Memorandum — Charles Schneider & Co. v. Commissioner

In the Supreme Court of the United States

OcTOBER TERM, 1974

No. 74-650

CHARLES SCHNE!DER & Co., ET AL., PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE EIGHTH CIRCUIT

MEMORANDUM FOR THE RESPONDENT IN OPPOSITION

Petitioners challenge the factual finding of the Tax Court,

which the court of appeals affirmed, that a portion of the

amounts paid by Charles Schneider & Co., Inc., and Future

Foam, Inc., under contingent compensation agreements

were unreasonably large and thereby not deductible under

Section 162(a) of the Internal Revenue Code of 1954.

In 1963, petitioners entered into compensation agree-

ments with their respective chief executive officers pursuant

to which each officer was to be paid a weekly salary plus a

bonus determined as a percentage of the net profits. In

effect, the agreements provided for the distribution of

virtually all of each petitioner's net profits, except for

amounts denominated “retained earnings” (equal to 2 per-

cent of net sales) (Pet. App. B 50-51, 54-55, 70-71). At the

time the agreements were executed, Charles Schneider

owned all the outstanding stock and was a chief executive

(1)

officer of each petitioner. The other chief executive of-

ficers participating in the contingent compensation plans

had, however, been granted options to aquire stock, and two

of the three had exercised those options to acquire stock,

prior to the years here in question. All of the reci-

pients of the contingent compensation approved the

compensation agreements on behalf of the petitioners

in their capacities as officers and directors (Pet.

App. B 36-37, 46-47, 49-51, 53-55).

The following table shows the amounts paid by peti-

tioners pursuant to these agreements during the years in

question, the deductions allowed by the Commissioner, and

the amounts found by the Tax Court to be deductible as

reasonable compensation for the services (Pet. App. B 51,

56, 64-65, 73-74):

Amounts paid Deduction Deduction

by allowed by allowed by

petitioners Commissioner Tax Court

Charles Schneider & Co.— 1966:

Charles Schneider $65,104.94 $35,000 $40,000

Leon Summer 74,414.50 50,000 60,000

Charles Schneider & Co.—1967:

Charles Schneider $59,052.98 $35,000 $40,000

Leor Summer 66,357.95 $0,000 60,000

Charles Schneider & Co.—1968:

Charles Schneider $65,000.00 $35,000 $40,000

Leon Summer 74,089.36 50,000 60,000

Future Foam— 1966:

Charles Schneider $45,000.00 $35,000 $40,000

William Grassman 80,176.00 50,000 65,000

Sol Friedman 80,176.00 50,000 65,000

Future Foam—1967:'

Charles Schne.der $45,780.00 $35,000 $40,000

FS A ER, Wee Co et es eg

3

The court of appeals affirmed, concluding that the Tax

Court’s findings were based on substantial evidence (Pet.

App. A 29-42).

1. Section 162(a) of the Code permits the deduction of

ordinary and necessary business expenses including “a

reasonable allowance for salaries or other compensation

for personal services actually rendered.” To be deductible,

such compensation must be both reasonable and in fact

paid purely for services. Treasury Regulations, Section

1.162-7(a). Petitioners paid no dividends during any of

the years the compensation agreements were in effect.

. Indeed, the compensation agreements themselves virtually

assured that nearly all of the petitioners’ increasing

profits would be distributed in the form of bonuses to

Schneider, Summer, Grassman and Friedman.

But, as both lower courts noted (Pet. App. A 38; Pet.

App. B 73), shareholders of corporations enjoying profits

as consistent and substantial as petitioners’ would cer-

tainly expect some return on their investment. The absence

of dividends justified the inference that some of the pur-

ported compensation represented a distribution of profits.

See McCandless Tile Service v. United States, 422 F.

2d 1336, 1340 (Ct. Cl.); Pacific Grains, Inc. v. Commissioner,

399 F.2d 603, 606 (C.A. 9).

Moreover, the compensation paid by petitioners to these

officers was also found far to exceed the amounts paid by

comparable concerns for comparable services. Exhibits

reflecting statistics for the furniture making industry dem-

onstrated that the compensation in question greatly ex-

‘Future Foam also paid Grassman and Friedman $31,874 each for

its taxable year 1967 (Pet. App. B 57). However, its deduction of those

amounts is not in question in this case.

7

Gaia a ln a Ri hl el BO Ah eae yeh a

ceeded the industry-wide averages for executive compen-

sation, although petitioners fell significantly below the in-

dustry averages both in size and sales volume (Pet. App.

B 41).? This evidence substantially controverted the vague

and general testimony of petitioners’ expert witnesses or

any inference which might be drawn from the fact that the

agreements were approved by petitioners’ respective boards

of directors. See East Tennessee Motor Co. v. United

States, 453 F.2d 494 (C.A. 6).

In any event, contrary to petitioners’ contention (Pet.

21-24), even the testimony of their expert witnesses

did compel not a finding in their favor on this issue.

The Tax Court has the duty to weigh ali of the evidence to

determine whether the petitioners satisfied their burden of

establishing the reasonableness of these salaries. See

Lakewood Manufacturing Company v. Commissioner, 453

F.2d 451, 454 (C.A. 6).

2. Recognizing the factual nature of the “reasonable

compensation” question (see e.g., Mayson Mfg. Co. v.

Commissioner, 178 F.2d 115, 119(C.A. 6); Hammond Lead

Products, Inc. v. Commissioner, 425 F.2d 31, 33 (C.A. 7)),

petitioners concede (Pet. 13-14) that the “clearly erron-

eous” rule announced by this Court in Commissioner

v. Duberstein, 363 U.S. 278, was the proper standard of

review to be applied by the court of appeals. See also East

Tennessee Motor Co. v. United States, supra, 453 F.2d

?Indeed, one of petitioners’ sister corporations, Charles, Inc., with

comparable sales and assets, paid considerably lower amounts to its

officers and offered far more modest incentive compensation agree-

ments than did petitioners (Pet. App. A 40; Pet. App. B 59-60, 62-63).

During the years in issue, petitioners paid out from about 70 percent

to about 90 percent of their before-tax income as compensation to their

officers. Charles, Inc., on the other hand, paid out less than 30 percent

of its profits as compensation to its officers (Pet. App. B 62-63).

5

at 496.) Nevertheless, petitioners contend (Pet. 24-26)

that these salaries should have been found to be reason-

able under Section 1.162-7 of the Regulations.

But the Regulations simply provide that amounts paid

pursuant to contingent compensation arrangements are

not to be treated any differently from any other type of

compensation, and that a deduction may be allowable only

so long as it results from free bargaining between the em-

ployer and the individual “not influenced by any consider-

ation on the part of the employer other than that of securing

[such individual's services] on fair and advantageous

terms * * *.” Treasury Regulations, Section 1.162-7(b)(2).

Indeed, that provision of the Regulations expressly states

that such arrangements are subject to close scrutiny to

insure that such contingent compensation is not actually

a distribution of corporate earnings and that, at all events,

the allowance for compensation of any form may not ex-

ceed what is reasonable under all the circumstances exist-

ing at the time the contract was made. Treasury Regula-.

tions, Section 1.162-7(b)(2) and (3). Thus, while the fact

that the salaries were contingent may be one factor to be

considered, that fact does not preclude the courts from

examining all the circumstances to determine whether the

contracts actually provided for payment of reasonable

compensation for services actually rendered.

>Given the factual nature of the question of unreasonable compensa-

tion, the decision below does not conflict with the cases cited by peti-

tioners (Pet. 26), all of which turn on their own peculiar facts.

— — oo a et BO ee BORE To 29 HOS

De at ME ee Pye ten Des One ROT age eR tae Rae Eee See a ee See ee ae -

6

Contrary to petitioners’ argument (Pet. 24-26), the

court of appeals did not ignore Section 1.162-7(b)(3) of

the Regulations, which provides that the circumstances

to be taken into account are those existing when the

contract for services is made and not when the coxtract

is questioned. The courts below considered the circum-

stances existing at the time the compensation agreements

were executed and concluded that the compensation

agreements were not a result of free bargaining between

petitioners and its officers, and that the bonus plans from

their very inception constituted a “built-in mechanism”

for the distribution of future profits without relation to

the services to be performed (Pet. App. A 36-37; Pet.

App. B 71).4

‘For the reasons stated, it is respectfully submitted that

the petition for a writ of certiorari should be denied.

ROBERT H. Bork,

Solicitor General.

JANUARY 1975.

“While petitioners contend (Pet. 20) that these contingent compen-

sation agreements were necessary to obtain the best efforts of their

officers, none of petitioners’ other employees were offered such in-

centive agreements. And, as both courts below noted (Pet. App.

A 36-37; Pet. App. B 71-72), none of these executives needed such

incentives to elicit his best efforts, since the value of their actual

and potential shareholdings itself would serve to motivate such

efforts.

DOJ-1975-01

SREPLEA PE