UNITED STATES TAX COURT
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T.C. Memo. 1996-136
UNITED STATES TAX COURT
WY'EAST COLOR, INC., AN OREGON CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4195-93.
Filed March 19, 1996.
Christopher H. Kent, Kevin O'Connell, and Steve Hval
(specially recognized), for petitioner.
Brenda M. Fitzgerald, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge:
Respondent determined deficiencies in
petitioner's Federal income tax of $223,038, $252,490, and
$240,727 for fiscal years 1989, 1990, and 1991, respectively.
After concessions, we must decide the following issues:
- 2 1.
Whether petitioner may deduct as management fees
$284,300, $699,359, and $738,239 for fiscal years 1989, 1990,
and 1991, respectively, as petitioner contends; $57,159,
$149,175, and $155,559, as respondent contends; or some other
amount.
We hold that petitioner may deduct 75 percent of the
management fees it paid for those years, i.e., $213,000,
$525,000, and $554,000.
2.
Whether (or to what extent) petitioner may deduct rent
it paid to its sole shareholder for the sublease of property in
excess of the rent its sole shareholder paid for the prime lease
of the property.
Petitioner contends it may deduct rent of
$216,000, $250,000, and $264,000 for fiscal years 1989, 1990, and
1991, respectively.
Respondent contends petitioner may deduct
rent of $97,975 for each of those years.
We hold that petitioner
may deduct rent of $120,087, $124,896, and $129,891 for fiscal
years 1989, 1990, and 1991, respectively.
Section references are to the Internal Revenue Code in
effect for the years in issue.
Rule references are to the Tax
Court Rules of Practice and Procedure.
Unless otherwise stated,
references to years are to calendar years and references to
fiscal years are to petitioner's fiscal year, which ends on March
31.
- 3 FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A.
Petitioner
1.
Petitioner’s Activities and Growth
Petitioner is an Oregon corporation the principal place of
business of which is in Portland, Oregon.
Dwight A. Cummings
(Mr. Cummings) owned all of petitioner's stock during the years
in issue.
He and his family (the Cummings) founded petitioner
and built it into a successful business.
Petitioner is a graphic arts prepress company.
It uses
original art, photographs, and page layouts to prepare film to
make plates for printing.
It also processes photographs for
commercial photographers and makes large display prints.
Petitioner's workforce grew from 60-70 employees to 100-110
employees during the years in issue.
Petitioner had gross sales
of about $12 million and had about 40 percent of the Portland
market in the late 1980's.
For each year in issue, petitioner
had retained earnings of $1 to $2 million.
Mr. and Mrs. Cummings organized petitioner into various
departments.
There were three production departments:
stripping, color, and planning.
Mr. and Mrs. Cummings.
meetings.
contracts.
Department managers reported to
Mrs. Cummings held weekly management
Petitioner's managers did not have written employment
- 4 2.
Petitioner’s Management Employees
a.
Grady Preston
Grady Preston (Preston) managed petitioner's color
department during the years in issue.
Preston is well informed
about the technical aspects of petitioner’s industry.
current with new technology.
He keeps
Preston was responsible for
electronics in his division, which was a large part of
petitioner's operation.
and competitive.
He tried to keep petitioner efficient
Petitioner paid Preston $55,874 in 1989,
$59,832 in 1990, and $60,816 in 1991.
b.
Steve Philps
Steve Philps (Philps) managed petitioner's color lab
division during the years in issue.
day.
He worked 8 to 12 hours per
Philps supervised film printing and processing, slide
production, display material production, and some advertising,
sales and customer relations.
He also interviewed, hired, fired,
trained, and supervised employees.
Petitioner paid Philps $8,395
in 1989, $50,917 in 1990, and $49,823 in 1991.
c.
Rick Capatosto
Rick Capatosto managed petitioner's planning department
during part of the years in issue.
account.
He also handled the Payless
Petitioner paid him $24,558.14 in 1989, $50,103.78 in
1990, and $51,997.67 in 1991.
- 5 d.
Larry Deal
Larry Deal (Deal) managed petitioner's planning department
at some time during the years in issue.
Petitioner paid Deal
$48,563.19 in 1989, $52,317.61 in 1990, and $54,536.14 in 1991.
e.
Jim Faust
Jim Faust (Faust) managed petitioner's planning department
at some time during the years in issue.
Petitioner paid Faust
$55,979.29 in 1989, $57,812.14 in 1990, and $60,059.19 in 1991.
3.
Management Fees, Sales, Assets, and Taxable Income
Petitioner did not deduct any officer compensation for the
years in issue.
Petitioner deducted management fees of $284,300,
$699,359, and $738,239 for fiscal years 1989, 1990, and 1991,
respectively.
Petitioner deducted salaries and wages of
$905,321, $1,092,762, and $1,293,692 for fiscal years 1989, 1990,
and 1991, respectively.
Petitioner included in costs of goods
sold, labor costs of $2,559,735, $3,048,681, and $3,836,954 for
fiscal years 1989, 1990, and 1991, respectively.
Management fees
as a percent of petitioner's salaries, wages, and labor, were
8.21 percent, 16.89 percent, and 14.39 percent in fiscal years
1989, 1990, and 1991, respectively.
Petitioner had sales, assets, and taxable income before
deducting net operating losses and management fees and before
adding to income deductions petitioner concedes are not allowable
(taxable income before certain adjustments) as follows:
- 6 -
Fiscal
Year
1989
1990
1991
B.
Gross Sales
$8,644,356
10,283,552
12,904,812
Taxable Income
Before Certain
Adjustments
$774,054
1,154,903
1,663,073
Assets
$4,119,578
5,106,452
5,443,713
The Cummings Family
Mr. Cummings is married to Karen R. Cummings (Mrs.
Cummings).
Their children are Grant, Bruce, Dwight D. (Deen),
Karen Ann, and Cynthia, who is married to Jim Medding (Medding).
1.
Mr. Cummings
Mr. Cummings lived in Redmond, Washington, during the years
in issue.
Mr. Cummings knew the technology that affected
petitioner's business.
He was president and a director of
petitioner; Dacor, Inc. (Dacor), petitioner's management company
(see par. C-1, below); and Lasercolor, Inc. (Lasercolor), another
photographic processing business (see par. D, below).
He had
offices at petitioner's Portland facility and at Lasercolor's
Bellevue, Washington, facility, near Seattle.
Mr. Cummings did
not keep records of how much time he worked for petitioner or
Lasercolor.
He was a shareholder and officer of Kadac, Inc.
(Kadac), petitioner's management company that succeeded Dacor
(see par. C-2, below).
He reported on Kadac's income tax return
that he devoted all of his time to Kadac.
He attended some of
petitioner's weekly management meetings.
He helped decide which
equipment petitioner would buy for the color lab.
Mr. Cummings
served on the boards of the International Prepress Association
- 7 and DuPont Crossfield Users Group and as president and vice
president of the Western States Prepress Conference.
2.
Mrs. Cummings
Mrs. Cummings lived in Redmond, Washington, during the years
in issue.
She resigned as associate administrator for Children’s
Hospital in Seattle in 1986 to help manage petitioner.
She was
earning about $70,000 per year at Children's Hospital.
Mrs. Cummings performed services for petitioner in 1988 as
an employee of Dacor.
1989 to 1991.
She was petitioner's general manager from
Mrs. Cummings interviewed all job applicants who
passed petitioner's color laboratory manager's inspection.
Mrs. Cummings had offices at petitioner's Portland facility
and at Lasercolor's facility in Bellevue, Washington.
When in
Portland, she lived at a house that petitioner owned.
The
previous occupants used the house as an office.
Petitioner paid
to remodel the house into a residence.
3.
Deen Cummings
Deen Cummings worked for petitioner in 1988 and in 1989
until Kadac was formed.
He then worked for Kadac.
He began to
live in Oregon in 1979.
He performed services through Kadac for
petitioner and Lasercolor during the years in issue.
60 to 70 hours a week for Kadac in 1990 and 1991.
He worked
He was on call
24 hours per day, 7 days per week.
He managed petitioner's plant
facilities and dispatch functions.
He handled sales to one of
- 8 petitioner's major retail accounts.
In 1990 or 1991, he provided
many more hours than usual of services to Lasercolor for 14 to 16
weeks.
4.
Grant Cummings
Grant Cummings was president of Kadac.
He performed
services for Lasercolor and petitioner during the years in issue
at Bellevue, Washington.
Grant Cummings worked full time for Kadac from May 1 to
December 31, 1989, and in 1990 and 1991.
He worked 60 to 80
hours per week for Kadac during the years in issue.
He spent
about 80 percent of his time working for Lasercolor and about
20 percent working for petitioner during the years in issue.
Lasercolor and Kadac paid him as follows:
Corporation
Lasercolor
Lasercolor
Kadac
Kadac
Kadac
Year
1988
1989
1989
1990
1991
Amount
$41,365.34
45,795.39
10,000.00
55,000.04
68,900.04
He attended some of petitioner's management meetings during
the years in issue.
He reported earning no income from services
performed in Oregon in 1988, 1989, 1990, and 1991.
5.
Bruce Cummings
Bruce Cummings performed technical services for petitioner
pertaining to telephones, computers, and lithography.
By 1991,
he was project manager for a group of people who worked for
Preston.
Bruce Cummings was a system operator for petitioner at
- 9 a time not specified in the record.
He worked full time for
Kadac in 1990 and 1991.
6.
Karen Ann Cummings
During the years in issue, Karen Ann Cummings worked as a
planner for petitioner's lithography department.
She provided
daily planning services (not otherwise described in the record)
to petitioner.
She attended some management meetings from 1988
to 1991.
7.
Jim Medding
Medding married Cynthia Cummings, daughter of Mr. and Mrs.
Cummings.
In 1989, 1990, and 1991, Medding performed research
and development for petitioner and was current with new
technology.
C.
Kadac paid him $6,875 in 1990 and $59,387 in 1991.
Dacor, Inc. and Kadac, Inc.
Dacor and Kadac provided management services to petitioner
and Lasercolor.
Dacor and Kadac did not compare the salaries
they paid to their employees to other salaries in the Portland
area.
Dacor did not have a written contract to perform services
during the years in issue.
1.
Dacor, Inc.
Mr. Cummings owned all of the stock of Dacor.
pay dividends during the years in issue.
only to petitioner and Lasercolor.
March 31.
Dacor did not
Dacor provided services
Dacor's fiscal year ended on
- 10 2.
Kadac, Inc.
Mr. Cummings formed Kadac to replace Dacor.
Kadac in Nevada on April 28, 1989.
He incorporated
Mr. Cummings, Mrs. Cummings,
and their sons, Deen, Grant, and Bruce, each owned 200 shares of
Kadac stock.
Kadac and Lasercolor share facilities in Bellevue,
Washington.
Kadac did not pay dividends during the years in
issue.
Kadac provided management services to petitioner and
Lasercolor.
Neither Dacor nor Kadac kept time sheets or other
records of the services they or any member of the Cummings family
performed for petitioner.
Kadac's taxable year ended on December
31 during the years in issue.
Kadac’s only employee from 1989 to 1991 who was not related
to the Cummings was Wendy Jo Goddard.
3.
Management Fees
Dacor received management fees of $276,266 in its fiscal
year 1989 (ending March 31, 1989) and Kadac received $317,906,
$806,658, and $881,820 in calendar years 1989, 1990, and 1991,
respectively (a total of $2,282,650 from April 1, 1988 to
December 31, 1991).1
1
Dacor paid officer compensation, salary,
Petitioner deducted management fees totaling $1,721,890
for fiscal years (1989, 1990, and 1991); i.e., from Apr. 1, 1988,
to Mar. 31, 1991. The record does not indicate whether
petitioner paid the $881,820 ratably throughout 1991. If
petitioner paid the $881,820 ratably throughout 1991, then Kadac
would have received one-fourth of that amount ($220,455) by
Mar. 31, 1991, and Dacor and Kadac would have received $1,621,285
from Apr. 1, 1988 to Mar. 31, 1991.
- 11 and wages of $152,296 in its fiscal year 1989 (ending March 31,
1989).
Kadac paid $194,430, $593,450, and $413,511, in 1989,
1990, and 1991, respectively (a total of $1,347,994 from April 1,
1988, to December 31, 1991), as shown below:2
Payor
Calendar
Year
Dacor
1988
1989
Kadac
1989
1990
1991
2
Employee
Officer
Compensation
Mr. Cummings
Mrs. Cummings
1988 Total [Dacor]
Salaries
and Wages
Totals
$104,615
39,635
$144,250
Mr. Cummings
Mrs. Cummings
1989 Total [Dacor]
1
Mr. Cummings
Mrs. Cummings
Grant Cummings
$10,000
Karen Ann Cummings
1989 Total [Kadac]
1989 Total [Dacor and Kadac]
144,615
34,615
Mr. Cummings
Mrs. Cummings
Grant Cummings
Deen Cummings
Bruce Cummings
Karen Ann Cummings
Jim Medding
Wendy Jo Goddard
1990 Total
360,000
45,000
17,308
9,346
26,654
5,200
194,430
221,084
55,000
54,000
40,500
Mr. Cummings
110,000
Mrs. Cummings
45,525
2
Grant Cummings
70,000
3
Deen Cummings
57,793
Bruce Cummings
43,500
Karen Ann Cummings
Jim Medding
1991 Total
Total for 1988 - 1991
26,382
6,875
5,693
593,450
27,599
59,387
413,804
1,372,584
The record does not indicate whether Kadac paid the
$413,511 ratably throughout 1991. If Kadac paid the $413,511
ratably throughout 1991, then Kadac would have paid one-fourth of
that amount ($103,377.75) by Mar. 31, 1991, and Dacor and Kadac
would have paid $1,037,860.80 from Apr. 1, 1988 to Mar. 31, 1991.
- 12 1
The parties agree that Dacor paid these amounts to Mr. Cummings in
1989 and that Dacor paid $72,115 to Dwight Cummings in its fiscal year 1989
(Apr. 1, 1988 to Mar. 31, 1989).
2
The parties stipulated that Kadac paid $70,000 to Grant Cummings in
1991 and that a Form W-2 for 1991 showed that Kadac paid him $68,900.04 in
1991. We find that Kadac paid him $70,000 in 1991. The $1,099.96 difference
does not alter our analysis.
3
Respondent determined that Kadac paid $57,793 to Deen Cummings.
Petitioner contends that Kadac paid $57,500. We accept respondent's
determination. The $293 difference does not alter our analysis.
D.
Lasercolor, Inc.
Lasercolor was a Washington corporation that did business in
Washington as Wy'East Color.
1988.
Mr. Cummings acquired Lasercolor in
He owned all of Lasercolor's stock during its fiscal years
ending March 31, 1990 and 1991.
Dacor filed a consolidated tax
return with Lasercolor for its fiscal year ending March 31, 1989,
on which Dacor reported that it owned Lasercolor.
Lasercolor did
not pay dividends during its 1989 fiscal year.
Lasercolor paid the following amounts for officer
compensation, salaries and wages, and management services:
Fiscal
Year
1989
1990
1991
E.
Officer
Compensation
$72,115
none
none
Salaries
and Wages
$206,002
113,534
102,769
Management
Services
Paid to
Kadac
unknown
$10,385
none
Other Related Corporations
During the years in issue, Mr. Cummings owned 30 percent of
Dynagraphics, a printing company in Portland, Oregon, that was
one of petitioner's clients.
- 13 On its 1989 return, petitioner reported that it was a member
of a controlled group of corporations which included Dacor,
Lasercolor, and Visionworks, Inc.
On its 1991 return, petitioner reported that it was a member
of a controlled group of corporations which included Lasercolor
and Nevada Graphics, Inc.
corporations.
Mr. Cummings was president of those
Kadac paid Mr. or Mrs. Cummings about half of
their wage and salary income for 1991.
F.
Oregon Income of the Cummings
Mr. and Mrs. Cummings reported on their Federal and Oregon
income tax returns that they earned the following amounts from
Dacor and Kadac:
Reported
on Federal
Tax Returns
$144,250.05
188,593.84
405,000.00
155,525.00
Year
1988
1989
1990
1991
Reported as
Earned in
Oregon
$30,643
43,961
20,250
19,069
The amounts reported as earned in Oregon in 1988 and 1991 were
Mr. and Mrs. Cummings' earnings.
The amounts reported as earned
in Oregon in 1989 and 1990 were Mrs. Cummings’ earnings.
Mr. Cummings did not file Oregon individual income tax returns
for 1989 or 1990.
1988 to 1991.
Deen filed Oregon tax returns for tax years
Grant Cummings did not file Oregon income tax
returns for tax years 1988 to 1991.
not have an income tax.
The State of Washington does
- 14 G.
Petitioner's Lease of the 4200 S.W. Corbett Street Property
Petitioner is located at 4200 S.W. Corbett Street, Portland,
Oregon (4200 S.W. Corbett St. property).
Before moving to 4200
S.W. Corbett Street, petitioner leased buildings at 4343 and 4321
S.W. Corbett Street (old property).
Petitioner leased the old
property from Mr. Cummings, doing business as Blackstone,3 under
an oral, month-to-month lease.
The buildings on the old property
had about 15,000 square feet.
Petitioner paid rent of $10,000
per month to Mr. Cummings.
In 1986, Mr. Cummings leased the 4200 S.W. Corbett St.
property from the American Red Cross for 12 years with an option
to buy.
The 4200 S.W. Corbett property was a three-story, wood
frame building with about 33,631 square feet, a detached shop and
storage building with 3,969 to 4,050 square feet, and an annex or
residence with about 2,400 square feet.
Mr. Cummings paid rent
of $8,164.61 per month ($97,975 per year) to the American Red
Cross.
He agreed to pay real estate taxes, maintenance, and
insurance expenses on the property.
The lease did not require
Mr. Cummings to perform major repairs.
The 4200 S.W. Corbett St. property was zoned for high
density multifamily residences.
Before Mr. Cummings leased the
4200 S.W. Corbett St. property from the American Red Cross,
3
Mr. Cummings did business in the name of "The Blackstone
Co." (Blackstone) before and during the years in issue.
- 15 petitioner obtained a revocable permit to use the property as a
photo processing lab as the tenant of the American Red Cross.
Petitioner paid all the expenses required to obtain the revocable
permit.
Mr. Cummings sublet the 4200 S.W. Corbett St. property to
petitioner before the years in issue.
Petitioner spent about
$1,000,000 to adapt the property for its use.
Petitioner paid
for insurance, maintenance, utilities, and other similar costs.4
Petitioner paid rent of $216,000 to Mr. Cummings for fiscal
year 1989, $250,000 for 1990, and $264,000 for 1991.
Mr. and Mrs. Cummings deducted rent of $97,975 in 1988 and
1991, and taxes of $64,378 for 1988 and $90,626 for 1991.
Mrs.
Cummings deducted rent of $97,975 for 1989 and 1990, and taxes of
$61,086 for 1989 and $101,048 for 1990.
In 1994, Mr. Cummings
paid about $100,000 to repair the roof and dry rot damage and to
remove an oil tank.
4
Petitioner contends that Blackstone paid real property
taxes for the 4200 S.W. Corbett St. property. Petitioner relies
on Exh. 20, which consists of copies of checks written by The
Blackstone Co. from Feb. 14, 1989 to Nov. 14, 1991, and a memo to
the file from petitioner's counsel dated Oct. 3, 1994, pertaining
to tax accounts associated with particular pieces of property.
Petitioner did not provide Exh. 20 to respondent in the time
required by the Court's standing pretrial order. The parties
stipulated that the information in the exhibit pertaining to tax
accounts for the particular pieces of property is based on
inadmissible hearsay. Thus, we do not consider Exh. 20.
- 16 OPINION
A.
Deductions for Management Fees
1.
Contentions of the Parties
A taxpayer may deduct payments for management services under
section 162 if the payments are for services actually rendered
and are reasonable in amount.
American Sav. Bank v.
Commissioner, 56 T.C. 828, 842-843 (1971).
This question is
decided based on a consideration of all of the facts and
circumstances of the case.
Id. at 843.
Petitioner bears the
burden of proving that it may deduct the management fees it paid.
Rule 142(a); Schaffer v. Commissioner, 779 F.2d 849, 857 (2d Cir.
1985), affg. in part and remanding in part Mandina v.
Commissioner, T.C. Memo. 1982-34.
Petitioner deducted management fees it paid to Dacor and
Kadac totaling $284,300, $699,359, and $738,239 for fiscal years
1989, 1990, and 1991, respectively.
Petitioner contends that it
paid the management fees exclusively for personal services and
that the fees are reasonable, ordinary, and necessary under
section 162.
Respondent contends that the management fees were excessive.
Respondent contends that part of the payments was for something
other than services, such as disguised dividends, a transfer of
wealth from Mr. Cummings to members of his family without gift
tax consequences, or a means of evading Oregon income tax.
- 17 Respondent contends that petitioner may deduct only $57,159,
$149,175, and $155,559 for those years.
Respondent determined
these amounts based on the amount Dacor's and Kadac's employees
reported on their Oregon income tax returns, increased by 30
percent for taxes and benefits.
2.
Whether the Amount of Management Fees That Petitioner
Paid Was Reasonable
The parties agree that we should apply the legal standards
which govern whether compensation is reasonable to decide whether
the management fees at issue here were reasonable.
More
specifically, the parties agree that we should apply the factors
in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983),
revg. and remanding T.C. Memo. 1980-282.
The factors are:
The
importance of the employees who perform services to the success
of the business; the character and condition of the company; the
hypothetical investor's viewpoint; the consistency of payments
for similar services within petitioner’s business; and a
comparison of amounts paid by other similar businesses for
similar services.
We also consider petitioner's contention that
comparing the management fees to petitioner's gross receipts
shows that the management fees were reasonable.
No single factor determines whether the fees at issue were
reasonable.
Pacific Grains, Inc. v. Commissioner, 399 F.2d 603,
606 (9th Cir. 1968), affg. T.C. Memo. 1967-7; Mayson
Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.
- 18 1949), revg. and remanding a Memorandum Opinion of this Court.
Whether the amount of management fees was reasonable is a
question of fact.
American Sav. Bank v. Commissioner, supra;
see Elliotts, Inc. v. Commissioner, supra.
Petitioner bears
the burden of proving that the amount of management fees was
reasonable.
Rule 142(a).
We evaluate the case by considering
the total amount of management fees petitioner seeks to deduct,
not the smaller amounts that Dacor and Kadac paid to various
members of the Cummings family.
If the employee controls the employer, we closely scrutinize
the reasonableness of compensation to see if it was paid for
something other than the employee's services.
Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1322-1324 (5th
Cir. 1987), affg. T.C. Memo. 1985-267; Elliotts, Inc. v.
Commissioner, supra at 1243; Charles Schneider & Co. v.
Commissioner, 500 F.2d 148, 152-153 (8th Cir. 1974), affg. T.C.
Memo. 1973-130; see also Dielectric Matls. Co. v. Commissioner,
57 T.C. 587, 591 (1972).
An exploitable relationship may exist
if the employees are the controlling shareholders or if a family
relationship suggests that the compensation plan was not the
result of a free bargain.
Elliotts, Inc. v. Commissioner, supra
at 1246; see Pacific Grains, Inc. v. Commissioner, supra at 607;
Harolds Club v. Commissioner, 340 F.2d 861, 865 (9th Cir. 1965),
affg. T.C. Memo. 1963-198.
Petitioner and the Cummings did not
- 19 deal at arm's-length and the Cummings controlled Dacor, Kadac,
and petitioner.
Thus, we will closely scrutinize the
reasonableness of the management fees petitioner paid.
3.
Application of the Factors
a.
Importance of Dacor and Kadac Employees to
Petitioner
The positions that Dacor and Kadac employees held with
petitioner, their hours and duties, and their importance to the
success of petitioner are relevant to deciding whether management
fees for their services are reasonable.
Elliotts, Inc. v.
Commissioner, supra at 1245; American Foundry v. Commissioner,
536 F.2d 289, 291-292 (9th Cir. 1976), affg. in part and revg. in
part 59 T.C. 231 (1972); Home Interiors & Gifts, Inc. v.
Commissioner, 73 T.C. 1142, 1158 (1980).
Mr. and Mrs. Cummings and other members of their family
built petitioner from a small prepress company to a successful
firm.
Mr. Cummings testified that petitioner is ranked in the
top 25 of 2,000 prepress companies in the nation.
Mr. and Mrs.
Cummings, Deen, and to a lesser extent other Dacor and Kadac
employees contributed to petitioner's success.
However, there
are no billing records for those services or records showing how
much time Dacor and Kadac employees spent providing services to
petitioner.
Oregon income tax returns filed by members of the Cummings
family suggest that the Cummings did not provide services to
- 20 petitioner in Oregon to the extent they claim.
Oregon income
tax law requires nonresident taxpayers who earned income from
personal services rendered in Oregon to apportion their Oregon
income based on the ratio of the number of days worked in Oregon
for a business over the number of days worked in and out of
Oregon for that business.
Or. Rev. Stat. sec. 316.127 (1993);
Or. Admin. R. 150-316.127-(A)(3)(a)(A).
Mr. Cummings and two employees testified that Mr. Cummings
spent a little more than 1 day a week in Portland.
However,
Mr. Cummings did not file Oregon income tax returns in 1989 and
1990.
That suggests that he did not perform services for
petitioner in Oregon during those years.
Mrs. Cummings testified that she worked in Oregon most of
the time during the years in issue.
She reported in her Oregon
income tax returns that she earned $43,961 in 1989 and $20,250
in 1990.
Dacor or Kadac paid her $43,961 in Oregon in 1989 and
$45,000 in 1990.
This suggests that Mrs. Cummings worked full
time for Dacor or Kadac in Oregon in 1989, but only about half
time in 1990.
Petitioner did not adequately explain these
apparent inconsistencies.
Mr. and Mrs. Cummings testified that they worked only for
Kadac in 1991.
However, Kadac paid Mr. or Mrs. Cummings only
about half of the wage and salary income they received in 1991.
- 21 Mr. and Mrs. Cummings did not explain this apparent
inconsistency.
This factor favors petitioner somewhat.
b.
Character and Condition of the Company
A company's size as indicated by its sales, net income, or
capital value, the complexities of the business, and general
economic conditions is relevant in deciding whether management
fees are reasonable.
Elliotts, Inc. v. Commissioner, 716 F.2d
at 1246; see E. Wagner & Son, Inc. v. Commissioner, 93 F.2d 816,
819 (9th Cir. 1937); General Water Heater Corp. v. Commissioner,
42 F.2d 419, 420 (9th Cir. 1930), affg. 14 B.T.A. 4 (1928).
Petitioner's performance improved during the years in issue.
Petitioner's gross sales increased 18.96 percent in fiscal year
1990 and 25.49 percent in fiscal year 1991.
Its total assets
increased 23.96 percent in fiscal year 1990 and 6.6 percent in
fiscal year 1991.
Its taxable income increased 49.20 percent in
fiscal year 1990 and 46.53 percent in fiscal year 1991.
This
factor favors petitioner.
c.
The Hypothetical Investor's Viewpoint
It is appropriate to consider whether the amount paid for
management service is reasonable from the perspective of a
hypothetical independent investor.
Commissioner, supra at 1247.
Elliotts, Inc. v.
To calculate the return on
investment, we divide taxable income before net operating losses
- 22 by the shareholder's equity for each fiscal year.
See Universal
Manufacturing Co. v. Commissioner, T.C. Memo. 1994-367 (citing
Elliotts, Inc. v. Commissioner, supra at 1245).
Petitioner
reported the following:
Fiscal
Year
1989
1990
1991
Taxable Income
Before NOL’s
$357,932
435,637
924,834
Shareholder's
Equity
$1,341,966
1,518,957
2,006,195
Return on
Investment
26.67%
28.68%
46.10%
Petitioner's rate of return would satisfy a hypothetical
See Elliotts, Inc. v. Commissioner, supra at 1247 (an
investor.
average return on equity of 20 percent would satisfy an
independent investor).
d.
This factor favors petitioner.
Comparison of Amounts Paid by Similar Businesses
for Similar Services
Evidence that similar companies pay comparable amounts for
similar work may indicate that compensation is reasonable.
Elliotts, Inc. v. Commissioner, supra at 1246; see Hoffman Radio
Corp. v. Commissioner, 177 F.2d 264, 266 (9th Cir. 1949); E.
Wagner & Son, Inc. v. Commissioner, supra at 819.
Neither party
offered any evidence of the compensation that similar
corporations pay for services similar to those performed by Dacor
and Kadac.
Because petitioner bears the burden of proof, Rule
142(a), this factor favors respondent.
- 23 e.
Consistency of Payments for Similar Services
Within Petitioner
Evidence that a company pays controlling shareholders the
same that it pays other employees for similar work may indicate
that compensation is reasonable.
Elliotts, Inc. v. Commissioner,
supra at 1247; Sunset Scavenger Co. v. Commissioner, 84 F.2d 453,
456 (9th Cir. 1936), affg. in part and revg. in part 31 B.T.A.
758 (1934).
Petitioner provided no convincing analysis whether
management fees it paid to Dacor and Kadac were reasonable in
relation to salaries it paid to its employees.
Petitioner contends that this factor favors petitioner
because the amounts Dacor and Kadac paid to their employees were
generally less or equal to the amounts petitioner paid to its
department managers during the years in issue.
We disagree.
Petitioner's argument does not explain why the full amount of the
management fee petitioner paid to Dacor and Kadac is reasonable.
Petitioner does not adequately explain why it is reasonable for
management fees to substantially exceed Dacor's and Kadac's
payments to the individuals.
If petitioner's payments to Kadac
and Kadac's payments to its employees in 1991 occurred ratably
throughout the year, then, for the period April 1, 1988, to March
31, 1991, petitioner's management fees paid to Dacor and Kadac
totaled $1,721,890 and Dacor and Kadac's payments to their
employees totaled $1,037,860.80.
- 24 It is difficult to compare the management fee and employee
salary data in our record because some of it is based on fiscal
years and some is based on calendar years.
and accompanying text at par. C-3.
See footnotes 1 and 2
However, it seems that the
management fees were substantially larger than the total amount
of salaries Dacor and Kadac paid to their employees.
f.
Comparison of Management Fees to Gross Receipts
Courts have compared gross receipts to compensation in
deciding whether compensation is reasonable.
Elliotts, Inc. v.
Commissioner, supra at 1246; Mayson Manufacturing Co. v.
Commissioner, 178 F.2d at 119.
Here, the management fees were
6.86 percent, 7.84 percent, and 17.69 percent of gross sales in
fiscal years 1989 to 1991, respectively.
Mr. Cummings'
compensation was 1.9 percent, 3.5 percent and 0.9 percent of
gross sales in fiscal years 1989 to 1991.
Petitioner contends that compensation of the key individual
in a company is reasonable if it falls between 10 and 25 percent
of gross sales.
Petitioner cites RAPCO, Inc. v. Commissioner,
T.C. Memo. 1995-128; Donald Palmer Co. v. Commissioner, T.C.
Memo. 1995-65 (compensation was 31.4 percent of gross sales for
Palmer; we allowed 5.5 percent); Acme Constr. Co. v.
Commissioner, T.C. Memo. 1995-6 (compensation was 10.2 percent of
gross sales for Horth); BOCA Constr., Inc. v. Commissioner, T.C.
Memo. 1995-5 (compensation totaled 27.7 percent and 31.1 percent
- 25 of gross sales for 1989 and 1990); and Comtec Sys., Inc. v.
Commissioner, T.C. Memo. 1995-4 (compensation was 28.1 percent of
gross sales for Vernon Beard and 2.3 percent for Reda Beard).
disagree with petitioner's reliance on those cases.
We
We did not
calculate or consider compensation as a percent of gross sales or
gross receipts in any of these cases except for BOCA Constr.,
Inc. v. Commissioner, supra.
We calculated those percentages
based on facts found in those cases.
In those cases, we
considered compensation as a percent of net sales, net profit, or
gross profit, but not compensation as a percent of gross sales.
RAPCO, Inc. v. Commissioner, supra; Donald Palmer Co. v.
Commissioner, supra; Acme Constr. Co. v. Commissioner, supra; and
Comtec Sys., Inc. v. Commissioner, supra.
In Donald Palmer Co. v. Commissioner, supra, we concluded
that a salary equal to 58.2 percent of gross profit was
reasonable because that percentage was similar to what the
taxpayer had paid in prior years.
Here, we have no evidence of
management fees as a percent of gross profit that petitioner paid
in prior years.
Acme Constr. Co. v. Commissioner, supra, and
Comtec Sys., Inc. v. Commissioner, supra, are unlike this case
because some pay during the years in issue in those cases was
catchup pay for prior years.
Acme Constr. Co. v. Commissioner,
supra, is unlike this case because the executive there personally
guaranteed all of the taxpayer's debt.
The taxpayers in Acme
- 26 Constr. Co. v. Commissioner, supra, and Comtec Sys., Inc. v.
Commissioner, supra, also provided evidence comparing the
compensation at issue with that paid by similar companies.
is no such evidence here.
There
In BOCA Constr., Inc. v. Commissioner,
supra, and RAPCO, Inc., v. Commissioner, supra, the taxpayer
applied a longstanding bonus formula or compensation plan.
is no similar formula or plan in this case.
There
In Comtec Sys., Inc.
v. Commissioner, supra, the taxpayer provided evidence which
compared the compensation at issue with compensation in a similar
company.
There is no similar evidence here.
Petitioner contends that this case is similar to Mortex
Manufacturing Co. v. Commissioner, T.C. Memo. 1994-110.
In that
case, we found that it was important that the company had a
longstanding compensation plan for its officer-stockholders that
was well within industry norms.
showing.
Petitioner did not make this
The taxpayer in Mortex provided evidence comparing the
compensation at issue to various published surveys.
Petitioner
has submitted no such evidence.
Petitioner cites Universal Manufacturing Co. v.
Commissioner, T.C. Memo. 1994-367, to show that Mr. Cummings'
compensation from Dacor and Kadac was reasonable because it was
2.35 percent of net sales.
Universal Manufacturing Co. v.
Commissioner, supra, is similar to BOCA Constr., Inc. v.
- 27 Commissioner, supra, in that it states that compensation as a
percentage of gross sales is one of the factors we may consider.
We disagree with petitioner's reliance on Universal
Manufacturing Co. v. Commissioner, supra.
The issue here is not
whether Mr. Cummings' compensation is reasonable.
It is whether
the management fees petitioner paid to Dacor and Kadac were
reasonable.
Further, in that case, unlike here, part of the pay
during the year in issue was catchup pay for prior years.
The
taxpayer in that case introduced evidence comparing the
compensation at issue with that paid by other companies.
Petitioner did not do so here.
The executive in that case
guaranteed the taxpayer's $2.8 million debt.
guarantee in this case.
There is no similar
The cases petitioner cites do not show
that the management fees at issue in this case are reasonable.
This factor favors petitioner.
4.
Conclusion About Management Fees
We conclude that petitioner is entitled to deduct more
management fees than respondent allowed for each year in issue,
but that part of the management fees that petitioner paid during
the years in issue was not reasonable.
Considering the above
discussion and the entire record, we hold that petitioner may
deduct management fees of $213,000, $525,000, and $554,000 for
fiscal years 1989, 1990, and 1991, respectively.
This amount is
- 28 75 percent of the management fee rounded to the nearest thousand
dollars.
B.
Whether Petitioner May Deduct Its Rent Payments to Mr.
Cummings In Excess of the Rent He Paid to the American Red
Cross
1.
Contentions of the Parties
Mr. Cummings paid rent of $97,975 per year ($293,925 for 3
years) to the American Red Cross for the 4200 S.W. Corbett St.
property.
Mr. Cummings sublet that property to petitioner.
Petitioner paid rent to Mr. Cummings of $216,000, $250,000, and
$264,000 for fiscal years 1989, 1990, and 1991, respectively
($730,000 for 3 years).
Respondent contends that petitioner may
not deduct more for rent than Mr. Cummings paid to the American
Red Cross.
Petitioner contends that it may deduct all the rent
it paid to Mr. Cummings in those years.
2.
Background
A taxpayer generally may deduct reasonable rents paid for
property used in a trade or business.
Sec. 162(a)(3); Limericks,
Inc. v. Commissioner, 165 F.2d 483, 484 (5th Cir. 1948), affg. 7
T.C. 1129 (1946).
A taxpayer who rents property from a related
person may not deduct more than he or she would have paid if the
parties had dealt at arm’s-length.
Sparks Nugget, Inc. v.
Commissioner, 458 F.2d 631, 635 (9th Cir. 1972), affg. T.C. Memo.
1970-74; Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 715
(1977).
A taxpayer may deduct only the fair rental value of
- 29 premises it rents from related persons.
Coe Lab., Inc. v.
Commissioner, 34 T.C. 549, 585-586 (1960).
We closely scrutinize
whether rents exceed fair rental value if the lessor and lessee
are related.
B. Forman Co. v. Commissioner, 453 F.2d 1144 (2d
Cir. 1972), affg. in part and revg. in part 54 T.C. 912 (1970);
Sparks Nugget, Inc. v. Commissioner, supra; Limericks, Inc. v.
Commissioner, supra.
Fair rental value is a question of fact.
Utter-McKinley Mortuaries v. Commissioner, 225 F.2d 870, 872-873
(9th Cir. 1955), affg. a Memorandum Opinion of this Court;5 Mark
R. Switz, Inc. v. Commissioner, T.C. Memo. 1979-162.6
bears the burden of proof.
Petitioner
Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115 (1933).
3.
Rental From American Red Cross by Mr. Cummings
A price chosen after arm’s-length bargaining close to the
time of the valuation date is the best evidence of value.
Estate
5
In Utter-McKinley Mortuaries v. Commissioner, 225 F.2d 870
(9th Cir. 1955), affg. a Memorandum Opinion of this Court, the
controlling stockholder leased the premises from a third party.
The taxpayer corporation then sublet the premises and paid rent
to the controlling stockholder that was three to four times as
much as the controlling stockholder paid to the third party
lessor. We held that the taxpayer corporation may not deduct the
increased amount of rent because there was no business purpose
for paying increased rent. The U.S. Court of Appeals for the
Ninth Circuit affirmed our decision.
6
In Mark R. Switz, Inc. v. Commissioner, T.C. Memo. 1979162, Mark Switz (Switz) controlled the taxpayer-corporation. He
leased property from a third party at a reasonable rental rate.
He sublet the property to the taxpayer-corporation for more than
twice that rate. We disallowed the deduction for rent to the
extent it exceeded the rent Switz paid to the third party.
- 30 of Spruill v. Commissioner, 88 T.C. 1197, 1229, 1233 (1987);
Utter-McKinley Mortuaries v. Commissioner, supra; Mark R. Switz,
Inc. v. Commissioner, supra.
There is no indication in the
record that the lease from the American Red Cross to Mr. Cummings
was not negotiated at arm's-length.
Thus, the lease payment
($97,975) is highly probative evidence of rental value of these
premises during the years in issue.
4.
Respondent's Expert
Respondent's expert, Steve Pietka (Pietka), concluded that
the fair rental values of the 4200 S.W. Corbett St. property were
$120,087, $124,896, and $129,891 for fiscal years, 1989, 1990,
and 1991, respectively.
Petitioner criticizes Pietka's comparables because they are
not located near 4200 S.W. Corbett Street.
We disagree because
there are no similar leased properties in that area.
Petitioner
points out that its experts said that the fair rental values of
Pietka’s comparables in North Portland and Beaverton are
generally lower than those in the 4200 S.W. Corbett Street area.
We disagree for reasons stated in par. 5, below.
We believe
Pietka's comparables are more like the 4200 S.W. Corbett St.
property than comparables considered by petitioner's experts.
Petitioner contends that Pietka did not consider the fact
that petitioner could gradually move from the old property to
4200 S.W. Corbett Street.
Petitioner did not state how much
- 31 value to attribute to this fact.
We are not convinced that it
added more than a minimal amount, if any.
Petitioner criticizes Pietka's assumption that petitioner
paid all of the expenses including real estate taxes.
petitioner did not prove otherwise.
However,
Mr. Cummings' testimony that
he paid the real estate taxes differs from his testimony in a
prior unrelated case before the Oregon Tax Court.
In the Oregon
Tax Court case, Mr. Cummings testified that petitioner paid the
real estate taxes on the 4200 S.W. Corbett St. property.
We make
no finding as to who paid those taxes.7
Petitioner offered documents showing that Mr. Cummings spent
about $100,000 for repairs in the spring of 1994.
The documents
were not admitted because they were exchanged too late (1 week
before trial).
About 5 months before this case was calendared
for trial, we sent a copy of the Court’s standing pretrial order
to the parties.
The standing pretrial order stated in part:
“Any documents or materials which a party expects to utilize in
the event of trial (except for impeachment), but which are not
stipulated, shall be identified in writing and exchanged by the
parties at least 15 days before the first day of the trial
session.”
Materials not provided in compliance with our pretrial
orders are not admitted into evidence.
7
See supra note 7.
Rule 104(c)(2); see
- 32 Freedson v. Commissioner, 565 F.2d 954 (5th Cir. 1978), affg. 65
T.C. 333 (1975) and 67 T.C. 931 (1977); McCoy v. Commissioner, 76
T.C. 1027 (1981), affd. 696 F.2d 1234 (9th Cir. 1983).
Even if
petitioner's documents had been admitted, we would give them very
little weight because they apply to periods much later than the
years in issue.
Petitioner contends that Pietka did not consider that
Mr. Cummings made repairs.
Petitioner points out that
Mr. Cummings paid about $70,000 to repair the roof and dry rot
in 1994.
We make no findings about who paid for repairs during
the years in issue.
We would give little weight to evidence of
who paid for repairs in 1994 because it occurred so long after
the years in issue.
Petitioner contends that Pietka considered an incorrect
amount of square footage for the 4200 S.W. Corbett St. property.
The parties agree that the 4200 S.W. Corbett St. property
included a 33,631 square-foot production facility.
about the size of the other areas.
They disagree
Petitioner contends that the
shop has 4,050 (rather than 3,969) square feet and that the annex
or residence has 2,408 (rather than 2,316) square feet.
These
differences are de minimis.
Petitioner contends that Pietka did not consider all of the
property that was subject to the lease.
Petitioner argues that
it leased property other than the 4200 S.W. Corbett St. property,
- 33 including a 840 square foot storage facility and 4,000 square
feet from the old property.
Petitioner bases this on
Mr. Cummings' testimony that by 1989 petitioner rented about
4,000 square feet in the old building, and an additional 800
square feet from another building that Mr. Cummings, doing
business as Blackstone, owns.
Petitioner has not convinced us
that its position about the rental area is correct.
Petitioner's
position is inconsistent with its expert's report.
Petitioner's
experts did not include a rental value for the 840 square-foot
storage space or the 4,000 square feet in the old building.
We
believe Pietka considered all of the property that was subject to
the lease.
5.
Petitioner's Experts
Petitioner relied on the expert testimony of John Vissotzky
(Vissotzky).
Petitioner also called Steve Zenker, George
Marandas, and Bruce Korter as expert witnesses, essentially to
corroborate Vissotzky.
fair rental value.
We believe Vissotzky overestimated the
He based his opinion on nine leases that he
said were comparable.
Most of the properties that he evaluated
were buildings with several tenants, which had offices up to
5,000 square feet.
Those spaces are considerably smaller than
the 4200 S.W. Corbett St. property.
Vissotzky’s comparable
properties were used as offices for professionals such as
lawyers, doctors, and securities brokers.
Only part of the
- 34 property leased by petitioner is used for offices.
used for production and storage.
Much of it is
It also includes a residence.
Vissotzky only evaluated leases under which the landlord
pays for insurance, maintenance, real estate taxes, and other
similar costs.
Petitioner admits that it paid insurance,
maintenance, and utilities.
Thus, Vissotzky's comparables are
not like petitioner's facilities.
Vissotzky’s fair rental value estimate includes the value
added to the property by the $1 million petitioner spent to
improve it.
We agree with Pietka's view that it is unreasonable
to expect a tenant to pay for the rental value of improvements
that the tenant made.
6.
Petitioner's Claim That It Had Business Reasons for
Paying More Rent to Mr. Cummings Than He Paid to the
Red Cross
Petitioner contends that it had substantial business reasons
for paying more rent to Mr. Cummings than Mr. Cummings paid to
the American Red Cross, unlike the taxpayers in Utter-McKinley
Mortuaries v. Commissioner, 225 F.2d 870 (9th Cir. 1944), and
Mark R. Switz, Inc. v. Commissioner, T.C. Memo. 1979-162.
Petitioner contends that it had a business purpose in having a
month-to-month rental instead of a 12-year lease.
Mr. Cummings
testified that a 12-year obligation on petitioner’s balance sheet
would give petitioner a poor debt to equity ratio and hurt
petitioner's banking relationships.
We are not convinced that
- 35 petitioner's banking relationships would have been hurt if
petitioner had signed a 12-year lease.
For each of the years in
issue, petitioner had retained earnings of from $1 million to $2
million.
Petitioner contends that it paid more rent to Mr. Cummings
than Mr. Cummings paid to the Red Cross because petitioner had a
month-to-month lease instead of a 12-year lease.
Mr. Cummings
also testified that binding petitioner to one location for 12
years would hurt its ability to grow and move.
We believe that
petitioner overstates the value of having a month-to-month lease,
especially considering that petitioner had spent $1 million to
adapt the property to its own needs.
Petitioner contends that a business reason for renting from
Mr. Cummings is that it could pay rent late if necessary.
However, petitioner had no right to pay rent late.
fact paid rent on time.
Petitioner in
Petitioner's claim that Mr. Cummings
might give it a break is entirely speculative.
The points cited by petitioner are far outweighed by the
fact that it paid rent of $730,000 for the 3 years in issue
instead of the $293,925 Mr. Cummings paid to the American Red
Cross.
Petitioner contends that W.H. Braum Family Partnership v.
Commissioner, T.C. Memo. 1993-434, is strikingly similar to the
instant case.
We disagree.
That case did not involve a lease
- 36 between a controlling shareholder and a third party followed by a
sublease by the controlling shareholder to the taxpayer
corporation for substantially more rent.
In W.H. Braum Family
Partnership v. Commissioner, supra, the Braum family owned the
properties that they leased to the taxpayer corporation.
We
found that the rent was not excessive.
7.
Conclusion
Petitioner has not shown that Mr. Cummings did not pay fair
rental value to the American Red Cross and has shown little or no
business purpose to increase the rent.
The facts of this case
are similar to those in Utter-McKinley Mortuaries v.
Commissioner, supra, and Mark R. Switz, Inc. v. Commissioner,
supra, and the reasoning of those cases applies here.
To account for the points described above in pars. B-4, B-5,
and B-6, we accept Pietka's conclusion of the fair rental value.
We conclude that the petitioner may deduct rental payments of
$120,087, $124,896, and $129,891 for fiscal years 1989, 1990, and
1991, respectively.
To reflect concessions and the foregoing,
Decision will be entered
under Rule 155.
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