Compensation is held reasonable and a management fee deduction allowed

The Tax Court regards the hypothetical-investor test as supporting the taxpayer's expert.
By Charles J. Reichert, CPA

The Tax Court held that officer compensation paid by a corporate taxpayer for two tax years was reasonable and therefore deductible. The court reached that conclusion by applying the five-factor test of Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983). The court also held that a $500,000 administrative fee expense paid by the taxpayer to a corporation wholly owned by two of the three shareholder-officers of the taxpayer was deductible because it was normal for the taxpayer's business and helpful to it.

Facts: In 2003 and 2004, H.W. Johnson Inc. (HWJ) was a concrete contracting business in Arizona owned by Margaret Johnson (51%) and her two sons, Bruce Johnson (24.5%) and Donald Johnson (24.5%). Margaret was the company president and chairman of the board of directors, while her sons served on the board of directors, were vice presidents, and each ran one of the company's two operating divisions.

The Johnson brothers also were co-owners of a holding company, DBJ Enterprises LLC. In 2003, DBJ, using funds obtained from the brothers, became a 52% owner in a newly formed concrete supply business, Arizona Materials, whose debt the brothers also guaranteed. In 2003 and 2004, Arizona Materials, as a result of DBJ's exercising its influence as Arizona Materials' majority shareholder, provided HWJ with a reliable supply of concrete at a fixed price when other concrete contractors in the area were unable to obtain it. In 2004, HWJ paid $500,000 to DBJ for its negotiating efforts with Arizona Materials and deducted the amount on its 2004 federal income tax return as an "administration fees" expense.

In 2003 and 2004, HWJ paid the Johnson brothers total compensation of $11,325,955, consisting of officer salaries, bonuses, and directors' fees, and deducted it on its 2003 and 2004 income tax returns.

The IRS sent HWJ a deficiency notice disallowing the $500,000 deduction and $8,196,591 of the officer compensation expense. The taxpayer petitioned the Tax Court for relief. The IRS later reduced the disallowed compensation to $1,579,955.

Issues: Sec. 162(a) allows taxpayers to deduct ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Ordinary expenses are normal, usual, or customary in the taxpayer's trade or business, while necessary expenses are helpful or appropriate to that trade or business. A deduction is allowed for compensation expense if the amount is reasonable and paid only for services rendered. In Elliotts, Inc., the Ninth Circuit (the court to which this case could be appealed) used a five-factor test to determine whether compensation is reasonable: (1) the employee's role in the company, (2) a comparison of compensation paid by similar companies for similar services, (3) the character and condition of the company, (4) potential conflicts of interest, and (5) the internal consistency of compensation arrangements. When analyzing the conflict-of-interest factor, the Elliotts court examined whether an independent investor would receive an adequate return on equity after the compensation.

In this case, the IRS argued the compensation was unreasonable, questioning whether an independent investor would receive an adequate return after considering the compensation paid to the brothers. The IRS also argued the $500,000 payment was not an ordinary and necessary business expense.

Holding: After considering all five Elliotts factors, the court held that the compensation paid by HWJ to the brothers in 2003 and 2004 was reasonable. It found the comparable compensation factor (second factor) neutral because the court could not find any reliable external benchmarks to make a meaningful compensation comparison. The court found that the other factors favored HWJ, as the brothers were integral to the company's success in 2003 and 2004 (first factor); HWJ experienced excellent growth in revenue, precompensation profits, and assets during 2003 and 2004 (third factor); HWJ's returns on equity of 10.2% and 9% for 2003 and 2004, respectively, would have satisfied an independent investor (fourth factor); and HWJ consistently followed its bonus plan established in 1991 (fifth factor).

Because HWJ's majority shareholder was the mother of the two brothers, the court examined the conflict-of-interest (fourth) factor more thoroughly by examining HWJ's rate of return on equity. It rejected the IRS's benchmark return on equity, finding its expert's data were drawn from companies that were not comparable to HWJ because of their size, operations, and other characteristics. The court also found persuasive the testimony of HWJ's expert witness, who showed the company's rate of return on equity to be equal to the average return for comparable companies in the concrete contracting business if the brothers' compensation had been reduced by 1%.

The court also allowed a deduction for HWJ's $500,000 payment to DBJ to obtain a reliable source of concrete because it was normal for a concrete contractor to do so and it helped HWJ meet customer demand when competitors were unable to obtain concrete. The IRS argued it was not an ordinary and necessary business expense because there was no written agreement obligating HWJ to pay DBJ, DBJ did not perform any services for HWJ for which it could be paid, and the payment was for services performed by the brothers in their capacities as officers of HWJ.

The court rejected all of these arguments, stating that many closely held corporations often act informally, HWJ benefited from having a reliable supply of concrete due to DBJ's efforts, and the brothers were not acting on behalf of HWJ because they, as individuals, not as officers of HWJ, personally invested money into DBJ and provided loan guarantees used to form Arizona Materials, which provided the reliable concrete supply.

  • H.W. Johnson, Inc., T.C. Memo. 2016-95

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.


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