United States Court of Appeals
For the First Circuit
No. 02-1761
HAFFNER'S SERVICE STATIONS, INC.,
Petitioner, Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent, Appellee.
APPEAL FROM A DECISION OF THE UNITED STATES TAX COURT
[Hon. David Laro, U.S. Tax Court Judge]
Before
Boudin, Chief Judge,
Torruella and Lipez, Circuit Judges.
Kenneth A. Cohen, P.C. with whom Don M. Kennedy, P.C., Jeffrey
Alan Simes, Collin O'Connor Udell and Goodwin Procter LLP were on
brief for petitioner.
Andrea R. Tebbets, Tax Division, Department of Justice, with
whom Richard Farber, Tax Division, Department of Justice, and
Eileen J. O'Connor, Assistant Attorney General, were on brief for
respondent.
March 31, 2003
BOUDIN, Chief Judge. The Commissioner of Internal Revenue
(the "Commissioner" or "IRS") assessed deficiencies against the
taxpayer Haffner's Service Stations, Inc. ("the company" or the
"taxpayer") for the three subject years (1990-1992), disallowing the
deduction of certain bonuses and imposing the accumulated earnings
tax. 26 U.S.C. §§ 162, 531-37 (2000). The Tax Court agreed with
the Commissioner, Haffner's Serv. Stations, Inc. v. Comm'r, 83
T.C.M. (CCH) 1211 (2002), and the company has now appealed to this
court. 26 U.S. § 7482 (2000).
The background facts are undisputed. The taxpayer is a
close corporation that sells oil and gas in Massachusetts and New
Hampshire through its own service stations and by delivery.
Throughout the tax years in question, Louise Haffner held all of the
voting shares of the company, and together with her husband Emile
Fournier a significant minority of the nonvoting shares. The
remaining nonvoting shares were held by their children, and by two
trusts of which Louise was the trustee (Emile was co-trustee of one)
and their children the beneficiaries.
In 1989, two of Louise and Emile's five children (Susan
and Richard) filed suit against them in state court, alleging breach
of fiduciary duty arising from a 1961 transfer of voting shares from
one of the trusts to Louise. In July 1990, Louise and Emile offered
to settle Richard's suit for $650,000, including a redemption of
Richard's shares in the corporation. Richard countered that his
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shares were worth at least $16 million, and no settlement occurred.
In 1995, a third child (Joline) joined the suit. In 1996, a state
court ruled that a breach had occurred, and that the transfer of
shares had to be rescinded and an independent trustee appointed.
After the rescission, Louise still held about 84 percent of all
voting shares. Haffner's, 83 T.C.M. (CCH) at 1214.
During each subject year, Louise, Emile and their sons
Haff and Richard, were employees of the company; Louise, Emile and
Haff also constituted the board of directors. Haff was the
president of the company and made most major business decisions.
For the three subject years, Haff received compensation of
approximately $742,400 (including a bonus of $625,000), $592,000,
and $469,250, respectively. Richard was the vice president of the
company, responsible for monitoring station condition and collecting
money from three of the stations. His compensation was
approximately $50,000 in each subject year. Haffner's, 83 T.C.M.
(CCH) at 1215.
Louise was the treasurer of the company, and Emile the
assistant treasurer and secretary. Louise and Emile performed
various office duties, such as answering the telephone and signing
checks; but they also discussed many of the business decisions with
Haff. Their salaries were never higher than $20,000 per year and
there is no evidence that they received substantial bonuses in prior
years. For the subject years, Louise and Emile received identical
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bonuses of $625,000, $475,000, and $250,000. The company allocated
$100,000 from each of their 1990-91 bonuses to a related corporate
entity, and deducted the rest on its tax return. The IRS disallowed
the company's deductions as unreasonable. Haffner's, 83 T.C.M.
(CCH) at 1215-16.
The company has never paid a dividend. In 1989, its
accountant recommended a build-up in reserves in contemplation of a
share redemption in connection with the family litigation. At the
end of 1989, the company's unappropriated retained earnings were
roughly $4.9 million; this figure rose to $6.3 million, $7.2
million, and $7.9 million, respectively, at the end of each subject
year. In 1996, the IRS notified the taxpayer that it would impose
the accumulated earnings tax on the increase in retained earnings
for the three years in question. See 26 U.S.C. § 535(a). The
company argued in the Tax Court that the accumulation was reasonable
for various business purposes, including the redemption of the
shares of dissenting shareholders.
The Tax Court rendered a detailed opinion, sustaining the
Commissioner's deficiency assessments but striking down the
Commissioner's imposition of penalties. Haffner's, 83 T.C.M. (CCH)
at 1212. The taxpayer has now appealed to challenge both the
disallowance of the bonuses and the imposition of the accumulated
earnings tax. We review questions of law de novo but fact findings
of the Tax Court only for clear error. 26 U.S.C. § 7482(a)(1); Fed.
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R. Civ. P. 52; MedChem (P.R.), Inc. v. Comm'r, 295 F.3d 118, 122
(1st Cir. 2002). Clear error exists if, on the entire record, the
court is "left with the definite and firm conviction that a mistake
has been made." Mitchell v. United States, 141 F.3d 8, 17 (1st Cir.
1998).
Compensation. Under current law, both dividends and wages
are treated as ordinary income to the recipient and taxed at the
same rate. But for the corporation that makes the payments, wages
are deductible while dividends are not. In close corporations,
there is an obvious incentive to disguise dividend distributions as
compensation expenses. See 26 C.F.R. § 1.162-7(b)(3) (2002). The
opportunity exists because leading shareholders are also often
managers of the company, and the benefit is obvious: by reducing
corporate taxes, more accrues to the shareholders. See generally,
e.g., 7 Mertens Law of Federal Income Taxation §§ 25E:04, 25E:29
(1996) ("Mertens").
The Internal Revenue Code limits deductibility to
"reasonable" compensation, 26 U.S.C. § 162(a)(1), which serves in
part as a safeguard against conversion of dividends into salary.
Treasury regulations--which are binding on us unless inconsistent
with the statute, see Boeing Co. v. United States, No. 01-1209, slip
op. at 9-10 (U.S. March 4, 2003)--require reasonableness to be based
on "all circumstances." 26 C.F.R. § 1.162-7(b)(1) (2002). What
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subsidiary factors are considered in this test of reasonableness is
apparently a question of first impression in this circuit.
Other circuits and the Tax Court have employed multi-
factor tests, the factors ranging from a handful to almost two dozen
in various formulations. See Bittker & Lokken, Federal Taxation of
Income, Estate and Gifts ¶ 22.2.2 (3d ed. 1999) (collecting cases
and discussing factors); 7 Mertens, § 25E:11-29 (same). By and
large, longer lists include elements that, in shorter ones, are
grouped together. The Second Circuit offers a typical example of a
short collection: the employee's role, payments by comparable
companies, nature and condition of the company (e.g., earnings),
incentives to distort, and consistency of compensation within the
company. Dexsil Corp. v. Comm'r, 147 F.3d 96, 100 (2d Cir. 1998).
The Seventh Circuit, in Exacto Spring Corp. v.
Commissioner, 196 F.3d 833 (7th Cir. 1999), has vividly criticized
the existing multi-factor tests as unpredictable. Id. at 835. The
company reads the decision as laying down a single-factor test which
asks whether "an independent investor" would approve the disputed
compensation as a reasonable reward for the manager's performance.
It asks us to adopt the test for this circuit. But in Exacto Judge
Posner conceded that the independent investor test was not an
exclusive answer to the problem, id. at 839, and Exacto's emphasis
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on the company's profits reflected in part the character of that
case.1
There is always a balance to be struck between simplifying
doctrine and accuracy of result, and for the present we think that
multiple factors often may be relevant. Exacto remains a useful
reminder that reasonableness under section 162(a)(1) is not a moral
concern or a matter of fairness; the inquiry aims at what an arm's-
length owner would pay an employee for his work. The problem is
that the actual payment--ordinarily a good expression of market
value in a competitive economy--does not decisively answer this
question where the employee controls the company and can benefit by
re-labeling as compensation what would otherwise accrue to him as
dividends.
Turning to the principal pertinent factors, the one
nominally most helpful to the taxpayer here is its general
performance and, in particular, the return on equity ("ROE"), which
averaged 24.6 percent during the period 1977-92 as compared with
17.4 percent for peer companies. The Tax Court said that the data
underlying the comparison were unreliable, Haffner's, 83 T.C.M.
(CCH) at 1218-19; and as support the IRS notes that the average
pertained to the 16-year period rather than the subject years and
1
The compensation at issue in Exacto was that of the chief
executive, presumptively due the primary credit for any successes,
196 F.3d at 839, and all the traditional factors favored the
taxpayer or were neutral, id. at 836-37.
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that the ROE and net income both declined substantially during the
subject years.
Certainly the ROE for the longer period looks impressive
and other factors (growth in revenues and profits) show an upward
curve over that period. But the decline in ROE and net income
during the subject years, accompanied by a spike in bonuses, does
raise substantial questions as to whether the increase was for
performance, whether the performance merited the compensation, and
whether, in any case, any successful performance can be properly
attributed to Louise and Emile.
Comparability of compensation is another common gauge, see
26 C.F.R. § 1.162-7(b)(3), operating in two quite different
dimensions. One is with pay for similar jobs at like companies; the
other is a comparison with others within the same company,
especially non-owner employees, making the appropriate adjustment
for differing responsibilities. Here, the Tax Court found that the
comparability evidence either affirmatively undercut or did not
support the company's position. Haffner's, 83 T.C.M. (CCH) at 1224.
In the end, the issue depends in part on what roles Louise and Emile
played.
As to horizontal comparison across companies, the
taxpayer's expert said that Louise and Emile's compensation for the
subject years was about 7-8 percent of gross income (20-23 percent
of net) and within the range for peer companies. The Tax Court
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criticized this assessment on several grounds (e.g., that the
comparison grouped the top three executives together and that
publicly traded companies were not comparable) and found the numbers
still too high. Haffner's, 83 T.C.M. (CCH) at 1220, 1222. The IRS
argues as well that a comparison with peer companies based on
similar job titles means little where, as here, Louise and Emile did
not (in the Commissioner's view) perform meaningful roles.
As to comparability within the company, the data at best
do not help the taxpayer and at worst hurt its position. Haff
himself received handsome bonuses, but he was the CEO and his
responsibility is undisputed. No one else in the company received
significant bonuses and, as the IRS points out, Louise and Emile's
bonuses in 1990 were each 12.5 times the salary of the next highest
paid employee. Of course, if Louise and Emile were the strategic
brains of the company, the differential can be explained; but it
turns out that they were not.
This brings us to their roles in the company. The
taxpayer showed that they were devoted to the business and worked
long hours, but there was little concrete evidence that their roles
during the years in question were very important. Many of their
functions were mundane (e.g., answering the telephone); and
relabeling the signing of checks as "responsible for . . . banking
relationships," as the taxpayer did here, is poor stuff. Neither
Haff, who testified that he consulted with his parents regularly,
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nor other employees could give specific examples of policy decisions
that Louise and Emile made during the subject years.
The Tax Court's view that Louise and Emile did not play
major executive roles is not clearly erroneous and this conclusion
undermines the support for very high bonuses. Even if the company
performed well in the subject period and even if executives at
comparable companies got large packages--both disputable premises--a
neutral owner would not pay Louise and Emile handsomely for
producing results for which others, or merely good economic times,
were responsible.
The company argues that present compensation can
legitimately reward past underpayment, and we do not mechanically
exclude this possibility. See, e.g., Bittker & Lokken, ¶ 22.2.2, at
22-24 & n.22. But such make-ups can be more convincingly defended
as market-based where performance is improving and retention of a
key executive a matter of forward-looking concern. Here,
performance was not improving; evidence of past executive
contributions was sparse; and there was almost nothing to show that
Louise and Emile were vital cogs in the subject years or likely to
be so in the future.
In the end, we agree with the Tax Court that the bonuses
deducted by the company were unsupported; the IRS has not challenged
the portion of the bonuses allocated to an affiliated company but,
as the affiliate is a subchapter S corporation, deductibility is not
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an issue. Perhaps a more modest bonus from the taxpayer would not
have been challenged or could have been more easily defended, but
the taxpayer has staked its position on defending the bonuses
actually paid and we have no basis for substituting a smaller figure
for which it has not argued.
Accumulated Earnings Tax. Section 531 of the Internal
Revenue Code imposes an accumulated earnings tax on a corporation
"availed of for the purpose of avoiding" the personal income tax on
shareholders by accumulating rather than distributing earnings.
Although this language is couched in terms of purpose, the statute
goes on to provide that an accumulation beyond the reasonable needs
of the business is ordinarily "determinative of the purpose to
avoid" tax. 26 U.S.C. § 533(a); United States v. Donruss Co., 393
U.S. 297, 307 (1969). In this case, as in most section 531 cases,
the touchstone is reasonableness.
In the Tax Court, the company offered several potentially
legitimate business reasons for this accumulation, among them to
resolve family litigation, to counter competition from better
financed and more established companies, to finance necessary
supplies of oil and gas, and to pay for regulatory compliance. The
Tax Court rejected the first ground on the merits and the others as
contrived after-thought justifications. We start with the family
litigation ground initially advanced by the taxpayer and then return
to the others.
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In 1989, the same year that Richard and Susan began their
law suit, the company accountant told the company that a redemption
of their stock was a plausible solution and that the company should
"start building up the reserves." One figure demanded by Richard
was $16 million, although the company thought at the time that this
was wildly inflated. The company asserted in the Tax Court that it
needed a reserve of $10 million to protect against litigation costs
and the potential cost of redemption--admittedly, this amount
exceeds its full retained earnings including the three-year
accumulation contested by the IRS.
Although this might at first appear a promising argument
for accumulation, the Tax Court rejected the claim root and branch:
it held that the accumulation was not in fact based on the asserted
purpose, that there was no specific plan to use the funds for
redemption, and that in this instance such a redemption was not
connected to the taxpayer's interests, however much it might have
helped Louise and Emile. Haffner's, 83 T.C.M. (CCH) at 1225-26. It
buttressed these conclusions with a considerable discussion of the
evidence.
On appeal, the company complains of Tax Court error,
first, in allegedly requiring that the stock redemption be
"necessary" for the company's survival rather than merely reasonably
connected with a business purpose, and, second, in supposedly
demanding that the plan of accumulation be a formal one, e.g., one
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committed to paper. It is not clear that the Tax Court adopted
either a "necessity" test,2 see Haffner's, 83 T.C.M. (CCH) at 1226,
or a formal plan requirement,3 but we need not pursue these issues
because at least a "specific plan" was required to justify the
accumulation, and none was present here.
The statute makes no reference to specific plans, formal
or otherwise, but the Treasury has adopted regulations implementing
the "reasonable needs" provision which include the following
language:
In order for a corporation to justify an
accumulation of earnings and profits for
reasonably anticipated future needs, . . . the
corporation must have specific, definite, and
feasible plans for the use of such
accumulation.
26 C.F.R. § 1.537-1(b)(1) (2002). The company does not challenge
the regulation as unauthorized or as inconsistent with the statute.
See 26 U.S.C. § 7805.
The regulation is fatal to the company's position.
Dispensing with formality does not create a license for vague,
2
A strict requirement that the redemption be "necessary" for
corporate survival would be legal error; the law only requires that
the redemption be "directly connected with the needs of the (2002);
see also Mountain State Steel Foundries, Inc. v. Comm'r, 284 F.2d
737, 745 (4th Cir. 1960); 10 Mertens, § 39.120, at 172.
3
There is no requirement that the plan be formal; indeed, the
accumulated earnings tax is almost always directed at close
corporations which are likely to be less formal in their record-
keeping. See Brookfield Wire Co. v. Comm'r, 667 F.2d 551, 555 (1st
Cir. 1981). But the lack of a paper record is still evidence as to
whether any plan existed.
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uncertain or indefinite plans. Brookfield, 667 F.2d at 555-56; 26
C.F.R. § 1.537-1(b)(1). Beyond the accountant's initial
recommendation, the Tax Court found virtually nothing in the record
to support a plan of accumulation for redemption: according to the
Tax Court, there were no written projections, no board resolution,
no evidence even of a board discussion of the matter, let alone any
careful study of amounts or likely need.
The company makes no effort to counter these factual
findings, and these findings make it impossible to describe the Tax
Court's ultimate conclusion--that no specific plan existed--as clear
error or unreasonable (one could argue for either standard but the
outcome would not be affected). The Tax Court did not adopt any per
se rule that the absence of some single element (such as writing or
projections) would be fatal under the specificity requirement; it
simply found that under all the circumstances no specific plan
existed in this case. It thus does not matter whether a plan if it
existed could have been justified.
The plan requirement is worth bearing in mind as we turn
to the other reasons offered on appeal--in fact, the taxpayer puts
them ahead of the redemption claim in its brief--to justify the
accumulation: competition, environmental regulations, securing
supply. As a first claim of error, the company argues that the Tax
Court improperly refused to consider most of this evidence, and
instead limited the taxpayer to the single rationale of family
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litigation (already discussed), because the taxpayer did not present
its other justifications until the case came to court. It says that
had these justifications been considered, the evidence would have
supported the accumulation.
After some prior discussions between the company and the
IRS with respect to the accumulated earnings tax, the IRS notified
the company in November 1996 that a deficiency notice was about to
issue, and invited the company to respond. The company answered in
December 1996, and mentioned only family litigation as a reason for
the accumulation. This remained for some time the sole
justification claimed by the company; it did not assert the other
business reasons until, at the earliest, sometime in late 1999,
roughly three years after the IRS notification.
The company suggests that the Tax Court took the late
proffer of these other business reasons as precluding their
assertion at trial. This, if true, would have been legal error:
the omission of the other business reasons from the December 1996
response merely left the burden of proof with respect to these
reasons with the taxpayer. 26 U.S.C. § 534(a). But this is not
what occurred. Rather, the taxpayer's argument is an imaginative
attempt to convert an evidentiary decision into a statutory error.
In its decision, the Tax Court did say that it would
"focus solely" on the family litigation explanation for the
accumulated earnings, and this in part resulted from the company's
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late proffer of the other business reasons. Haffner's, 83 T.C.M.
(CCH) at 1225. But at trial the Tax Court did not exclude evidence
of the other business reasons, nor did it fail to consider them in
its decision; instead, it found these reasons to be "an after the
fact rationalization" not worthy of acceptance. Id. It was this
factual finding--not any misreading of section 534--that doomed the
alternative justifications. Thus, the Tax Court said:
Petitioner asserts in brief that it also
accumulated earnings during the subject years
for reasons other than a stock redemption.
Neither the petitioner's December 16, 1996,
letter nor its pleadings in this case set forth
any reason for the earnings accumulation other
than a stock redemption. Nor did petitioner's
authorized representative state any other
reason when, during petitioner's audit, he
responded to the IDR. In fact, the first time
that petitioner asserted that it was also
accumulating earnings to meet certain business
contingencies and to provide working capital
was at or about the time of trial. Such an
after the fact rationalization to support the
accumulation of earnings is unavailing.
Id. (footnote omitted).
We accept as correct, or at least not clearly erroneous,
the Tax Court's finding that these late-proffered reasons were not
the actual, subjective motives for the accumulation. The company
does not explicitly contest this finding on appeal; the fragments
of evidence it cites on this issue are so vague and qualified as to
underscore, rather than undermine, the Tax Court's own finding.
Principally, its brief on appeal simply proceeds from the
proposition that section 534 does not prevent the taxpayer from
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objectively justifying the accumulation on competition, supply and
government regulation grounds. This in turn poses a question of
some interest: whether the reasons proffered to justify the
accumulation need to have been the actual reasons that in fact
motivated the taxpayer's accumulation.
If one looked solely at statutory language, it might be
plausible to argue that, in the absence of conclusive proof of the
forbidden "purpose to avoid" (a purpose which is alone fatal under
section 531(a)), an after-the-fact justification that is objectively
reasonable would suffice. One could also argue that it would be
unfair or unreasonable to penalize a taxpayer who lacked an
avoidance purpose for having accumulated an otherwise legal amount
of earnings for the wrong reasons. The form of the company's
argument implicitly assumes that this is the law.
We need not pursue this issue because the "specific plan"
requirement in the regulations is again fatal to the taxpayer: on
a sensible reading, one cannot have a "specific. . . plan[ ]" to
accumulate "for" a reasonable business need unless that need is an
actual reason for the accumulation. Other language in the
regulation underscores the requirement that the reasonable needs
must be recognized at the time of the accumulation.4 This
4
See, e.g., 26 C.F.R. § 1.537-1(b)(2) (2002) ("[S]ubsequent
events may be considered to determine whether taxpayer actually
intended to consummate" plan of accumulation.); see also, e.g.,
Northwestern Ind. Tel. Co. v. Comm'r, 127 F.3d 643, 647 (7th Cir.
1997) (noting the lack of contemporaneous planning records and
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requirement may be overkill as to the main thrust of the statute,
but it obviously serves a valid purpose in preventing contrived post
hoc explanations.
Of course, section 533 merely creates a rebuttable
presumption that tax avoidance was "a" purpose (the statute says
"the" but the Supreme Court says "a" purpose to avoid is enough to
condemn an accumulation, Donruss, 393 U.S. at 307-09). The statute
provides that unreasonable accumulation is "determinative" against
the taxpayer "unless" the taxpayer proves the contrary, so in
principle the taxpayer could unreasonably accumulate and still avoid
the tax. See 26 U.S.C. § 533(a). But in this case the company has
not sought to walk the camel through this aperture in the needle.
Affirmed.
disbelieving ex post justifications), cert. denied, 525 U.S. 810
(1998); Herzog Miniature Lamp Works, Inc. v. Comm'r, 481 F.2d 857,
863 (2d Cir. 1973) (similar).
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