, investment
firms, attorneys, and accountants.
Dennis negotiated the union
contracts and the employee fringe benefit plans.
He was
responsible for addressing all complaints and concerns about the
daily operations of the company.
Dennis was also responsible for the final decisions on the
purchase of major assets.
Dennis approved all subcontract
payments and verified that all subcontractor deficiencies were
corrected.
He was responsible for negotiating all financing
arrangements and equipment rental rates.
Dennis made the final
decision on when to purchase and select stocks, securities, and
investments.
He negotiated all private business contracts and
made the final decision on billings and collections.
- 8 Dennis attended bid lettings, prebid showings, job meetings,
and inspections, prepared job schedules, and worked with project
engineers on payment schedules, job problems, and change orders.
He was the primary contact person between petitioner and all
regulatory or governmental agencies.
Further, Dennis was responsible for dispatching equipment
with the operators.
He managed construction projects by
supervising all projects on a regular basis.
He also supervised
the company's maintenance shop and the maintenance, repair, and
certification of petitioner's large fleet of machinery and
equipment.
Dennis supervised all sand and gravel operations,
wood storage, and dump-site operators employed by the company.
He hired personnel, scheduled layoffs, and determined pay raises
and bonuses.
Dennis negotiated all subcontract arrangements and
supervised the subcontractor's performance.
He made change
orders and approved all extra work or deductions on projects.
Dennis secured all permits and licenses necessary for the company
to conduct its businesses.
He could operate all equipment owned
by the company and would fill in as needed to operate equipment,
drive trucks, or work as a laborer.
Dennis devoted all his work activity to petitioner and
worked long hours, 6 or 7 days a week.
- 9 Dennis diversified petitioner's operations in order to
provide year-round employment for employees, to use equipment
more efficiently, and to increase earnings.
Dennis bought or leased property to store and dispose of
waste construction materials generated in connection with
petitioner's construction contracts.
He began recycling
construction waste materials for use in its sand and gravel pit
operations, for use as materials in other construction projects,
and for sale to third parties.
Dennis negotiated petitioner's logging contracts and
purchase rights directly with property owners.
He began using
real estate, originally purchased to store and dispose of
construction waste, as a storage yard in petitioner's logging
operations and also for log storage for third parties.
D.
Curtis' Responsibilities and Qualifications
After graduating from high school in 1973, Curtis began
working for his father in the construction and logging
businesses.
By 1995, he had more than 20 years of experience in
the construction and logging businesses and had been petitioner's
vice president for 10 years.
Curtis supervised petitioner's major construction projects
in and around International Falls, Minnesota.
In addition, he
regularly consulted with the other construction foremen via the
radio or mobile telephone, giving technical assistance with other
- 10 construction projects.
equipment operator.
Curtis was petitioner's most skilled
He operated the largest heavy equipment
daily and recommended maintenance policies.
He recommended and
assisted with petitioner's equipment purchase decisions.
Curtis supervised petitioner's winter logging operations.
Since
1985, Boise Cascade Corp. has awarded numerous logging contracts
to petitioner.
These contracts were the direct result of Curtis'
effective management and supervision of the logging operation.
Curtis devoted all his work activity to petitioner and
worked long hours, 6 or 7 days a week.
E.
Salaries, Bonuses, and Profit-Sharing Contributions Paid by
Petitioner to Dennis and Curtis
From 1986 to 1996, petitioner paid annual salaries, bonuses,
and profit-sharing contributions to Dennis and Curtis as
follows:2
2
These amounts were stipulated by the parties as being paid
during the "taxable" year. Petitioner reported all amounts paid
to Dennis and Curtis as compensation during the calendar years
1985 through 1996 on Forms W-2, Wage and Tax Statement. The
stipulated amounts vary slightly from the amounts reported on the
Forms W-2 as paid during the calendar year but vary in much
greater amounts than reported on petitioner's Federal income tax
returns as compensation paid to officers during the taxable
(fiscal) year.
- 11 -
Year
Salary
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
$51,810
40,456
40,456
40,456
42,239
45,050
43,350
44,720
44,720
47,528
49,088
Dennis Wagner
Profit-Sharing
Bonus
Contribution
$82,500
-033,750
120,000
165,000
700,000
550,000
740,000
800,000
1,000,000
650,000
$20,146
6,096
11,131
24,068
30,000
30,000
30,000
30,000
30,000
22,500
22,500
Year
Salary
Curtis Wagner
Profit-Sharing
Bonus
Contribution
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
$33,190
40,456
40,456
40,456
42,239
45,050
43,350
44,720
44,720
47,528
49,088
$27,500
-011,250
40,000
55,000
300,000
150,000
160,000
353,333
200,000
350,000
$9,103
6,096
7,756
12,068
14,673
30,000
29,477
30,000
30,000
22,500
22,500
Total
$154,456
46,552
85,337
184,524
237,239
775,050
623,350
814,720
874,720
1,070,028
721,588
Total
$69,793
46,552
59,462
92,524
111,912
375,050
222,827
234,720
428,053
270,028
421,588
Petitioner paid to Dennis and Curtis weekly salaries equal
to the highest wage that petitioner paid to its operators.
At the end of each fiscal year from 1986 to 1996, Dennis
reviewed financial information with petitioner's accountants.
Dennis limited the amount of the bonuses he and Curtis received
to ensure that petitioner had sufficient funds to expand its
business, purchase needed equipment, pay subcontractors on time,
satisfy business creditors and bonding companies, pay top wages
- 12 to its employees, and remain profitable.
Dennis and Curtis
agreed that bonuses would be paid on a ratio of 3 to 1 with
Dennis receiving three times the bonus amount paid to Curtis.3
Petitioner generally paid bonuses to Dennis and Curtis in
October of the fiscal year to which they related.
were paid for the year ending October 31, 1987.
No bonuses
Beginning with
the year ending October 31, 1993, a portion of the bonuses, with
interest, was paid to Dennis and/or Curtis in the following
January.
F.
Petitioner's Officers and Directors
From 1986 to 1996, Dennis, Curtis, and Dennis' wife Wendy
served as petitioner's officers and directors.
Dennis was
president, Curtis was vice president, and Wendy was
secretary/treasurer.
G.
Petitioner's Financial Statements and Federal Income Tax
Returns
At all times since its incorporation, petitioner has had a
fiscal year and taxable year ending October 31 and has used the
accrual method of accounting for financial reporting purposes.
Before November 1, 1991, however, petitioner used the cash method
of accounting for tax purposes.
3
The stipulated bonus amounts do not reflect the 3-to-1
ratio, in part, because (1) there were differences in the
calendar year reporting for Dennis and Curtis and the fiscal year
used by petitioner, and (2) in some years, a portion of the
bonuses was paid in the following January.
- 13 Effective November 1, 1991, petitioner changed its method of
accounting for tax purposes from the cash method to the accrual
method.
Petitioner realized a section 481(a) adjustment of
$1,637,156 on account of the change in accounting methods.
Petitioner included $409,289 of the adjustment in income in each
of the 4 taxable years ending October 31, 1992 through 1995.
Since November 1, 1991, petitioner has used the accrual method of
accounting for tax purposes and for financial purposes.
Petitioner engaged accountants to prepare financial
statements and reports for its operations.
For the taxable years
ending October 31, 1986 and 1987, the accountant prepared
combined financial statements for petitioner and Wagner & Wagner.
Those statements show the following balance sheets:
- 14 Separate
Partnership/corporation
Assets
Current assets
Property and equipment
Other assets
Total assets
Liabilities
Current liabilities
Long-term debt
Total liabilities
Stockholders Equity
Common stock
Paid-in capital
Retained earnings
Treasury stock
Total
Partners Equity
Total liabilities and
equity
Partnership
$122,128
315,179
80,918
518,225
10/31/86
Corporation
$1,060,510
19,600
602
1,080,712
Combined
$1,112,860
334,779
81,520
1,529,159
Partnership
$126,739
437,683
-–
564,422
10/31/87
Corporation
$1,406,116
18,300
451
1,424,867
Combined
$1,571,777
455,983
451
2,028,211
224,378
13,631
238,009
581,694
244,000
825,694
736,294
257,631
993,925
220,998
63,676
284,674
848,505
133,566
982,071
1,027,507
197,242
1,224,749
-–
––-–280,216
2,000
332,373
78,529
(157,884)
255,018
–-
----255,018
280,216
535,234
-–
––-–360,666
2,000
332,373
266,307
(157,884)
442,796
–-
----442,796
360,666
803,462
518,225
1,080,712
1,529,159
645,340
1,424,867
2,028,211
- 15 For each of the taxable years ending October 31, 1988 to
1996, the accountants prepared a separate financial statement for
petitioner.
The financial statements show balance sheets for
petitioner for those years as follows:
Assets
Current assets
Property and equipment
Other assets
Total assets
Liabilities
Current liabilities
Long-term debt
Total liabilities
Stockholders Equity
Common stock
Paid-in capital
Retained earnings
Treasury stock
Total equity
Total liabilities and equity
Assets
Current assets
Property and equipment
Other assets
Total assets
Liabilities
Current liabilities
Long-term debt
Total liabilities
Stockholders Equity
Common stock
Paid-in capital
Retained earnings
Treasury stock
Total equity
Total liabilities and equity
10/31/88
10/31/89
10/31/90
$2,060,231
672,050
300
2,732,581
$2,483,018
545,040
-03,028,058
$3,862,379
958,851
223,437
5,044,667
1,496,368
692,428
2,188,796
1,321,926
871,633
2,193,559
2,101,079
1,036,257
3,137,336
2,000
332,372
367,297
(157,884)
543,785
2,732,581
2,000
332,372
658,011
(157,884)
834,499
3,028,058
2,000
332,372
1,730,843
(157,884)
1,907,331
5,044,667
10/31/91
10/31/92
10/31/93
$3,314,652
982,165
223,972
4,520,789
$3,928,507
1,292,130
221,522
5,442,159
$3,471,251
973,986
193,843
4,639,080
1,309,273
969,136
2,278,409
2,080,527
396,568
2,477,095
1,373,010
223,440
1,596,450
2,000
332,372
2,065,892
(157,884)
2,242,380
4,520,789
2,000
332,372
2,788,576
(157,884)
2,965,064
5,442,159
2,000
332,372
2,866,142
(157,884)
3,042,630
4,639,080
- 16 Assets
Current assets
Property and equipment
Other assets
Total assets
Liabilities
Current liabilities
Long-term debt
Total liabilities
Stockholders Equity
Common stock
Paid-in capital
Retained earnings
Treasury stock
Total equity
Total liabilities and equity
10/31/94
10/31/95
10/31/96
$2,898,541
877,553
106,309
3,882,403
$3,584,901
1,032,037
101,710
4,718,648
$3,295,219
1,118,592
92,286
4,506,097
827,931
149,780
977,711
1,584,793
243,107
1,827,900
1,114,378
257,842
1,372,220
2,000
332,372
2,728,204
(157,884)
2,904,692
3,882,403
2,000
332,372
2,714,260
(157,884)
2,890,748
4,718,648
2,000
332,372
2,957,389
(157,884)
3,133,877
4,506,097
From 1986 to 1993, Dennis and Curtis made loans to
petitioner, which were unsecured.
The outstanding loan amounts
petitioner owed to Dennis and Curtis on the last day of fiscal
years ending October 31, as reflected on petitioner's financial
statements, were as follows:
Fiscal Year
Loan Amounts
1986
1987
1988
1989
1990
1991
1992
1993
$198,982
131,574
153,484
351,424
547,621
496,838
51,729
-0-
- 17 Petitioner's financial statements and Forms 1120, U.S.
Corporation Income Tax Return (Forms 1120 or returns), for the
years ending October 31, 1986 through 1996, show the following
income:
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Taxes
Net income
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Provision for taxes
Net income
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Provision for taxes
Net income
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Provision for taxes
Net income
10/31/86
Financial
Statement
Return
$2,135,832
$2,108,148
(2,009,634)
(2,005,650)
126,198
102,498
1,239
20,805
147,003
103,737
(37,689)
(27,469)
109,314
76,268
10/31/88
Financial
Return
Statement
$4,416,990
$3,910,680
(4,318,785)
(3,847,599)
98,205
63,081
45,745
21,225
143,950
84,306
(16,914)
(42,960)
100,990
67,392
10/31/90
Financial
Statement
Return
$6,746,331
$6,014,515
(5,269,014)
(5,008,338)
1,737,993
745,501
58,139
59,876
1,796,132
805,377
(723,300)
(272,170)
1,072,832
533,207
10/31/92
Financial
Statement
Return
$7,442,762
$7,388,353
(6,503,283)
(6,809,208)
939,479
579,145
176,050
524,359
1,115,529
1,103,504
(392,845)
(375,191)
722,684
728,313
10/31/87
Financial
Statement
Return
$3,666,642
$3,359,825
(3,409,657)
(3,327,492)
256,985
32,333
57,384
37,038
314,369
69,371
(46,141)
(13,481)
268,228
55,890
10/31/89
Financial
Return
Statement
$4,423,002
$4,489,886
(3,986,317)
(4,351,131)
436,685
138,755
50,024
21,629
486,709
160,384
(195,995)
(54,825)
290,714
105,559
10/31/91
Financial
Statement
Return
$5,156,266
$5,581,672
(4,812,253)
(5,141,657)
344,013
440,015
203,106
149,527
547,119
589,542
(212,070)
(193,077)
335,049
396,465
10/31/93
Financial
Statement
Return
$5,090,933
$5,088,511
(4,983,762)
(5,174,854)
107,171
(86,343)
130,396
593,430
237,567
507,087
(160,001)
(172,410)
77,566
334,677
- 18 -
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Provision for taxes
Net income
General & contract revenue
Operating expenses
Income from operations
Other income/(loss)
Net income before taxes
Provision for taxes
Net income
10/31/94
Financial
Statement
Return
$4,615,746
$4,633,752
(4,737,810)
(4,876,375)
(122,064)
(242,623)
(119,795)
491,262
(241,859)
248,639
103,921
(80,219)
(137,938)
168,420
10/31/96
Financial
Statement
Return
$6,141,479
$6,069,677
(5,907,484)
(6,063,715)
233,995
5,962
79,668
137,722
371,717
85,630
(128,588)
(17,364)
243,129
68,266
10/31/95
Financial
Statement
Return
$5,312,291
$5,443,976
(5,504,288)
(5,640,193)
(191,997)
(196,217)
123,346
504,140
(68,651)
307,923
54,707
(103,340)
(13,944)
204,583
Petitioner's gross receipts/sales, net earnings, and profit
before interest and taxes as reflected on its Forms 1120 and
financial statements for the years ending October 31, 1986 to
1996, were as follows:
Year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Gross
Receipts/Sales
Financial
Return
Statement
$2,108,148
$2,135,832
3,359,825
3,666,642
3,910,680
4,416,990
4,489,866
4,423,002
6,014,515
6,746,331
5,581,672
5,156,266
7,388,353
7,442,762
5,088,511
5,090,933
4,633,752
4,615,746
5,443,976
5,312,291
6,069,677
6,141,479
Net
Income/(Loss)
Financial
Return
Statement
$76,268
$109,314
55,890
268,228
67,392
100,990
105,559
290,714
533,207
1,072,832
396,465
335,049
728,313
722,684
334,677
77,566
168,420
(137,938)
204,583
(13,944)
68,266
243,129
Profit
Before Interest & Taxes
Financial
Return
Statement
$107,882
$170,099
91,505
355,062
128,110
219,691
274,428
564,877
891,514
1,881,196
686,366
643,943
1,155,251
1,187,754
558,886
289,650
255,090
(229,787)
340,176
(32,698)
126,942
417,147
Petitioner's financial statements and the Schedules E,
Compensation of Officers, of Forms 1120 for the years ending
October 31, 1986 through 1996, reported compensation of officers
as follows:
- 19 Return
Year
Dennis
Curtis
Total Officer
Compensation
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
$134,310
40,641
74,206
160,456
207,239
745,050
593,350
784,470
847,109
1,048,200
699,192
$60,690
40,641
51,706
80,456
97,239
345,050
193,350
204,450
399,260
246,688
400,573
$195,000
81,282
125,912
240,912
304,478
1,090,100
786,700
988,920
1,246,369
1,294,888
1,099,765
Financial Statement
Total Officer
Compensation
$195,000
81,282
285,912
243,090
304,478
930,100
788,400
988,920
1,246,437
1,293,948
1,099,825
Since its incorporation in 1985, petitioner has neither paid
nor declared any dividends.
Petitioner timely filed its Forms 1120 for the taxable years
1995 and 1996 with the Internal Revenue Service Center at Kansas
City, Missouri.
On November 25, 1998, respondent issued a notice
of deficiency to petitioner for the taxable years ending October
31, 1995 and 1996.
Respondent's proposed adjustments concerned
only the reasonableness of petitioner's total officer
compensation payments made to Dennis and Curtis.
OPINION
A. Positions of the Parties
On its Forms 1120, petitioner deducted officer compensation
of $1,294,888 ($1,048,200 for Dennis and $246,688 for Curtis) in
1995 and $1,099,765 ($699,192 for Dennis and $400,573 for Curtis)
in 1996.
Petitioner contends that the amounts paid to Dennis and
Curtis were reasonable and were for services they provided to
petitioner.
- 20 In the notice of deficiency, respondent disallowed
$1,084,719 of the officer compensation deducted in 1995 (allowing
$210,169) and disallowed $898,560 deducted in 1996 (allowing
$201,205).
On brief, respondent now contends that officer
compensation in excess of $435,450 ($243,000 paid to Dennis and
$192,450 to Curtis) in 1995 and in excess of $460,950 ($258,600
paid to Dennis and $202,350 to Curtis) in 1996 was unreasonable,
was disguised dividends, and was not compensation for services
Dennis and Curtis rendered to petitioner.
B. Controlling Factors
A taxpayer may deduct payments for compensation if the
amount paid is reasonable and for services actually rendered.
See sec. 162(a)(1).
The reasonableness of compensation is a
question of fact that must be answered by comparing each
employee's compensation with the value of services that he or she
performed in return.
See RTS Inv. Corp. v. Commissioner, 877
F.2d 647, 650 (8th Cir. 1989), affg. per curiam T.C. Memo. 198798; Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151
(8th Cir. 1974), affg. T.C. Memo. 1973-130; Estate of Wallace v.
Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th
Cir. 1992).
Where, as in this case, the corporation is
controlled by the same employees to whom the compensation is
paid, there is a lack of arm's-length bargaining.
Special
scrutiny must be given to bonus payments paid under such
- 21 circumstances, because such payments "may be distributions of
earnings rather than payments of compensation for services
rendered; even if they are reasonable, they would not be
deductible."
Charles Schneider & Co. v. Commissioner, supra at
153 (emphasis supplied).
Nevertheless, the existence of a
compensatory purpose can often be inferred if the amount of the
compensation is determined to be reasonable.
See O.S.C. &
Associates, Inc. v. Commissioner, 187 F.3d 1116, 1120 (9th Cir.
1999), affg. T.C. Memo. 1997-300.
For that reason, courts
generally focus on the reasonableness of the amount of the
purported compensation.
See id.
Courts generally do not delve
into whether a compensatory purpose exists unless there is
evidence that purported compensation payments, although
reasonable in amount, were in fact disguised dividends.
See id.
"[I]f there is evidence that the payments contain disguised
dividends, the corporation must separately satisfy both the
reasonableness and the compensatory intent prongs of the test.
Reasonableness alone will not suffice."
C.
Id. at 1121.
Expert Witness Reports
Both parties submitted expert witness reports to establish
the amount of compensation paid to Dennis and Curtis that was
reasonable.
Expert witness reports may help the Court understand
an area requiring specialized training, knowledge, or judgment.
See Snyder v. Commissioner, 93 T.C. 529, 534 (1989).
We may be
- 22 selective in deciding what part of an expert witness' report we
will accept.
See Helvering v. National Grocery Co., 304 U.S.
282, 295 (1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d
Cir. 1976), affg. T.C. Memo. 1974-285; Parker v. Commissioner, 86
T.C. 547, 561 (1986).
1.
Robert F. Reilly
Petitioner presented the report and testimony of Robert F.
Reilly (Mr. Reilly), a compensation expert and a business
valuation expert from the firm of Willamette Management
Associates.
In order to prepare his report, Mr. Reilly reviewed
petitioner's Forms 1120 and financial statements covering periods
from 1986 to 1996.
He interviewed Dennis and reviewed various
documents produced by petitioner, respondent, and third parties
to obtain information regarding petitioner and the services
provided by Dennis and Curtis.
Mr. Reilly researched the
published proxy data of public companies in 1995 and 1996 in an
effort to find companies comparable to petitioner but found no
specific public companies comparable to petitioner for
compensation purposes.
Additionally, he used various surveys to
evaluate the compensation paid to Dennis and Curtis in 1995 and
1996.
Mr. Reilly considered developments of petitioner's business
from 1986 through 1996, including the following:
- 23 (a)
Petitioner won and held onto logging contracts with
Boise Cascade Corp.;
(b)
petitioner purchased land (or rented land from Wagner &
Wagner) to store construction wastes from its construction
operations and for others;
(c)
petitioner converted portions of land from construction
waste storage to log storage for its logging operations and those
of Boise Cascade Corp.;
(d)
petitioner purchased land and developed sand and gravel
pits for use in its construction business and for sale to others;
(e)
petitioner entered into advantageous agreements to
extract gravel from other properties for use in its construction
business and its sand and gravel operations;
(f)
petitioner's revenues increased from $2.1 million in
1986 to $6.1 million in 1996;
(g)
from 1985 to 1996, both Dennis and Curtis devoted
themselves exclusively to petitioner's construction and related
businesses, and they worked up to 90 hours per week;
(h)
by 1995, Dennis had more than 30 years of experience
and Curtis had more than 20 years of experience in the
construction and logging industries; and
(i)
Dennis and Curtis were petitioner's only officers from
1985 to 1996; they performed all the executive and administrative
- 24 duties and assumed all the responsibilities for petitioner's
operations.
Mr. Reilly based his analysis of compensation paid to Dennis
on the duties performed as president and chief executive officer
(CEO), chief financial officer, vice president of marketing and
sales, and chief operating officer (COO).
Mr. Reilly based his
analysis of compensation paid to Curtis on the duties performed
as vice president and chief engineering executive, COO (in
Dennis' absence), and supervisor of petitioner's logging
operations.
Mr. Reilly found that, in his efforts to compare petitioner
to other highway and heavy construction companies, petitioner was
unique because it had a management team of only two people,
Dennis and Curtis, who operated a business with annual revenues
between $5 and $6 million.
Petitioner's management structure was
comparable to that of highway and heavy construction companies
with annual revenues between $1 and $3 million.
Furthermore, in
Mr. Reilly's opinion, it would take four people to replace
Dennis.
Mr. Reilly also noted, in comparing petitioner to other
highway and heavy construction companies of comparable size, that
petitioner operates in northern Minnesota where the construction
season is very short.
In comparing petitioner's financial
information to the published survey data, Mr. Reilly used
- 25 petitioner's Forms 1120 for sales figures of $5.4 million in 1995
and $6.1 million in 1996.
Mr. Reilly reviewed the "Almanac of Business and Industrial
Financial Ratios" for the period from July 1995 to June 1996,
which uses data from the Federal income tax returns of businesses
included in the various categories.
Mr. Reilly determined that
of the nearly 21,000 businesses included in the highway and heavy
construction contractor category, 71 percent had total assets of
less than $1 million, fewer than 10 percent had total assets in
excess of $5 million, 62 percent had a positive net income, and
38 percent of the companies showed a loss in 1995 and 1996.
Mr. Reilly concluded that petitioner's Forms 1120 showed a
profit every year from 1986 to 1996.
Mr. Reilly viewed
petitioner's financial record over 10 years because, in his
opinion, examining only 2 years would not take into account prior
undercompensation of executives.
Further, in his opinion, a
company's historical record is the best way to determine whether
a company has provided a fair return to its stockholders.
Mr. Reilly, using the "CFMA's 1996 Construction Industry
Annual Financial Survey" (the CFMA survey), calculated that
highway and heavy construction contractors with revenue under $10
million reported a net income (or after-tax profit margin)
percentage of 2.3 percent for 1995 and 0.3 percent for 1996.
The
record does not indicate whether the CFMA survey used data from
- 26 financial statements or tax returns.
On the basis of the income
reported on petitioner's Forms 1120, Mr. Reilly calculated that
petitioner had a net income percentage (or after-tax profit
margin) of 3.8 percent for 1995 and 1.1 percent for 1996.
Mr. Reilly did not compare compensation paid to Dennis and
Curtis to that paid to petitioner's other employees because no
other employee held an administrative or executive position.
Mr.
Reilly observed that petitioner maintained a profit-sharing plan
that included other employees, and the union employees were paid
top scale wages for the State of Minnesota rather than the
specific region governed by petitioner's union contracts.
Mr. Reilly performed two separate analyses of petitioner's
executive compensation for purposes of determining a range of
reasonable compensation.
Mr. Reilly first compared the executive compensation of
Dennis and Curtis to published executive compensation study
figures for positions in companies that, in his opinion, were of
comparable size and in comparable industries.
He used annual
compensation surveys from the National Institute of Business
Management (the NIBM survey) and Aspen Publishers, Inc. (the
Aspen survey).
The NIBM survey covers companies in the
construction, contracting, and extraction industries with annual
sales exceeding $5 million.
There is no upper limit on the sales
volume of companies included in the survey segment and,
- 27 accordingly, the survey segment could include companies with
sales of as much as $500 million.
Mr. Reilly also used Watson Wyatt Data Services (Watson
Wyatt), which publishes an annual regression analysis report on
top management compensation.
The Watson Wyatt data includes data
for the general services sector; this sector includes all service
industries except banking, insurance, and financial services and
is not limited to the construction industry.
For each position
reported, Watson Wyatt provides equations used to calculate a
predicted mean total compensation as a function of sales or
stockholders equity.
In addition, the log of the standard
deviation provided with each equation allows for the calculation
of predicted total compensation at different percentiles.
The median and high compensation of executives reported for
1995 and 1996 by the NIBM survey, the Aspen survey, and the
Watson Wyatt computation (calculated on the basis of shareholder
equity of $2,904,691 at the beginning of 1995 and $2,890,745 at
the beginning of 1996) is as follows:
- 28 NIBM Survey
Year/Position
1995
CEO/president
Marketing
Finance
COO/manufacturing
Watson Wyatt Data
3rd
Quartile
84th
Median Percentile
$203,000 $300,000
95,000 134,000
97,000 150,000
94,000 147,500
81,450 125,000
$215,000 $386,000
73,000 120,000
73,000 110,000
194,000 222,000
74,000 111,000
$220,190 $378,180
110,659
164,319
108,194
170,766
176,470
248,296
93,513
127,666
160,787
80,600
97,392
106,000
140,200
140,000
69,000
64,000
115,000
79,000
224,427
112,162
109,955
179,169
94,218
Median
75th
Percentil
e
Aspen Survey
Median
Engineering/production
1996
CEO/president
Marketing
Finance
COO/manufacturing
239,000
122,190
125,000
150,000
157,000
299,000
74,000
72,000
870,000
98,000
385,456
166,550
173,547
252,095
128,628
Engineering/production
Using the NIBM survey, the Aspen survey, and the Watson
Wyatt data and not taking into account any undercompensation in
prior years, Mr. Reilly computed the upper range of reasonable
compensation for Dennis and Curtis in 1995 and 1996.
In
computing the compensation for Dennis, Mr. Reilly added the
compensation for the CEO, highest marketing position, highest
financial position, and the COO, and then subtracted 25 percent
of the COO position (which he allocated to Curtis).
In computing
the compensation for Curtis, Mr. Reilly added to the compensation
for the top engineering position 25 percent of the compensation
for the COO.
On the basis of those computations, Mr. Reilly's
opinion is that the upper range of reasonable compensation for
Dennis was between $694,625 and $899,487 for 1995 and between
$598,690 and $1,097,500 for 1996.
The reasonable compensation
for Curtis was between $161,875 and $189,740 for 1995 and between
- 29 $191,652 and $315,500 for 1996.
We do not accept certain aspects of Mr. Reilly's analysis.
Mr. Reilly's aggregation approach would result in compensation
equal to that of four full-time corporate executives.
We reject
Mr. Reilly's suggestion that Dennis performed the work of four
full-time executives serving as petitioner's president and CEO,
chief financial officer, vice president of marketing and sales,
and COO.
Although Dennis may have performed some of the duties
and functions of four such executives, he did not perform work
equal to the full-time services of four such executives.
Although the more roles or functions an employee performs the
more valuable his services are likely to be, an employee who
performs four jobs, each on a part-time basis, is not necessarily
worth as much to a company as four employees each working full
time at one of those jobs.
Dennis testified that he worked 80 to 90 hours per week.
Four full-time employees would have worked at least 160 combined
hours each week.
It is therefore inappropriate to aggregate the
normal full-time salary for four jobs to compute the reasonable
compensation of the employee who fills all four of them.
See
Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. 564, 569 (1974),
affd. 528 F.2d 176 (10th Cir. 1975); Richlands Med. Association
v. Commissioner, T.C. Memo. 1990-660, affd. without published
opinion 953 F.2d 639 (4th Cir. 1992); Ken Miller Supply, Inc. v.
Commissioner, T.C. Memo. 1978-228.
- 30 We also find questionable some of the data from the surveys
Mr. Reilly used in forming his opinion.
For example, Mr. Reilly
opined that reasonable compensation for Dennis was between
$598,690 and $1,097,500 for 1996.
The $1,097,500 results in
large part from the use of data from the Aspen survey.
Specifically, Mr. Reilly used annual compensation for a COO of
$870,000 reported in the Aspen survey for the third quartile
amount.
The third quartile compensation was computed on the
basis of information reported by only three incumbents for the
COO category.4
The average amount was $132,000 and the median
was $115,000.
It is clear therefore that the $870,000 of the
third quartile was reported by one incumbent.
One company
reporting in the $2 to $5 million of sales category also reported
$870,000.
The $870,000 reported by the two companies is
substantially out of line with all other companies reporting COO
compensation in all categories.
Therefore, we do not find the
$870,000 to be reliable.
We also find that Mr. Reilly's use of the income data from
petitioner's Forms 1120 for the 2 years at issue in his analysis
was inherently flawed because of the distortion caused by the
section 481(a) adjustment.
The adjustment resulted from
petitioner's change in accounting methods in 1991.
4
Before
The survey notes that where fewer than three incumbents
report in a given category, median, first quartile, and third
quartile information is not statistically relevant.
- 31 November 1, 1991, petitioner used the cash method of accounting
for tax purposes.
Effective November 1, 1991, petitioner changed
its method of accounting for tax purposes from the cash method to
the accrual method.
As a result of the change in accounting
method, petitioner realized a section 481(a) adjustment of
$1,637,156 and included $409,289 of the adjustment in income for
each of the 4 taxable years ending October 31, 1992 through 1995.
Thus, the section 481(a) adjustment affected the taxable year
1995 and artificially increased petitioner's income by $409,289
for that year.
Mr. Reilly's second analysis estimated the reasonableness of
petitioner's executive compensation by calculating petitioner's
residual economic income after a fair return on the total fair
market value of the stockholders' invested capital.
In order to
assess the reasonableness of executive compensation under this
method, Mr. Reilly allocated to management all the profits in
excess of a fair return on the total fair market value of the
stockholders' invested capital.
Mr. Reilly estimated that, over the period from 1987 to
1996, a fair before-tax annual rate of return on petitioner's
common stock would vary year to year from 26.0 percent to 32.7
percent.
Mr. Reilly's estimated fair return was 28.2 percent for
1995 and 26 percent for 1996.
Mr. Reilly calculated an estimated
value of invested capital in each year and increased the value by
- 32 the fair after-tax return from year to year, representing the
increase in theoretical retained earnings from October 31, 1985
through 1996, if a fair return was earned in each year through
1996 but no dividends were paid.
Mr. Reilly then added the actual executive compensation paid
to income before taxes in order to calculate the amount available
to pay a fair return on invested capital and compensation to
officers.
Mr. Reilly used the income and executive compensation
reported on petitioner's Forms 1120.
He then subtracted from
this subtotal a fair return on the stockholders' invested
capital.
Under Mr. Reilly's analysis, the remainder (residual)
represents the amount available to pay the company's officers as
compensation for the results of their managerial efforts.
Mr.
Reilly then calculated the difference between the amount
available to pay petitioner's officers and the actual officers'
compensation, which, in his opinion, represented the
undercompensation or overcompensation in each year.
Mr. Reilly calculated the amount of undercompensation or
overcompensation for the taxable years ending October 31, 1987
through 1996, as follows:
- 33 10/31/1987
10/31/1988
10/31/1989
10/31/1990
10/31/1991
17.5%
$150,653
19.57%
$210,218
21.61%
$401,296
20.29%
$1,109,855
20.72%
$1,679,642
315,766
26.5%
83,678
66,975
81,282
(14,307)
(14,307)
370,993
29.7%
110,185
100,033
125,912
(25,879)
(40,186)
443,716
32.7%
145,095
256,201
240,912
15,289
(24,897)
539,478
30.7%
165,620
944,235
304,478
639,757
614,860
648,787
31.4%
203,719
1,475,923
1,090,100
385,823
1,000,683
10/31/1992
10/31/1993
10/31/1994
10/31/1995
10/31/1996
After-tax rate of return
Taxable income plus officers'
compensation
Fair return on capital
Value begin year
Pretax rate of return1
19.76%
1,890,204
19.67%
1,496,007
17.59%
1,495,008
18.60%
1,602,811
17.18%
1,185,395
783,242
29.9%
937,807
29.8%
1,122,255
26.7%
1,320,019
28.2%
1,565,701
26.0%
Fair pretax return
Available for officers' compensation
Actual compensation
Under/(over) compensation
Cumulative under/(over) compensation
234,189
1,656,015
786,700
869,315
1,869,997
279,467
1,216,540
988,920
227,620
2,097,618
299,642
1,195,366
1,246,369
(51,003)
2,046,615
372,245
1,230,566
1,294,888
(64,322)
1,982,293
407,082
778,313
1,099,765
(321,452)
1,660,840
After-tax rate of return
Taxable income plus officers'
compensation
Fair return on capital
Value begin year
Pretax rate of return1
Fair pretax return
Available for officers' compensation
Actual compensation
Under/(over) compensation
Cumulative under/(over) compensation
1
Pretax rate of return divided by 34 percent Federal tax rate.
- 34 Mr. Reilly concluded that the total amount available as
reasonable compensation for Dennis and Curtis, as indicated by
the residual from a fair return of invested capital analysis, was
$1,230,566 for 1995 and $778,313 for 1996.
Mr. Reilly combined the results of his two analyses and
found that the upper end of the range of reasonable combined
compensation for Dennis and Curtis was approximately $1.2 million
for 1995 and $1.1 million for 1996, without any adjustment for
undercompensation in prior years.
Mr. Reilly concluded that
Dennis and Curtis were undercompensated by more than $2 million
for the period from 1986 to 1994.
We question Mr. Reilly's use of his fair return on invested
capital analysis to show that Dennis and Curtis were
undercompensated in prior years.
An executive has not been
undercompensated simply because the stockholders received an
excellent return on invested capital that greatly exceeds a
"fair" return.
As Mr. Reilly acknowledged, a fair return on
invested capital is the minimum a stockholder would expect and
demand; a stockholder who has not received such a return will
either replace management or sell the stock.
Mr. Reilly's use of the cumulative excess amounts over a 10year period created a distortion that was merely an attempt to
justify payments in excess of the maximum Mr. Reilly could
compute using his other methods.
The Court notes that Mr. Reilly
- 35 used a hypothetical investment in capital for purposes of
computing a fair return on the capital.
Use of the hypothetical
investment in capital resulted in a smaller fair return for most
years.
The smaller fair return resulted in a larger excess,
which Mr. Reilly accumulated and used as the amount of
undercompensation.
Mr. Reilly used the more realistic
stockholders equity shown on petitioner's Forms 1120, however, to
compute compensation using the Watson Wyatt formula.
We reject
this inconsistency.
As an additional analysis, Mr. Reilly calculated the average
compound annual returns to petitioner's stockholders.
He used
$315,766 (approximately twice the price petitioner paid for
Clifford's 1,000 shares of stock) as the value of the
stockholders' initial investment on October 31, 1986, and three
different measures of petitioner's stockholders equity.
Using
his fair return of invested capital analysis and the estimated
value of $1,834,375 as of October 31, 1996, Mr. Reilly calculated
that the average annual after-tax return over the 10-year period
from 1986 to 1996 was 19.24 percent.
Using the $3,133,877 book
value of stockholders equity as of October 31, 1996, Mr. Reilly
calculated that the average annual after-tax return over the 10year period was 25.80 percent.
Finally, using the $1,150,000
purchase price Dennis paid to Curtis for his 25 percent of
petitioner's stock in November 1997 to determine an estimated
- 36 value of $4.6 million for all of petitioner's stock as of that
date, Mr. Reilly calculated that the average annual after-tax
return over the 11-year period was 27.57 percent.
We question Mr. Reilly's use of $315,766 as the value of the
stockholders' initial capital investment on October 31, 1986.
The purchase of Clifford's shares of stock was not the result of
an arm's-length negotiation and was made in conjunction with
Dennis' transfer of 25 percent of his stock to Curtis and with
the gratuitous transfer of Clifford's interest in Wagner & Wagner
to Dennis and Curtis.
We also give little weight to the use of the purchase price
Dennis paid to Curtis for his 25 percent of petitioner's stock in
November 1997.
The sale occurred after the years in issue, and
the full terms of the purchase are not in evidence.5
2.
John M. Lacey
Respondent offered the report and testimony of John M.
Lacey, Ph.D. (Dr. Lacey), to establish that petitioner's return
on equity for 1995 and 1996 was not comparable to that of the
industry and would not meet a reasonable investor's expectations,
and to establish that petitioner did not fairly distribute its
earnings between management and stockholders.
5
At trial, petitioner objected in another context to the
admission of facts related to events occurring after the years
before the Court.
- 37 To determine the reasonableness of the return on equity, Dr.
Lacey compared petitioner's returns on equity for 1995 and 1996
with those of publicly traded companies in the construction
industry for the same years.
Dr. Lacey found 19 publicly traded
companies in the highway and heavy construction industry.
He
excluded seven companies for one or more of the following
reasons:
(1)
The company's annual sales exceeded $5 billion;
(2)
a large portion of the company's operations were
conducted outside the United States;
(3)
the company made large acquisitions during the relevant
period;
(4)
the company reported negative equity, indicating
insolvency;
(5)
construction was not the company's primary business;
(6)
the company had material expense for settlement of
contract claims and unapproved change orders.
The 12 remaining companies that Dr. Lacey used to compare to
petitioner included Amerilink Corp. (AmC), Atkinson, G.F. Co.
(AtC), Dycom Industries, Inc. (DII), Foster Wheeler (FW),
Goldfield Corp. (GoC), Granite Construction (GrC), Insituform
Technologies (IT), Jacobs Engineering (JE), Mastec Inc. (MI),
Meadow Valley Corp. (MV), MYR Group (MG), and Utilx Corp. (UC).
- 38 In making his comparisons, Dr. Lacey used the following data for
petitioner and the publicly traded companies:
- 39 Gross Profit
Sales
Recalculated
Net Income
Return on
Equity
Equity
1995
1996
1995
Dollar Amounts in Millions
1996
1995
1996
Comparables:
AmC
AtC
DII
FW
GoC
GrC
IT
JE
MI
MV
MG
UC
$47.54
417.00
143.91
3,042.18
12.77
894.80
272.20
1,723.06
174.58
90.05
266.97
49.72
$56.06
468.47
143.93
4,005.50
13.16
928.80
289.93
1,798.97
472.80
133.72
310.58
48.99
$15.68
39.17
26.17
399.89
0.70
111.96
89.92
189.23
43.82
4.35
29.55
6.74
$17.11
44.25
28.20
494.53
1.29
110.66
88.71
208.06
120.47
2.81
31.64
6.41
$1.45
3.61
4.43
83.14
(0.68)
28.54
14.85
32.24
19.79
1.23
3.43
(2.02)
$0.46
5.02
6.39
111.42
(0.34)
27.35
11.37
40.36
30.08
(0.09)
3.97
(4.49)
$8.75
83.46
11.19
625.87
12.47
209.91
116.81
238.76
50.50
11.76
26.62
28.07
$9.21
89.28
17.78
688.96
12.10
233.61
123.20
283.39
103.50
11.68
29.57
23.46
16.6%
4.3
39.6
13.3
-5.4
13.6
12.7
13.5
39.2
10.5
12.9
-7.2
5.0%
5.6
35.9
16.2
-2.8
11.7
9.2
14.2
29.1
-0.7
13.4
-19.1
Average
Median
Petitioner
594.56
220.77
5.31
722.58
300.26
6.14
79.76
34.36
1.20
96.18
37.95
1.44
15.83
4.02
(0.01)
19.29
5.70
0.24
118.68
39.29
2.89
135.48
59.43
3.13
13.6
13.1
-0.5
9.8
10.5
7.8
1995
1996
1995
1996
- 40 Dr. Lacey computed the return on equity for 1995 and 1996
for each of the 12 publicly traded companies by dividing
"recalculated net income" by common equity.
Recalculated net
income is net income excluding income from discontinued
operations, minority interests, the writeoff of offering costs,
and special charges.
Dr. Lacey calculated that the median return
on equity of the publicly traded companies was a gain of 13.1
percent in 1995 and a gain of 10.5 percent in 1996.
In addition,
he calculated that the average return was a gain of 13.6 percent
in 1995 and 9.8 percent in 1996.
He calculated that petitioner's
return on equity was a loss of 0.5 percent in 1995 and a gain of
7.8 percent in 1996.
Dr. Lacey concluded that petitioner's
return on equity would not satisfy the expectation of reasonable
investors because it was below the median and average returns for
the industry.
In order to assess the fairness of petitioner's division of
earnings, Dr. Lacey examined petitioner's distribution among debt
holders (in the form of interest expense), executive officers (in
the form of bonuses and other compensation), stockholders (in the
form of net income, some of which may be paid out currently as
dividends), and the Government (in the form of taxes).
Dr. Lacey
compared petitioner's distribution of its earnings among the four
groups to those made by the 12 publicly traded companies.
- 41 Using data from the 12 publicly traded companies, Dr. Lacey
calculated that the total pool of funds available for
distribution among the four groups was equal to operating income
plus other income/expense plus management compensation.
In
calculating management compensation paid by the publicly traded
companies, Dr. Lacey included only salaries and bonuses paid to
executive officers.
He did not include stock options or any
other perquisite compensation paid to executive officers of the
publicly traded companies or compensation to managers such as
supervisors who were not officers.
Dr. Lacey calculated distributable funds, net income
distributable to equity holders, and management compensation for
the 12 publicly traded companies and petitioner as follows:
- 42 Distributable Funds
1995
1996
Comparables:
AmC
$3,399.84
$1,750.56
AtC
7,460.96
10,241.00
DII
8,510.67
10,633.17
FW
176,540.16 214,251.74
GoC
(105.10)
340.18
GrC
50,336.00
49,365.00
IT
26,960.10
24,333.89
JE
59,281.82
73,718.78
MI
24,087.00
60,111.00
MV
3,240.70
1,058.73
MG
8,798.35
9,657.00
UC
(2,173.66) (1,513.00)
Average
Median
Petitioner
1,262.99
1,516.94
Net Income/Equity Holders
Dollar Amounts in Thousands
1995
1996
$1,449.77
42.6%
3,609.00
48.4
4,433.20
52.1
83,144.00
47.1
(677.56) 644.7
28,542.00
56.7
14,850.00
55.1
32,242.00
54.4
19,785.00
82.1
1,232.35
38.0
3,429.00
39.0
(2,022.00) 93.0
(13.94)
-1.1
$457.04
26.1%
5,019.00
49.0
6,390.14
60.1
111,416.00
52.0
(337.84) -99.3
27,348.00
55.4
11,367.00
46.7
40,360.00
54.7
30,083.00
50.0
(85.23) -8.1
3,968.00
41.1
(4,489.00) 296.7
243.13
16.0
Management Compensation
1995
1996
$612.19
1,806.96
994.57
3,256.16
510.46
1,589.00
1,730.10
3,684.82
1,183.00
342.24
1,311.35
748.34
18.0%
24.2
11.7
1.8
-485.7
3.2
6.4
6.2
4.9
10.6
14.9
-34.4
10.2
8.5
$552.31
1,744.00
1,513.45
3,269.74
678.02
1,589.00
1,758.89
4,120.38
2,933.00
553.77
1,431.00
985.00
31.6%
17.0
14.2
1.5
199.3
3.2
7.2
5.6
4.9
52.3
14.8
-65.1
11.1
7.2
1,293.95
102.5
1,099.83
72.5
- 43 For comparison purposes, Dr. Lacey excluded two companies in
1995 (GoC and UC) and three companies in 1996 (GoC, MV, and UC)
because the companies reported losses.
Dr. Lacey calculated that
petitioner distributed more than 100 percent of its available
funds to management (Dennis and Curtis) in 1995 and 72.5 percent
in 1996 compared with the remaining publicly traded companies
that ranged from 1.8 to 24.2 percent in 1995 and 1.5 to 31.6
percent in 1996.
Generally, equity holders received twice as
much as management.
Dr. Lacey also reviewed the annual proxy statements filed by
the 12 publicly traded companies with the Securities and Exchange
Commission.
The proxy statements indicate that four of the
companies do not have a formal bonus policy.
companies limit the size of the bonuses.
The other eight
For example, five
companies limit the bonus to a percentage of the base salary
(ranging from 50 to 150 percent).
Other companies create a bonus
pool determined on the basis of the company's financial
performance.
Individual officers then receive a portion of the
total pool as recommended by top management or the board of
directors.
One company gives its CEO a bonus equal to 5 percent
of the company's operating income above a target level.
Dr. Lacey also used two studies compiled from data submitted
for 1995 to compare the bonuses petitioner paid to those paid by
other businesses.
Dr. Lacey's report does not disclose the range
- 44 of the bonuses paid by the other companies.
According to one
survey, CEO's in the construction industry earned median bonuses
equal to 100 percent of their base salaries, and COO's in the
construction industry earned median bonuses equal to 53 percent
of their base salaries.
According to the other survey, CEO's
from all industries earned a median bonus equal to 90 percent of
their base salaries.
Dr. Lacey compared petitioner to the industry as a whole
using two financial ratios derived from the Robert Morris
Associates "RMA Annual Statement Studies".
He calculated
officers', directors', and owners' compensation as a percentage
of sales for petitioner and compared the results with the median
for highway and heavy construction companies for which data was
available.
Dr. Lacey calculated that petitioner's percentage of
sales ratio (on the basis of compensation paid to Dennis and
Curtis) was 24.4 percent in 1995 and 17.9 percent in 1996.
He
calculated the median ratio for companies in each of the four
subcategories in the highway and heavy construction industry and
reported that the median ratio for companies doing highway and
heavy construction did not exceed 4 percent.
The report does not
show the range of ratios for companies included in his
evaluation.
Dr. Lacey also calculated petitioner's pretax profit as a
percentage of tangible net worth and compared the results with
- 45 the medians for highway and heavy construction companies.
A
larger percentage indicates that equity holders receive a higher
return, in relation to the book value of their investment in the
company.
Petitioner's ratio was -2.4 percent in 1995 and 11.9
percent in 1996.
The medians for companies in the four
subcategories with sales between $1 and $10 million were between
11.2 and 20.4 percent in 1995 and between 11.1 and 19.1 percent
in 1996.
Dr. Lacey's analysis has a fatal flaw; none of the 12
publicly traded companies he selected was reasonably comparable
to petitioner.
All of them were much larger than petitioner,
particularly in terms of their respective annual sales.
The
largest company, FW, had sales of $3.04 billion in 1995 and $4
billion in 1996.
The smallest company, GoC, had sales of $12.77
million in 1995 and $13.16 million in 1996.
Eight of the
companies had gross receipts in excess of $100 million in 1995
and 1996.
Another had gross receipts in excess of $90 million in
1995 and $133 million in 1996.
Of the three remaining smaller
companies (gross receipts between $12 and $50 million), Dr. Lacey
eliminated two companies (GoC and UC) from many of his
calculations because they showed losses in both 1995 and 1996.
Dr. Lacey concluded that petitioner's return on equity would
not satisfy the expectation of a reasonable investor because the
return was below the median and average returns of the publicly
- 46 traded companies.
The returns on equity of the publicly traded
companies, however, ranged from a loss of 7.2 percent to a gain
of 39.6 percent for 1995 and from a loss of 19.1 percent to a
gain of 35.9 percent for 1996.
Petitioner's equity showed a loss
of 0.5 percent for 1995 and a gain of 7.8 percent for 1996.
Of
the 12 publicly traded companies, 2 had returns on equity lower
than petitioner's in 1995, and 5 had returns lower than
petitioner's in 1996.
Petitioner's returns on equity were within
the range of the returns realized by the publicly traded
companies.
Thus, without more,6 comparison to those companies
does not show that petitioner's returns on equity would not
satisfy the expectation of reasonable investors.
Dr. Lacey opined that the compensation paid to Dennis and
Curtis in salaries and bonuses exceeded the 1995 and 1996 total
cash compensation of management for the large publicly traded
companies he examined.
However, as petitioner points out, Dr.
Lacey failed to take into account the stock options granted to
the executive officers of the publicly traded companies.
Top
executives at many publicly traded companies typically receive
stock options as part of their compensation packages.
These
stock options can produce substantial compensation in the event
6
Dr. Lacey offered no evidence that stockholders sold their
stock in the corporations reporting losses, that the prices of
stock of the companies were lower, or that the corporations
replaced management.
- 47 that the company's stock price rises greatly.
In at least one
other case, the Commissioner conceded that the value of stock
options granted to employees in public companies should be
considered in determining what like enterprises paid for like
See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d
services.
1315, 1330 n.60 (5th Cir. 1987) (experts calculated the average
amounts the top three executives could expect to earn in cash and
stock options for an outstanding performance), affg. T.C. Memo.
1985-267.
When the compensation paid to Dennis and Curtis is
compared with that of other CEO's who did receive options, the
options must be considered as part of the compensation packages
being used for comparison.
See Labelgraphics, Inc. v.
Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir.
2000).
3.
Accordingly, we reject Dr. Lacey's opinion.
Paul A. Katz
Respondent offered the report and testimony of Paul A. Katz
(Mr. Katz) for purposes of establishing whether the compensation
petitioner paid to Dennis and Curtis in 1995 and 1996 was
comparable to that paid for similar positions in the industry.
Mr. Katz is a compensation consultant certified by the American
Compensation Association.
Mr. Katz compared the compensation paid to Dennis and Curtis
in 1995 and 1996 to the median compensation paid in those years
to CEO's, and COO's, respectively, as reported by the Economic
- 48 Research Institute (ERI).
ERI compiles data from 2,400 surveys
taken by associations, governmental organization, and reports
submitted to the Government.
Mr. Katz analyzed the data for
CEO's7 and COO's8 of construction companies with revenues of
approximately $6 million and doing business within 200 miles of
International Falls, Minnesota (but excluding the Minneapolis
area).
Using the ERI data, Mr. Katz calculated that the median
comparable compensation (including bonuses but excluding
benefits) for CEO's and COO's for 1995 and 1996 was as follows:
Position
CEO
Base
Bonus
Total
COO
Base
Bonus
Total
1995
1996
$142,800
19,200
162,000
$152,400
20,100
1
172,500
99,700
28,600
128,300
106,400
28,500
134,900
1
Mr. Katz incorrectly indicated a total of $172,400 in his
report.
Mr. Katz opined that compensation for comparable positions
can vary as much as 50 percent above or below the median and that
variances greater than 50 percent are generally not considered
7
The ERI survey defines the CEO as the highest ranking and
paid officer in the company with overall responsibility for
directing the running and planning of the company's business
activities.
8
The ERI survey defines the COO as the second highest
ranking and paid officer in the company with subordinate
responsibility to manage costs and achieve goals.
- 49 good compensation practice.
On that basis, Mr. Katz opined that
Dennis and Curtis were overpaid by an almost unprecedented
amount.
On the basis of Mr. Katz' opinion, respondent contends
on brief that compensation petitioner paid to Dennis and Curtis
in excess of the following amounts for 1995 and 1996 was
unreasonable:
Position
Dennis (CEO)
Curtis (COO)
1995
$243,000
192,450
1996
$258,600
202,350
Mr. Katz based his analysis of compensation paid to Dennis
on the duties performed as the CEO and his analysis of
compensation paid to Curtis on the duties performed as the COO.
Mr. Katz did not consider any other functions performed by Dennis
and Curtis or the number of hours they worked.
We find the report of Mr. Katz to be unreliable.
contains several typographical and mathematical errors.
The report
Although
some errors were corrected by Mr. Katz' testimony at trial,
others were not.
Except for a statement in his report that the
median salaries were based on ERI data, the report does not
include the ERI data used by Mr. Katz to determine the median
salaries and does not indicate the number of corporations, CEO's,
or COO's included in the data.
Additionally, although Mr. Katz
testified that he looked at the range of compensation to evaluate
the quality of the data, the report does not provide a range of
compensation amounts from the ERI data.
- 50 Finally, Mr. Katz opined that salaries and bonuses paid to
Dennis and Curtis were excessive because the compensation
exceeded the 1995 and 1996 median cash compensation for CEO's and
COO's included in the ERI data.
However, Mr. Katz, like Dr.
Lacey, failed to take into account the stock options granted to
the CEO's and COO's of the publicly traded companies.
See
Labelgraphics, Inc. v. Commissioner, supra.
Accordingly, we reject Mr. Katz' opinion concerning
reasonable compensation paid to Dennis and Curtis for the years
at issue.
D.
Rejection of Expert Witness Opinions
Because of fundamental differences in approach among the
experts engaged by both parties, the values arrived at in the
reports are extremely far apart.
Although it is not unusual in
valuation cases that two experts reach significantly different
conclusions, the reports and testimony of the experts in this
case are so dissimilar that the reliability of the experts is
brought into question.
In this case, the experts reached
conclusions that patently favored their respective clients, and
their reports were designed to support their conclusions.
The purpose of expert testimony is to assist the trier of
fact to understand evidence that will determine the fact in
issue.
See Laureys v. Commissioner, 92 T.C. 101, 127-129 (1989).
That purpose is jeopardized when an expert assumes the position
- 51 of an advocate.
See id.
An expert has a duty to the Court that
exceeds his duty to his client; the expert is obligated to
present data, analysis, and opinion with detached neutrality and
without bias, regardless of the effect of such unbiased
presentation on his client's case.
See, e.g., Estate of Halas v.
Commissioner, 94 T.C. 570, 577-578 (1990).
When an expert
displays an unyielding allegiance to the party who is paying his
or her bill, we generally will disregard that testimony as
untrustworthy.
See id.; Laureys v. Commissioner, supra; see also
Jacobson v. Commissioner, T.C. Memo. 1989-606 (when experts act
as advocates, "the experts can be viewed only as hired guns of
the side that retained them, and this not only disparages their
professional status but precludes their assistance to the Court
in reaching a proper and reasonably accurate conclusion").
The
experts' lack of impartiality has caused a disservice to the
Court and the system of tax administration.
E.
Reasonableness of Compensation
We first determine the amount of compensation that was
reasonable for petitioner to pay to Dennis and Curtis for their
services.
In Charles Schneider & Co. v. Commissioner, 500 F.2d
at 151-152, the Court of Appeals for the Eight Circuit, to which
an appeal in this case would lie, listed the following factors
courts consider in assessing the reasonableness of an employee's
compensation:
- 52 (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) the prevailing general economic conditions;
(5) the prevailing rates of compensation for comparable
positions in comparable concerns;
(6) the salary policy of the taxpayer as to all employees;
(7) in the case of small corporations with a limited number
of officers the amount of compensation paid to the particular
employee in previous years;
(8) a comparison of salaries paid with the gross income and
the net income; and
(9) comparison of salaries with distributions to
stockholders.
We carefully scrutinize the facts at hand because Dennis
and Curtis, the employees to whom the compensation was paid,
control petitioner, the paying corporation.
We must be sure that
any amounts purportedly paid as compensation were actually paid
for services rendered by Dennis and Curtis, rather than
distributions to them of earnings that petitioner could not
otherwise deduct.
See Paul E. Kummer Realty Co. v. Commissioner,
511 F.2d 313, 315-316 (8th Cir. 1975), affg. T.C. Memo. 1974-44;
Charles Schneider & Co. v. Commissioner, supra at 152-153.
single factor controls.
We examine these factors from the
No
- 53 perspective of an independent investor.
See RAPCO, Inc. v.
Commissioner, 85 F.3d 950, 954-955 (2d Cir. 1996), affg. T.C.
Memo. 1995-128.
1. Employee's Qualifications
An employee's superior qualifications for his or her
position with the business may justify high compensation.
See
Charles Schneider & Co. v. Commissioner, supra at 152; Mayson
Manufacturing Co. v. Commissioner, 178 F.2d 115, 121 (6th Cir.
1949); Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C.
1142, 1158 (1980).
By 1995, Dennis and Curtis had many years of experience in
the construction and logging industries.
During the years at
issue, both Dennis and Curtis devoted themselves exclusively to
petitioner's business, and they worked up to 90 hours per week.
Dennis and Curtis performed all the executive and administrative
duties and assumed all the responsibilities for petitioner's
operations.
Their experience and knowledge of petitioner's
construction, logging, and other diverse business activities made
them uniquely qualified for their positions with the business and
warrant high compensation.
2. Nature, Extent, and Scope of Employee's Work
An employee's position, duties performed, hours worked, and
general importance to the success of the company may justify high
compensation.
See Charles Schneider & Co. v. Commissioner,
- 54 supra; see also Rutter v. Commissioner, 853 F.2d 1267 (5th Cir.
1988), affg. T.C. Memo. 1986-407; Mayson Manufacturing Co. v.
Commissioner, supra at 121.
6 or 7 days a week.
Dennis and Curtis worked long hours,
They were petitioner's only officers.
Dennis performed all the duties of a CEO, and Curtis performed
all duties of a COO.
We view Dennis and Curtis as indispensable
to petitioner's various business activities, including highway
and heavy construction, logging, construction waste storage, and
sand and gravel operations.
Petitioner's growth and prosperity
are due directly to the skills, dedication, and efforts of Dennis
and Curtis.
We find the nature and scope of the work performed by Dennis
and Curtis warrant high compensation.
3. Size and Complexity of Business
We consider the size and complexity of a taxpayer's business
in deciding whether compensation is reasonable.
See Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323; Mayson
Manufacturing Co. v. Commissioner, supra.
A company's size is
measured by its sales, net income, gross receipts, or capital
value.
See E. Wagner & Son, Inc. v. Commissioner, 93 F.2d 816,
819 (9th Cir. 1937).
Petitioner's business is more complex than that of many
highway and heavy construction companies; petitioner's business
also includes logging, construction, waste storage, and sand and
- 55 gravel operations.
In 1995, petitioner had gross receipts of
$5.31 million and capital value of $2.89 million (on the basis of
shareholder equity).
In 1996, petitioner had gross receipts of
$6.14 million and capital value of $3.13 million (on the basis
shareholder equity).
We find that the size and complexity of petitioner's
business warrants high compensation for its officers.
4. General Economic Conditions
General economic conditions may affect a company's
performance and thus show the extent of the employee's effect on
the company.
See Rutter v. Commissioner, supra at 1271; Mayson
Manufacturing Co. v. Commissioner, supra at 119.
This factor
helps to determine whether the success of a business is
attributable to general economic conditions, as opposed to the
efforts and business acumen of the employee.
Adverse economic
conditions, for example, tend to show that an employee's skill
was important to a company that grew during the bad years.
See
Mad Auto Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153.
Petitioner's sales increased from $4.62 to $6.14 million
during the 2 years at issue.
There is no evidence that
petitioner's success resulted from general economic conditions.
The record shows that petitioner's success resulted in large part
from the expertise of Dennis and Curtis and their long hours of
hard work.
- 56 5.
Prevailing Rates of Compensation for Comparable
Positions in Comparable Companies
In deciding whether compensation is reasonable, we compare
it to compensation paid to persons holding comparable positions
in comparable companies.
See Rutter v. Commissioner, supra at
1271; Mayson Manufacturing Co. v. Commissioner, supra at 119.
Petitioner and respondent rely on their experts' reports and
testimony with respect to this factor.
We are not persuaded by
any of the experts.
Dr. Lacey's report does not provide any data or opinion as
to the amount of compensation that would be reasonable for
petitioner to pay to Dennis or Curtis.
Respondent uses the
compensation amounts Mr. Katz concluded were reasonable.
Those
amounts, however, do not take into account the valuable stock
options received by executives of the publicly traded companies.
We think that those amounts are less than the amounts that Dennis
or Curtis would expect to be paid or that an independent investor
would agree to pay for their services.
By contrast, the amounts calculated by Mr. Reilly for Dennis
exceed the amounts paid by other companies for four full-time
executives, and they are excessive.
On the basis of their value to petitioner's business, we
find that an independent investor would agree to pay Dennis, as
CEO, the highest amount of reasonable compensation for a CEO and
Curtis, as COO, the highest amount of reasonable compensation for
- 57 a COO.
Therefore, on the basis of the data that we have found
reliable for other companies in the industry contained in Mr.
Reilly's report, we find that for both years in issue at least
$385,000 is reasonable compensation for Dennis as CEO and at
least $250,000 is reasonable for Curtis as COO.
6.
Petitioner's Compensation Policy for All Employees
Courts have considered the taxpayer's compensation policy
for its other employees in deciding whether compensation is
reasonable.
See Mayson Manufacturing Co. v. Commissioner, 178
F.2d at 119; Home Interiors & Gifts, Inc. v. Commissioner, 73
T.C. at 1159.
This factor focuses on whether the entity pays top
dollar to all employees, including both stockholders and
nonstockholders.
See Owensby & Kritikos, Inc. v. Commissioner,
supra at 1329-1330.
We look to this factor to determine whether
Dennis and Curtis were compensated differently than petitioner's
other employees merely because of their status as stockholders.
See id.
Petitioner paid its employees the highest wages under the
union contracts.
That fact, along with petitioner's success,
supports paying Dennis and Curtis the highest salaries for
officers.
The salaries paid to Dennis and Curtis were
substantially lower than the compensation paid to top executives
of other companies.
This supports a finding that part of the
bonus was compensation for services rendered during the year.
- 58 None of petitioner's employees other than Dennis and Curtis,
however, shared in the large distribution of profits petitioner
made at yearend.
Cf. Home Interiors & Gifts, Inc. v.
Commissioner, 73 T.C. at 1159-1160 (compensation paid to the
taxpayer's shareholder-employees was reasonable in part because
the taxpayer had a longstanding practice of paying all its key
employees on the basis of commissions).
Thus, petitioner's bonus
policy for its nonshareholder employees is not similar to the
bonus policy for Dennis and Curtis.
Cf. id.
Furthermore, the
bonuses were paid to Dennis and Curtis in the same proportion as
their stockholdings.
This factor indicates that the bonus was in part
compensation for services and in part a distribution of profits.
7.
Compensation Paid in Prior Years
An employer may deduct compensation paid in a year for
services rendered in prior years.
See Lucas v. Ox Fibre Brush
Co., 281 U.S. 115, 119 (1930); R.J. Nicoll Co. v. Commissioner,
59 T.C. 37, 50-51 (1972).
To currently deduct amounts paid as
compensation for past undercompensation, a taxpayer must show
that it intended to compensate employees for past services from
current payments and must establish the amount of past
undercompensation.
See Pacific Grains, Inc. v. Commissioner, 399
F.2d 603, 606 (9th Cir. 1968), affg. T.C. Memo. 1967-7; Estate of
Wallace v. Commissioner, 95 T.C. at 553-554.
- 59 Petitioner contends that parts of the payments to Dennis and
Curtis were for services rendered in prior years.
Petitioner
relies on its expert to establish the amount of past
undercompensation.
We have rejected Mr. Reilly's calculation of
undercompensation paid to Dennis and Curtis from 1986 to 1996.
We find that any undercompensation that may have occurred in
earlier years was rectified prior to the years at issue.
The
record does not indicate that the compensation paid to Dennis and
Curtis in 1995 and 1996 was attributable to services performed
for petitioner in earlier years.
This fact further indicates that part of the bonus was a
distribution of profits and not compensation for services.
8. Comparison of Salaries Paid With Gross Income and Net
Income
Courts have compared compensation to gross and net income in
deciding whether compensation is reasonable.
See Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323; Mayson
Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949).
In most cases, considering compensation as a percentage of net
income is more probative than considering compensation as a
percentage of gross receipts because compensation as a percentage
of net income more accurately gauges whether a corporation is
disguising the distribution of dividends as compensation.
See
Owensby & Kritikos, Inc. v. Commissioner, supra at 1325-1326.
- 60 According to its financial statements, petitioner had gross
receipts of $5,312,291 in 1995 and $6,141,479 in 1996.
After
payment of compensation, petitioner had a net loss of $13,944 in
1995 and net income of $243,129 in 1996.
In 1995, petitioner
paid $1,292,888 in officer compensation (or more than 100 percent
of petitioner's net income before payment of officer
compensation) and 24.4 percent of gross receipts.
In 1996,
petitioner paid $1,099,765 in officer compensation (or 81.9
percent of petitioner's net income before payment of officer
compensation) and 17.9 percent of gross receipts.
Although
petitioner reported net income of $204,583 on its 1995 Form 1120,
the positive net income is attributable in large part to the
section 481(a) adjustment that artificially increased
petitioner's income by $409,289 for that year.
We think this factor favors respondent for 1995 and is
neutral for 1996.
9.
Comparison of Salary to Distributions to Stockholders
and Retained Earnings
The failure to pay more than a minimal amount of dividends
may suggest that some of the amounts paid as compensation to the
shareholder-employee are dividends.
See id. at 1322-1323;
Edwin's, Inc. v. United States, 501 F.2d 675, 677 n.5 (7th Cir.
1974); Charles Schneider & Co. v. Commissioner, 500 F.2d 148 (8th
Cir. 1974).
Corporations, however, are not required to pay
dividends; stockholders may be equally content with the
- 61 appreciation of their stock if the company retains earnings.
See
Owensby & Kritikos, Inc. v. Commissioner, supra at 1326-1327;
Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1161.
In reviewing the reasonableness of an employee's
compensation, a hypothetical independent investor standard may be
used to determine whether a shareholder has received a fair
return on investment after the payment of the compensation in
question.
That leads us to consider whether an independent
investor would have approved the compensation in view of the
nature and quality of the services performed and the effect of
those services on the investor's return on his or her investment.
See Owensby & Kritikos, Inc. v. Commissioner, supra at 1326-1327;
see also Summit Sheet Metal Co. v. Commissioner, T.C. Memo. 1996563.
The prime indicator of the return a corporation is earning
for its investors is the return on equity.
See Owensby &
Kritikos, Inc. v. Commissioner, supra at 1324.
In his report,
Mr. Reilly provides rates of return that an independent investor
would expect to earn on his investment.
following table shows:
From 1986 to 1996, the
(1) The equity shown on petitioner's
financial statements; (2) Mr. Reilly's fair after-tax rate of
returns on equity that an independent investor would expect to
earn; (3) the fair after-tax returns on equity using Mr. Reilly's
rates; (4) petitioner's actual after-tax returns on equity; (5)
- 62 petitioner's actual after-tax rate of return; and (6) the
officers' compensation.
Year
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Year-End
Equity
$176,489
255,018
442,796
543,785
834,499
1,907,331
2,242,380
2,965,064
3,042,630
2,904,692
2,890,748
3,133,877
Fair
Return Rate
Fair
Return
Actual
Return
NA
17.50%
19.57
21.61
20.29
20.72
19.76
19.67
17.59
18.60
17.18
NA
$44,628
86,655
117,512
169,320
395,199
443,094
583,228
535,199
569,320
496,631
$78,529
187,778
100,990
290,714
1,072,832
335,049
722,684
77,566
(137,938)
(13,944)
243,129
Actual
Officers'
Return Rate Compensation
44.5%
73.6
22.8
53.5
128.6
17.6
32.2
2.6
-4.5
-0.5
8.4
$195,000
81,282
285,912
243,090
304,478
930,100
788,400
988,920
1,246,437
1,293,948
1,099,825
From 1986 to 1992, petitioner's actual after-tax return on
equity greatly exceeded the expected fair return on equity, and
the increase in petitioner's retained earnings increased the
value of its stock.
During that period, Dennis and Curtis, in
effect, treated the company as a "growth stock", reinvesting
earnings to increase the value of their shares in the company.
hypothetical investor would have considered $2,788,575 growth in
A
equity to have been an exceptional performance for the 7-year
period from 1986 to 1992 ($176,489 beginning year equity in 1986
to $2,965,064 end of year equity in 1992).
As Mr. Reilly points out in his opinion, Dennis and Curtis
kept large amounts of cash in the company in order to build the
business.
Rather than having the profits distributed to them,
they caused petitioner to retain the earnings, in effect,
- 63 reinvesting the money in the business.
By the end of the 1992
fiscal year, they had invested $2,965,064 in the business.
From 1993 to 1996, however, the bonuses paid to Dennis and
Curtis left petitioner with either an operating loss or a nominal
profit.
During the 4-year period from 1993 to 1996, shareholder
equity increased by only $168,813 (to $3,133,877 ending year
equity in 1996).
Having reinvested profits from earlier years, a
hypothetical investor would have considered a return of $168,813
on the $2,965,064 investment to have been an unacceptable
performance.
An absence of profits paid to the stockholders as dividends
or reinvested in the business as retained profits justifies an
inference that some of the purported compensation really
represents a distribution of profits.
Paying most of
petitioner's taxable income as compensation to its officers from
1993 to 1996 suggests that the distributions to Dennis and Curtis
were in part disguised dividends.
See Owensby & Kritikos, Inc.
v. Commissioner, 819 F.2d at 1325.
Although an independent
investor might have approved of the very large payments made to
Dennis and Curtis in 1993 and 1994 because of the exceptional
returns in prior years, we do not think such an investor would
forgo profits beyond that period.
We think that an independent
investor would not have been satisfied with the large bonuses
petitioner paid to Dennis and Curtis in 1995 and 1996, since it
- 64 appears that profits were being siphoned out of the company
disguised as salary.
See id. at 1327.
The ability to disguise dividends as salary, particularly if
the employee is the sole or majority shareholder, or if a large
percentage of the compensation is paid as a bonus, may suggest
that compensation is not reasonable.
Commissioner, 85 F.3d at 954.
See RAPCO, Inc. v.
Payment of bonuses at the end of a
tax year when a corporation knows its revenue for the year may
enable it to disguise dividends as compensation.
See Owensby &
Kritikos, Inc. v. Commissioner, supra at 1329; Estate of Wallace
v. Commissioner, 95 T.C. at 555-556.
The large yearend payments
made to Dennis and Curtis suggest that part of their compensation
was disguised dividends.
See Petro-Chem Mktg. Co. v. United
States, 221 Ct. Cl. 211, 602 F.2d 959, 968 (1979); Builders Steel
Co. v. Commissioner, 197 F.2d 263, 264 (8th Cir. 1952); Owensby &
Kritikos, Inc. v. Commissioner, T.C. Memo. 1985-267; Rich Plan,
Inc. v. Commissioner, T.C. Memo. 1978-514.
Whether petitioner in fact intended to pay Dennis and Curtis
those amounts as salaries is material because to be deductible
under section 162(a)(1) they must be paid for services actually
rendered as well as be reasonable in amount.
The following factors indicate that payments to shareholder
officers may be disguised dividend distributions rather than
payment for services rendered:
- 65 (1)
The bonuses were in exact proportion to the officers'
stockholdings;
(2)
payments were in lump sums rather than as the services
were rendered;
(3)
there was a complete absence of formal dividend
distributions by an expanding corporation;
(4)
the system of bonuses was completely unstructured,
having no relation to services performed;
(5)
the company's negligible taxable income for 4
consecutive years was an indication that the bonus system was
based on funds available rather than on services rendered; and
(6)
bonus payments were made only to the officer-
stockholders in proportion to their stockholdings, and not to
other employees.
See, e.g., O.S.C. & Associates, Inc. v. Commissioner, 187 F.3d at
1120; Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361-362
(9th Cir. 1974), affg. T.C. Memo. 1971-200.
In this case, all the factors indicate that portions of the
bonuses were disguised dividends.
F.
Conclusion
We do not think that petitioner intended the relatively
small salaries paid to Dennis and Curtis during the year to fully
compensate them for their services.
Thus, portions of the
bonuses paid to Dennis and Curtis at the end of the year were
- 66 intended as compensation for services.
We have found that for
both years in issue at least $385,000 is reasonable compensation
for Dennis as CEO and at least $250,000 is reasonable for Curtis
as COO.
We think another corporation would pay those amounts to
Dennis and Curtis for their services.
We do not think, however, that an independent investor would
approve salaries in excess of $635,000, unless the investor were
receiving at least a fair return on his investment.
Mr. Reilly, petitioner's expert, determined that 28.2
percent would be a fair pre-tax return (18.6 percent after-tax
return) on equity in 1995.
For 1995, an independent investor
would expect a pre-tax return of $819,123 ($2,904,692 beginning
year equity times fair pre-tax return of 28.2 percent).
In 1995,
petitioner deducted $1,294,888 as officer compensation and
reported a net loss of $13,946.
The $659,888 excess reported as
compensation ($1,294,888 less $635,000) is less than the fair
return and is, therefore, a nondeductible dividend.
Mr. Reilly determined that 26 percent would be a fair pretax return (17.18 percent after-tax return) on equity in 1996.
For 1996, an independent investor would expect a pre-tax return
of $751,594 ($2,890,748 beginning year equity times fair pre-tax
return 26 percent).
In 1996, petitioner deducted $1,099,765 as
officer compensation and had retained earnings of $243,132.
$464,765 excess reported as compensation ($1,099,765 less
The
- 67 $635,000) plus the $243,132 retained earnings equals $707,897.
That amount is less than the fair return and is a nondeductible
dividend.
We hold that petitioner may deduct $635,000 ($385,000 paid
to Dennis plus $250,000 paid to Curtis) as officer compensation
in each of the taxable years ending October 31, 1995 and 1996.
Decision will be entered
under Rule 155.
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