T.C. Memo. 1996-129
UNITED STATES TAX COURT
PULSAR COMPONENTS INTERNATIONAL, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15172-92. Filed March 14, 1996.
Held: Compensation paid by P to two of its
officers/shareholders is reasonable. Both officers had
the appropriate education and employment background for
their positions with P, worked long hours for the
company and its predecessor, and helped increase its
gross sales in a volatile market. The success of the
business required great expertise in trading computer
chips and microprocessors. These qualities were
especially exemplified during the taxable year at issue
when P proved profitable even though it faced adverse
economic conditions. Moreover, P's retained earnings
grew, and P paid regular dividends. Although P paid
the officers more compensation than provided for in
their employment agreements, all of their compensation
was reasonable in light of the significant appreciation
in the value of P's stock and other facts and
circumstances.
Charles R. Goulding and Michael S. Press, for petitioner.
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Halvor N. Adams III and Thomas J Kerrigan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Pulsar Components International, Inc.,
petitioned the Court to redetermine respondent's determination of
a $382,771 deficiency in its income tax for its taxable year
ended July 31, 1985. Respondent determined that $822,000 of the
$2,922,000 claimed by petitioner as officers' compensation was
unreasonable. In an amendment to her answer, respondent asserted
that $2,324,170 of the claimed compensation was unreasonable,
increasing the claimed deficiency to $1,089,369. Respondent also
asserted in the amendment that petitioner was liable for an
addition to tax under section 6661.
We must decide the amount of compensation paid by petitioner
that is reasonable and thus deductible as a business expense
under section 162. We hold all of it is.1 Unless otherwise
stated, section references are to the Internal Revenue Code in
effect for the year in issue. Rule references are to the Tax
Court Rules of Practice and Procedure. We separately refer to
Thomas F. Laviano and Peter T. Woll as Mr. Laviano and Mr. Woll,
respectively. We collectively refer to them as the Officers.
FINDINGS OF FACT
1
Accordingly, we also hold that petitioner is not liable
for the addition to tax asserted by respondent.
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Some of the facts have been stipulated and are so found.
The stipulations and attached exhibits are incorporated herein by
this reference. Petitioner's principal office was in Hicksville,
New York, when it petitioned the Court. Petitioner filed its
Federal income tax return based on a fiscal year ending July 31,
1985, and it used the cash receipts and disbursements method.
1. Petitioner
Petitioner is a "third-tier chip broker” that locates,
purchases, and sells computer chips, electronic components, and
integrated circuits.2 Petitioner and its predecessor, Pulsar
Components, Inc. (Components), developed a niche in their field
that enabled them to take advantage of supply and demand
imbalances caused by the production capacities of microchip
manufacturers and the production needs of computer manufacturers.
Petitioner located scarce parts during periods of low supply and
high demand by using a network of brokers, surplus houses,
distributors, and manufacturers, of which it had a working
2
Computer manufacturers obtain electronic components and
microchips from three sources (tiers) of supply. The first tier,
the primary source of supply of electronic components, is a chip
manufacturer such as Intel, Micron, or Fujitsu. Approximately
90 percent of the parts purchased by equipment manufacturers are
purchased directly from chip manufacturers. The second tier,
franchise distributors such as Arrow Electronics, Hamilton-Avnet,
and Schweber, are typically large corporations that warehouse
substantial inventories of parts. Franchised distributors have
franchise agreements to represent product lines of certain
manufacturers, and they sell parts out of inventory for a set
markup that is usually 15 to 20 percent. The third tier consists
of chip brokers and traders like petitioner.
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knowledge, and by using the sources of supply that were developed
therefrom.
Unlike its competitors, petitioner derived economies by
copying the trading operations of some of the large securities
firms on Wall Street in New York, New York. Petitioner’s traders
worked out of a trading pit where purchasing and selling
transactions were brokered in a matter of seconds. Petitioner’s
traders did not have a set markup on parts sold; instead, they
worked off market prices; i.e., petitioner profited on the spread
between the purchase and selling price when it was able to match
a customer's need with the integrated circuits that petitioner
could locate. Petitioner carried minimal inventory, had a high
inventory turnover rate, and had no written agreements with
manufacturers. Petitioner generally did not order goods for
which it did not have a buyer, and in the rare cases that it did,
it always had the option of selling the goods before they were
delivered or canceling the order.
2. Petitioner's Owners
The Officers were longtime friends who met in grade school.
They organized Components in October 1979 by contributing a total
of $2,000 in cash in return for all of its stock. Mr. Laviano
received 75 percent of the stock, and Mr. Woll received the other
25 percent. The business of Components was headquartered in the
basement of the home of Mr. Laviano's parents. The Officers used
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card tables and folding chairs as furniture, and they rented
telephones.
With the Officers at the helm, Components prospered and
became a successful entity. Although its gross receipts varied
greatly from year to year, based on the volatility of the
industry, Components reported the following results for the
taxable years ended November 30, 1979, through November 30, 1982:
Nov. 30, 1979 Nov. 30, 1980 Nov. 30, 1981 Nov. 30, 1982
Sales $251,588 $5,061,159 $1,876,555 $2,061,989
Gross profit
on sales $5,349 $1,499,411 $779,655 $832,036
Gross profit
on sales as
a percentage
of sales 2.1% 29.6% 41.5% 40.4%
Taxable income
(loss) ($110) ($4,592) $4,136 $32,967
Retained earnings
(deficit) ($110) ($14,691) ($11,562) $23,806
In the fall of 1982, the Officers agreed to transfer
Components to petitioner so that Mr. Woll could increase his
ownership percentage and John Laviano, Mr. Laviano's younger
brother, could become a shareholder. Petitioner was organized on
August 3, 1982. From petitioner's organization through July 31,
1985, Mr. Laviano owned 55 percent of its stock, Mr. Woll owned
40 percent, and John Laviano owned the remaining 5 percent.
Petitioner's board of directors consisted of Mr. Laviano,
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Mr. Woll, and John Laviano. Petitioner commenced business on
December 1, 1982.
Petitioner conducted the same business as Components; the
only changes were the addition of the word “International” to the
name and the change in ownership percentages. All of Components'
accounts and sources of supply that were developed prior to
petitioner's organization, and all employees who were trained
prior to the organization of petitioner, were transferred to
petitioner.
a. Mr. Laviano
Mr. Laviano was petitioner's president. He received a
bachelor of science degree in accounting from St. John's
University in 1977. After graduating from college, Mr. Laviano
worked for Semi-Specialists of America, Inc. (SAI), one of the
largest and most profitable semiconductor brokerages in the
nation. SAI was an electronics business that functioned as a
middleman for computer chips and other electronic components,
much as petitioner did. Mr. Laviano worked for SAI for
approximately 1 year. While he was employed there, Mr. Laviano
learned SAI's business well enough to go into the business for
himself. During the year in issue, Mr. Laviano worked for
petitioner approximately 60 to 80 hours per week, 52 weeks per
year. Mr. Laviano was a devoted workaholic who was committed to
petitioner's business and success.
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b. Mr. Woll
Mr. Woll was petitioner's secretary and treasurer. He
graduated from Yale University, cum laude, in 1977, receiving his
bachelor of arts degree in economics and political science. After
graduating from college, Mr. Woll worked on Wall Street as a
trader in U.S. Treasury securities, first for A.G. Becker, Inc.,
for about 1 year, and then for First International Money Markets.
At A.G. Becker, Inc., he placed third on its list of top salesmen
for the month in which he left. Mr. Woll also did very well at
First International Money Markets. He left First International
Money Markets in September 1979 to organize Components with
Mr. Laviano. During the year in issue, Mr. Woll worked for
petitioner approximately 50 to 80 hours per week. Like Mr.
Laviano, Mr. Woll was a devoted employee who was totally
dedicated and committed to petitioner's business and its success.
c. The Officers' Duties
The Officers were involved in every aspect of petitioner’s
business. They performed all of its executive and managerial
functions, oversaw all of its employees, and were directly
responsible for its success. The Officers served as co-chief
traders, overseeing all of petitioner’s purchases and sales and
approving all of its deals. The Officers bought and sold parts
for petitioner, quoted all of its prices, and supervised all of
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its traders. The Officers recruited, interviewed, hired, and
trained petitioner’s employees.
The Officers also were petitioner’s executive officers and
managers. They were directly responsible for profit
maximization, long-term business planning, office automation,
cash management, physical plant expansion, marketing, and all
other management functions. When not trading, Mr. Woll focused
on administrative functions and was in charge of cash
disbursements, cash receipts, billing, receivables, and
investigating credit. Mr. Woll also dealt with petitioner’s
accountants, lawyers, and bankers, and he supervised petitioner's
bookkeeping staff. The Officers supervised the shipping staff,
and they personally inspected every part received by petitioner
in order to ensure that the parts were not counterfeit or
defective.
3. Petitioner's Operations
For the 3-year period ended with the year in issue,
petitioner's gross receipts (net of returns and allowances),
gross income, book income, taxable income, Officers'
compensation, Officers' compensation percentages, and Officers'
equity were (rounded to the nearest dollar):
Taxable
Year Gross
Ended Receipts Net Income Taxable Officers' Gross
July 31 (Net) Per Books Net Income1 Compensation Income
19832 $2,671,061 $88,903 $88,903 $26,000 $279,158
1984 29,763,657 1,796,032 1,823,904 1,449,000 5,415,936
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1985 10,693,635 3,546,647 3,546,647 2,922,000 4,830,348
1
Before deduction of officers compensation.
2
This year, petitioner's first, represents approximately 8 months of
operation.
Officer Compensation
Percentages
Taxable Officer Compensation Divided by:
Year Gross
Ended Receipts Gross Net Income Taxable
July 31 (Net) Income Per Books Net Income
1983 1.0% 0.9% 29.2% 29.2%
1984 4.9 26.8 80.7 79.4
1985 27.3 60.5 82.4 82.4
As of the end of these 3 years, petitioner reported the following
total assets, liabilities, and equity:
Taxable
Year Ended
July 31 Total Assets Total Liabilities Equity
1983 $116,298 $52,395 $63,903
1984 900,935 500,000 400,935
1985 961,032 450 960,582
4. The Officers' Compensation From Petitioner
a. Overview
The Officers each signed an employment agreement with
petitioner that entitled each of them to $650,000 of compensation
per year.
b. Mr. Woll's Efforts
Mr. Woll recognized that he was a minority shareholder and
he believed that, in the absence of an employment agreement,
Mr. Laviano could set Mr. Woll's compensation at any amount.
One of the Officers' first efforts to address the concerns of
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Mr. Woll was to form petitioner, giving Mr. Woll a larger
ownership interest. Mr. Woll continued to try to negotiate a
higher salary after petitioner's formation. Mr. Laviano, on the
other hand, wanted to limit the amount Mr. Woll was paid.
Mr. Woll never threatened to leave the employment of petitioner
if his compensation was not increased, but he constantly tried to
convince Mr. Laviano to increase his compensation. One of the
ways Mr. Woll attempted to convince Mr. Laviano to increase his
compensation was to report to Mr. Laviano his estimate of what
executives in other firms in petitioner's industry were making.
Most of the information upon which Mr. Woll based his estimate
was obtained from the owners of companies that competed with
petitioner.
After much discussion among themselves, the Officers agreed
to set their salaries at $650,000 a year for 3 years, beginning
on November 5, 1982. In doing so, the Officers considered what
they understood other people in petitioner's industry were
making. They considered that they would be acting as chief
traders, as well as managers and executives. They discussed
whether they should receive commissions, but decided to work
strictly on a salary basis. In agreeing to set their
compensation at a fixed annual rate, the Officers did so with the
understanding that it might not be possible for petitioner to pay
them $650,000 each year due to the cyclical nature of its
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industry, and that any underpayment in a year would be made up
when petitioner had the available resources.3
On November 1, 1982, petitioner's board of directors met and
resolved that the "compensation for the next three (3) years for
Mr. Peter Woll and Mr. Thomas Laviano, should be set at $650,000
per year."4
c. Amounts Claimed by Petitioner as Officers' Compensation
The Officers served as officers of petitioner during each of
its taxable years ended July 31, 1983, through July 31, 1985.
3
Par. 4(e) of the principal officer employment agreements
states:
during some fiscal years of the Corporation, available
cash may not allow compensation of the Employee to the
extent of immediate and long term effects of his
efforts upon the profitability of the Corporation.
* * * * * * *
it is acknowledged between the Employee and the
Corporation that full compensation for all Employee’s
services may not be possible, from a cash standpoint
during years in which there has been a downturn or
recession in the semiconductor market. Therefore, the
Corporation shall, in setting compensation for the
Employee in later more profitable fiscal periods, take
into account previously uncompensated services arising
at former, less profitable years. * * *
4
Petitioner's contracts with the Officers also entitled
them to benefits including: (1) Automobiles (2) financial
counseling, (3) disability benefits, (4) any benefits (including
pension, retirement, profit sharing, insurance, and medical
benefits) provided by petitioner to its employees in general,
(5) apartments and vacation condominiums, (6) reimbursement for
expenses incurred on behalf of petitioner, and (7) reimbursement
for club dues and expenses.
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Petitioner deducted the following Officers' compensation on its
Federal corporate income tax returns for those years as follows:
Taxable
Year Ended Deduction Claimed
July 31 Mr. Laviano Mr. Woll Total
1983 $11,000 $15,000 $26,000
1984 729,000 720,000 1,449,000
1985 1,461,000 1,461,000 2,922,000
Total 2,201,000 2,196,000 4,397,000
A comparison of the Officers' compensation and their stock
ownership interests is as follows:
Taxable
Year Ended
July 31 Mr. Laviano (55%) Mr. Woll (40%)
1983 42.3% 57.7%
1984 50.3 49.7
1985 50.0 50.0
d. Board Resolution Concerning Undercompensation
Petitioner's board met on August 6, 1984, and reported that
each of the Officers was actually paid less than the amounts that
were fixed in their employment agreements. Specifically, the
board found, the Officers were entitled to receive $650,000 per
year, but were actually paid the following amounts:
1983 1984
Thomas Laviano $11,000 $729,000
Peter Woll 15,000 720,000
The board decided that petitioner owed Mr. Laviano $560,000 and
that petitioner owed Mr. Woll $565,000. The board unanimously
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decided that petitioner would pay these debts in the taxable year
ended July 31, 1985.
5. Petitioner's Employees
Petitioner employed many individuals to buy and sell
electronic components. Most of petitioner's employees did not
have prior experience in the electronics industry before they
commenced their employment with petitioner. The Officers taught
petitioner's new employees to be traders by sitting next to them,
having the new employees watch them, and answering the new
employees' questions. After a while, the new employees were
given simple tasks to do on their own, and if they performed
those tasks correctly, the new employees were given a few
well-established accounts to manage in order to develop their
trading skills. From 1980 through 1984, approximately eight
individuals terminated their employment with petitioner (or
Components) in order to start a competing businesses.
Petitioner also employed several individuals to support its
sales and purchasing operations. Petitioner's support staff
ranged from one to three employees in the shipping and receiving
department, one to two secretaries, a bookkeeper, and an
individual to perform administrative functions.
a. Compensation of Petitioner's Employees
Petitioner generally paid its employees a rate of
compensation which the Officers thought was commensurate with
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each employee's skill and experience and, particularly due to the
fierce competition in petitioner's industry, what the Officers
believed it would take to hire and retain the employee.
Petitioner's compensation package differed depending upon whether
the employee was a member of petitioner's sales and purchasing
staff or its administrative or support staff. Petitioner, unlike
Components, did not have a pension plan. The only benefits that
petitioner provided to its employees were paid vacations and,
beginning in the year in issue, medical insurance.
Petitioner's sales and purchasing staff received a base
salary plus commissions for sales greater than monthly sales
quotas. They did not receive any other bonuses. Their
commissions ranged from 2 to 15 percent, and the average
commission was 10 percent of the gross profits from the
transactions consummated by the employee. Commissions were the
bulk of the annual compensation received by sales or purchasing
agents.5 During the 1984 and 1985 calendar years, petitioner
paid its sales and purchasing employees the following amounts:
5
Consequently, such employees' annual compensation varied
greatly depending on the economic conditions in petitioner's
industry. In periods of high profitability, many of petitioner's
sales personnel were highly compensated, earning in excess of
$100,000. In more fallow periods, petitioner's sales personnel
earned only a fraction of that amount.
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Employee 1984 1985 Total
John Laviano1 $515,397 $196,000 $711,397
Michael Lavelle 263,764 148,000 411,764
Kenneth Forster 172,004 34,695 206,699
Ginny Neitzel 105,139 38,199 143,338
Lee Ackerly2 138,319 -0- 138,319
1
John Laviano, received commissions based on 15 percent of
the gross profits from the transactions in which he was involved.
2
Lee Ackerley left the petitioner during 1984 to start a
competing business.
Petitioner paid its support staff a salary and occasional
monthly bonuses depending on petitioner's profitability. No
bonuses were paid during periods of low profitability. During
periods of high profitability, bonuses were mediocre and were
paid with an intent to permit petitioner's support personnel to
participate in its profits.
6. Petitioner's Retained Earnings and Dividend Policy
Petitioner retained earnings for the 3-year period ended
July 31, 1985, were as follows:
Taxable
Year Ended Retained
July 31 Earnings
1983 $62,903
1984 399,935
1985 959,582
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During these years, petitioner paid the following dividends:6
Taxable
Year Ended Dividends
July 31 Mr. Laviano Mr. Woll John Laviano
1983 -0- -0- -0-
1984 $5,500 $4,000 $500
1985 35,750 26,000 3,250
Total 41,250 30,000 3,750
Petitioner’s retained earnings increased by approximately
1,525 percent from $62,903 on July 31, 1983, to $959,582 on
July 31, 1985. Its shareholder’s equity increased by 1,503
percent from $63,903 on July 31, 1983, to $960,582 on July 31,
1985. Even though petitioner had a cash surplus on July 31,
1985, petitioner was retaining these funds for business reasons.
7. The Officers' Other Entities
The Officers, jointly or individually, were engaged in other
activities aside from their interest in petitioner. They were
equal partners in a partnership that was formed to increase their
market share in petitioner's industry, and to allow for volume
discounts on purchases.
Petitioner used the services of the other entities that were
entirely owned by the Officers. Services performed by these
other entities included financial, marketing, and management
consulting. Petitioner, through the Officers, devoted some of
6
Components paid dividends of $12,500 in its taxable year
ended Nov. 30, 1980, and $8,000 in its taxable year ended
Nov. 30, 1981.
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its time to (and performed services on behalf of) the operations
of these other entities.
OPINION
Once again, we are faced with perhaps one of the most
litigated issues in Federal income taxation, the deductibility of
compensation paid to shareholders/employees in the setting of a
closely held corporation. In order for employee compensation to
be deductible by a cash method taxpayer, the compensation must
be: (1) Paid in the taxable year for services rendered to the
taxpayer in the conduct of its trade or business, (2) reasonable
in amount, and (3) ordinary and necessary in character. Sec.
162(a)(1); Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243
(9th Cir. 1983), revg. and remanding T.C. Memo. 1980-282; sec.
1.162-7(a), Income Tax Regs. While each criterion may be at
issue from time to time, it is the reasonableness standard that
presents the most difficult issue. As the Court has observed:
Inherently there is a natural tension between:
(1) Shareholders/employees who feel that they are entitled to
be paid from a corporation's profits, even to the exhaustion
thereof, of an amount that reflects their skills and efforts,
and (2) a provision in the tax law that conditions the
deductibility of compensation on the concept of
reasonableness. What is reasonable to the
entrepreneur/employee often may not be to the tax collector.
* * * The term "reasonable", however, must reflect the
intrinsic value of employees in the broadest and most
comprehensive sense. [Mad Auto Wrecking, Inc. v.
Commissioner, T.C. Memo. 1995-153.]
The parties do not dispute that the Officers' compensation
was an ordinary and necessary expense of petitioner. Thus, we
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assume it was, and we limit our discussion to the other two
prongs, and we pass on these prongs seriatim.
1. Whether the Compensation Paid by Petitioner Was Reasonable
a. Overview
Reasonable compensation is determined by comparing the
compensation paid to an employee with the value of the services
that he or she performed in return. Such a determination is made
with respect to each employee individually, rather than with
respect to the compensation paid to all employees collectively.
Such a determination is a question of fact. RTS Inv. Corp. v.
Commissioner, 877 F.2d 647, 650 (8th Cir. 1989), affg. per curiam
T.C. Memo. 1987-98; Charles Schneider & Co. v. Commissioner,
500 F.2d 148, 151 (8th Cir. 1974), affg. T.C. Memo. 1973-130;
Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115, 119
(6th Cir. 1949), revg. and remanding a Memorandum Opinion of this
Court; Estate of Wallace v. Commissioner, 95 T.C. 525, 553
(1990), affd. 965 F.2d 1038 (11th Cir. 1992). Respondent's
determination is presumed correct, and petitioner must prove it
wrong. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933); RTS Inv. Corp. v. Commissioner, supra at 650.
The cases concerning reasonable compensation are legion and
list many factors to be considered in making this factual
determination. The factors which may be considered, none of
which is controlling in itself, include: (a) The employee's
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qualifications; (b) the nature, extent, and scope of the
employee's work; (c) the size and complexities of the employer's
business; (d) a comparison of salaries paid with the employer's
gross and net income; (e) the prevailing general economic
conditions; (f) a comparison of salaries with distributions to
Officers and retained earnings; (g) the prevailing rates of
compensation for comparable positions in comparable concerns;
(h) the salary policy of the employer as to all employees;
(i) the amount of compensation paid to the particular employee in
previous years; (j) the employer's financial condition;
(k) whether the employer and employee dealt at arm's length;
(l) whether the employee guaranteed the employer's debt;
(m) whether the employer offered a pension plan or profit-sharing
plan to its employees; and (n) whether the employee was
reimbursed by the employer for business expenses that the
employee paid personally. See Rutter v. Commissioner, 853 F.2d
1267, 1274 (5th Cir. 1988), affg. T.C. Memo. 1986-407; Elliotts,
Inc. v. Commissioner, supra at 1245-1248; Kennedy v.
Commissioner, 671 F.2d 167, 174 (6th Cir. 1982), revg. and
remanding 72 T.C. 793 (1979); Charles Schneider & Co. v.
Commissioner, supra at 151-152; Mayson Manufacturing Co. v.
Commissioner, supra at 119; Estate of Wallace v. Commissioner,
supra at 553; Home Interiors & Gifts, Inc. v. Commissioner,
73 T.C. 1142, 1155-1156 (1980); see also Mad Auto Wrecking, Inc.
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v. Commissioner, supra. In analyzing these factors, the Court
must carefully scrutinize the facts of a case in which the paying
corporation is controlled by the employees to whom the
compensation is paid. In such a situation, we must be convinced
that the purported compensation was paid for services rendered by
the employees as opposed to a distribution of earnings to them
that the payor could not deduct. RTS Inv. Corp. v. Commissioner,
supra at 650; 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; Seven Canal
Place Corp. v. Commissioner, 332 F.2d 899 (2d Cir. 1964),
remanding T.C. Memo. 1962-307.
b. Employee's Qualifications
An employee's superior qualifications for his or her position
with the business may justify high compensation. See, e.g.,
Home Interiors & Gifts, Inc. v. Commissioner, supra at 1158;
Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C. 338,
352-353 (1972).
The Officers are exceptionally qualified for petitioner's
business, by virtue of their education, training, experience, and
dedication. They understand and control every aspect of
petitioner's operations. They are highly motivated and extremely
productive employees. They are the primary reason for
petitioner's success. The Officers’ outstanding qualifications
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justify high compensation. Petitioner's profitability, which
rests upon its sales, and the Officers' ambition, inventiveness,
and energy (as opposed to petitioner's investment in capital) are
the primary reasons for petitioner's sales, growth, and success.
See Home Interiors & Gifts, Inc. v. Commissioner, supra at 1158;
Dave Fischbein Manufacturing Co. v. Commissioner, supra at
352-353. This factor favors petitioner.
c. Nature, Extent, and Scope of the Employee's Work
An employee's position, hours worked, duties performed, and
general importance to the success of a business may justify high
compensation. Elliotts, Inc. v. Commissioner, 716 F.2d at
1245-1246; 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); Mayson Manufacturing Co. v. Commissioner, supra; Home
Interiors & Gifts, Inc. v. Commissioner, supra at 1158.
The Officers performed all of petitioner's executive and
managerial functions. They performed or oversaw virtually all of
its trading activities. They supervised its daily operations,
including supervising and directing its employees, and they made
its business decisions. Given the vital role played by the
Officers in petitioner's operations and success, and the long
hours that they each dedicated thereto, we view the Officers as
indispensable to petitioner's business. Petitioner's growth and
prosperity are due directly to their skills, dedication, and
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creativity. This factor favors petitioner. See Elliotts, Inc.
v. Commissioner, supra at 1245-1246; Kennedy v. Commissioner,
supra at 176; Home Interiors & Gifts, Inc. v. Commissioner, supra
at 1158; Dave Fischbein Manufacturing Co. v. Commissioner, supra
at 352-353.
d. Size and Complexities of the Employer's Business
Courts have considered the size and complexity of a
taxpayer’s business in deciding whether compensation is
reasonable. Elliotts, Inc. v. Commissioner, supra at 1246;
Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d 176, 179
(10th Cir. 1975), affg. 61 T.C. 564 (1974); Mayson Manufacturing
Co. v. Commissioner, 178 F.2d at 119.
Petitioner is a highly specialized semiconductor trading
company, and its split-second trading operations demand
expertise. Petitioner's business is highly competitive, with
thousands of competitors trying to locate and sell the same parts
as petitioner. Petitioner's unique trading method introduced by
the Officers enabled it to survive and become extremely
profitable in a highly competitive industry. Petitioner's gross
receipts during the year in issue totaled more than $10 million.
This factor favors petitioner. See Elliotts, Inc. v.
Commissioner, supra at 1246.
e. Comparison of Salaries Paid to Net and Gross Income
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Courts have compared sales, net income, and capital value to
amounts of compensation in deciding whether compensation is
reasonable. Elliotts, Inc. v. Commissioner, supra at 1241;
Mayson Manufacturing v. Commissioner, supra.
For the year in issue, Officers' salaries were 27.3 percent
of gross receipts and 60.5 percent of gross income. Officers’
salaries were 82.4 of book net income (before deducting Officers'
compensation) and 82.4 percent of taxable net income (before
deducting Officers' compensation).
These percentages are reasonable in light of the
qualifications of the Officers and the nature, extent, and scope
of their work, and the years of prior undercompensation. During
1983, petitioner paid the Officers less compensation than they
were entitled to, while they helped petitioner increase its gross
sales from $2,671,061 in 1983 to $10,693,635 in 1985. We also
find relevant the fact that petitioner reported more than
$995,460 in taxable income during the subject year,
notwithstanding its payment of large compensation to the
Officers. This factor favors petitioner.
f. General Economic Conditions
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 employees.
General economic conditions may affect a business' performance
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and indicate the extent (if any) of the employees effect on the
company. Mayson Manufacturing Co. v. Commissioner, supra at
119-120. Adverse economic conditions, for example, tend to show
that an employee's skill was important to a company that grew
during the bad years.
Because petitioner's industry seeks to take advantage of
supply imbalances present in the computer chip/semiconductor
market, it is characterized by periods of rapid growth and
profitability followed by periods of sharp decline. Petitioner
faced declining sales during the subject year as market
imbalances in supply began to correct themselves, and petitioner
was forced to compete with an increasing number of competitors.
Although petitioner's gross receipts declined significantly,
petitioner experienced an increase in its taxable income,
retained earnings, and shareholder’s equity. The adverse
economic conditions tend to show that the Officers' skill and
diligence were important to petitioner's success. This factor
favors petitioner.
g. Comparison of Salaries With Distributions to
Officers and Retained Earnings
The failure to pay more than minimal dividends may suggest
that reported compensation actually is (in whole or in part) a
dividend. Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d
1315, 1322-1323 (5th Cir. 1987), affg. T.C. Memo. 1985-267;
Charles Schneider & Co. v. Commissioner, 500 F.2d at 151.
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Corporations, however, are not required to pay dividends.
Shareholders may be equally content with the appreciation of
their stock caused, for example, by the retention of earnings.
Owensby & Kritikos, Inc. v. Commissioner, supra; Elliotts, Inc.
v. Commissioner, supra; Home Interiors & Gifts, Inc. v.
Commissioner, 73 T.C. at 1162 (1980).
Petitioner has a history of regularly declaring and paying
dividends. In reviewing the reasonableness of an employee's
compensation, we often apply a hypothetical independent investor
standard to determine whether a shareholder has received a fair
return on investment after the payment of the compensation in
question. Owensby & Kritikos, Inc. v. Commissioner, supra at
1326-1327; Elliotts, Inc. v. Commissioner, 716 F.2d at 1244;
Medina v. Commissioner, T.C. Memo. 1983-253; see also Rev. Rul.
79-8, 1979-1 C.B. 92 (compensation is not unreasonable merely
because a corporation pays an insubstantial portion of its
earnings as dividends). Whether to pay a dividend, and the
amount thereof, were business decisions made by petitioner's
board taking into account that petitioner had accumulated
sufficient earnings during profitable years and that petitioner
might need to retain some (or all) of those earnings in order to
weather less profitable periods that were likely ahead. We
refuse to second-guess the board's business judgment under the
facts of this case; we view its decisions concerning the payment
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of dividends and the amounts thereof as reasonable business
decisions.7 Petitioner paid $65,000 in dividends in the year at
issue. Its shareholder’s equity grew from $63,903 on July 31,
1983, to $960,582 on July 31, 1985. Its retained earnings grew
from $62,902 on July 31, 1983, to $959,582 on July 31, 1985.
See Comtec Sys., Inc. v. Commissioner, T.C. Memo. 1995-4. In
addition to the fact that the increase in petitioner's retained
earnings most likely increased the value of its stock, we believe
that a hypothetical investor would have considered $959,582 in
retained earnings to have been a worthy performance for the
3-year period. Moreover, the Officers received dividends from
petitioner's earnings. The dividends per share increased from
$95 per share on July 31, 1984, to $617.50 per share on July 31,
1985. On this record, it is clear that an investment in
petitioner's stock was very attractive and that the Officers
received an adequate share of petitioner's profits through
dividends. This factor favors petitioner.
h. Prevailing Rates of Compensation for Comparable
Positions in Comparable Companies
Both petitioner and respondent rely on expert testimony with
respect to this factor. Expert testimony is appropriate to help
7
Bearing in mind that respondent has not determined that
petitioner is liable for the accumulated earnings tax of sec.
531, it is possible that she would agree that the large increase
in petitioner's retained earnings was necessary for the
reasonable needs of petitioner's business.
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the Court understand an area requiring specialized training,
knowledge, or judgment. Fed. R. Evid. 702; Snyder v.
Commissioner, 93 T.C. 529, 534 (1989). The Court, however, is
not bound by an expert's opinion. We weigh an expert's testimony
in light of his or her qualifications, and with respect to all
credible evidence in the record. Depending on what we believe is
appropriate under the facts and circumstances of the case, we may
either reject an expert's opinion in its entirety, accept it in
its entirety, or accept selective portions of it. Helvering v.
National Grocery Co., 304 U.S. 282, 294-295 (1938); Seagate
Technology, Inc. & consol. Subs. v. Commissioner, 102 T.C. 149,
186 (1994); Parker v. Commissioner, 86 T.C. 547, 562 (1986).
Petitioner's expert is Paul R. Dorf, managing director of
Compensation Resources, Inc., of Upper Saddle River, New Jersey.
Respondent's expert is E. James Brennan III, president of
Brennan, Thomsen Associates, Inc., of Chesterfield, Missouri.
Mr. Brennan is no stranger to this Court, having testified before
us on no fewer than 13 prior occasions. See Alondra Indus. Ltd.
v. Commissioner, T.C. Memo. 1996-32; Guy Schoenecker, Inc. v.
Commissioner, T.C. Memo. 1995-539; Mad Auto Wrecking, Inc. v.
Commissioner, T.C. Memo. 1995-153, and the cases cited therein.
We are not persuaded by either of the experts. Mr. Dorf's
testimony was unconvincing because it did not directly address
the factor at hand; i.e., the prevailing rates of compensation
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for comparable positions in comparable concerns. Considering his
testimony in its entirety, we find that Mr. Dorf was retained by
petitioner to advocate its position herein. See Laureys v.
Commissioner, 92 T.C. 101, 129 (1989). We are no more convinced
by Mr. Brennan. We have had difficulty accepting Mr. Brennan's
"expert" opinions in previous cases. As in the past, we have
trouble accepting his conclusions as they are not based on data
from businesses that are akin to the business at hand; i.e.,
third-tier supply firms in the computer chip and semiconductor
industry. Restating what we have previously stated with respect
to Mr. Brennan's "expert" testimony: "We are not satisfied that
a reasonable level of compensation for an executive like * * *
[the Officers] can be accurately determined by reference to the
industries Brennan surveyed because of the absence of significant
information on other businesses similar to petitioner's."
Mad Auto Wrecking, Inc. v. Commissioner, supra (quoting
Thomas A. Curtis, M.D., Inc. v. Commissioner, T.C. Memo.
1994-15). Indeed, comparing compensation paid to officers of
companies that differ markedly provides guidance of dubious
value. See Diverse Indus., Inc. v. Commissioner, T.C. Memo.
1986-84; Niagara Falls Coach Lines, Inc. v. Commissioner, T.C.
Memo. 1977-269. This factor favors neither party. We consider
it neutral.
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i. Employer's Salary Policy As to All Employees
Courts have considered salaries paid to other employees of a
business in deciding whether compensation is reasonable.
Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1159.
We look to this factor to determine whether the Officers were
compensated differently than petitioner's other employees merely
because of the Officers' status as shareholders. Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323. A
reasonable, longstanding, and consistently applied compensation
plan, for example, is evidence that compensation is reasonable.
Elliotts, Inc. v. Commissioner, supra at 1247.
Petitioner generally offered its employees an amount that, in
its board's judgment, was a competitive level of compensation
designed to secure and retain employees. Petitioner paid its
sales and purchasing staff a base salary, commissions, and
benefits. Petitioner paid its other employees a salary, some
benefits, and an occasional bonus. This factor favors neither
party. We consider it neutral.
j. Compensation Paid in Prior Years
An employer may deduct compensation paid to an employee in a
year although the employee performed the services in a prior
year. Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); see
also R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-51 (1972),
and the cases cited therein. In order to do so, the employer
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must show: (1) That the employer intended to compensate the
employee for past undercompensation, and (2) the amount of the
undercompensation. 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. 525, 553-554 (1990),
affd. 965 F.2d 1038 (11th Cir. 1992).
Petitioner has met both of these requirements. Its board
found that, during the 2-year period ended July 31, 1984, the
Officers had not received $1,125,000 of the compensation provided
in their employment agreements. Its board decided that
petitioner would pay this liability during the year in issue.
During the 2 years prior to the year in issue petitioner
experienced cash-flow problems, particularly during its first
year of operation, and sought to preserve its cash. Petitioner
deferred the payment of some of the Officers' compensation until
the year in issue. This factor favors petitioner.
k. Employer's Past and Present Financial Condition
Petitioner grew and became very profitable. Its equity grew
from $63,903 on July 31, 1983, to $960,582 on July 31, 1985, an
increase of 1,403 percent. This factor favors petitioner.
l. Whether Employer and Employee Dealt at Arm's Length
Where an employer and an employee are not dealing at arm's
length, the amount of compensation paid may be unreasonable.
Owensby & Kritikos, Inc. v. Commissioner, supra at 1324; Elliotts
- 31 -
Inc. v. Commissioner, 716 F.2d at 1246; see Gilman Paper Co. v.
Commissioner, 284 F.2d 697 (2d Cir. 1960), affg. T.C. Memo.
1960-13.
Respondent argues that some of the compensation that
petitioner paid to the Officers was unreasonable by virtue of the
fact that some portion of their compensation exceeded the amounts
fixed in their employment agreements. We disagree. While it may
have been good corporate form for petitioner to have amended the
employment agreements to provide for the extra compensation, such
a formality is not dispositive of the realities here. Surely the
compensation paid was agreed to by the Officers, and certainly
the Officers were in control of petitioner and could have had
petitioner approve the increase in compensation. It is not
dispositive that petitioner failed to adhere to corporate
formalities in setting the amount of compensation to the
Officers. As the Court observed in Levenson & Klein, Inc. v.
Commissioner, 67 T.C. 694, 714 (1977) (quoting Reub Issacs & Co.
v. Commissioner, 1 B.T.A. 45, 48 (1924)): “Closely held
corporations, as is well known, often act informally, 'their
decisions being made in conversations, and oftentimes recorded
not in minutes, but by action.'" See id. at 713-714 (courts may
give little or no weight to the lack of corporate formality in
closely held corporations); Mad Auto Wrecking, Inc. v.
Commissioner, T.C. Memo. 1995-153.
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We find most relevant the percent of stock owned by each of
the Officers in determining whether their compensation is
attributable to arm's-length bargaining. Mr. Woll was a minority
shareholder, and he was constantly trying to increase his
ownership interest and salary. Mr. Laviano, on the other hand,
was the majority shareholder. He wanted petitioner to keep cash
reserves in the business for working capital. We believe that
Mr. Woll bargained at arm's length with petitioner.
Given Mr. Laviano's relationship to petitioner as its
controlling shareholder, we must inquire whether an independent
investor would have paid Mr. Laviano the amount of compensation
that he received during the subject year. See Owensby &
Kritikos, Inc. v. Commissioner, supra at 1326-1327; see also
Elliotts, Inc. v. Commissioner, supra at 1246-1247. We conclude
that an independent investor would have approved of the
compensation paid to Mr. Laviano, in view of the nature and
quality of the services that he performed for petitioner and the
effect of his services on a hypothetical investor's return on
investment. This factor favors petitioner.
m. Whether Employee Guaranteed Employer's Debt
Courts have considered whether an employee personally
guaranteed his or her employer's debt, in determining whether the
employee's compensation is reasonable. In certain situations, an
employee's personal guaranty of his or her employer's debt may
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entitle the employer to pay a greater salary to the employee than
the employer would otherwise have paid. See Owensby & Kritikos,
Inc. v. Commissioner, 819 F.2d at 1325 n.33; R.J. Nicoll Co. v.
Commissioner, supra at 51; see also Acme Constr. Co. v.
Commissioner, T.C. Memo. 1995-6; BOCA Constr. Inc. v.
Commissioner, T.C. Memo. 1995-5.
The Officers guaranteed the repayment of $500,000 that
petitioner borrowed from the First National Bank of Long Island
on June 20, 1984. Thus, at first blush, this factor would appear
to favor petitioner. We bear in mind, however, that the $500,000
proceeds were lent to the Officers by petitioner interest free,
immediately after petitioner received these funds from the bank.
The fact that the Officers received an interest-free loan from
petitioner negates the fact that the Officers guaranteed the
debt. This factor favors neither party. We consider it neutral.
n. Absence of Pension Plan/Profit-Sharing Plan
Courts have considered the absence of a pension plan or a
profit-sharing plan in determining reasonable compensation.
Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988),
affg. T.C. Memo. 1986-407; Kennedy v. Commissioner, 671 F.2d at
174-175. Such an absence may allow the employer to pay the
employee more compensation than the employer would have paid had
the employer offered the employee a pension plan or a profit-
sharing plan. Rutter v. Commissioner, supra at 1274.
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Petitioner did not have a pension plan; thus, the Officers
did not receive the benefit of any pension contributions. This
factor favors petitioner.
o. Reimbursement of Business Expenses
Courts have considered the reimbursement of business expenses
in determining reasonable compensation. An employer may pay
greater compensation to an employee to reflect the fact that the
employee is not being reimbursed for expenses that he or she paid
on behalf of the employer. Id.
The Officers were reimbursed for their out-of-pocket expenses
incurred on behalf of petitioner. The record, however, does not
disclose the exact amount of these expenses. Moreover, it does
not appear that any of those expenses were incurred with other
than a corporate benefit in mind. This factor favors neither
party. We consider it neutral.
p. Conclusion on Reasonableness
Most of the factors described above favor petitioner, and
none of them favor respondent. We conclude that the $1,461,000
paid to Mr. Laviano in 1985 was reasonable compensation for that
year. We conclude likewise with respect to the $1,461,000 paid
to Mr. Woll in 1985.
2. Whether Compensation Was Paid for Services Rendered to
Petitioner
According to respondent, petitioner is not entitled to deduct
all of the compensation paid to the Officers because it paid part
of this compensation for services that they performed on account
of other, related companies. We disagree. Although the Officers
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provided some services to other related entities, we are unable
to find that these services were performed on behalf of anyone
other than petitioner. We hold that petitioner paid the Officers
the subject compensation for services that they rendered to it.
3. Conclusion
Based on the above, we conclude that petitioner may deduct
the $1,461,000 that it paid to Mr. Laviano, and it may deduct the
$1,461,000 that it paid to Mr. Woll. In so concluding, we have
considered all arguments made by respondent for a contrary
holding and, to the extent not discussed above, we find them to
be without merit.
To reflect the foregoing,
Decision will be entered
for petitioner.