T.C. Memo. 1996-563
UNITED STATES TAX COURT
SUMMIT SHEET METAL CO., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20131-93. Filed December 30, 1996.
Elliott H. Kajan and Steven R. Mather, for petitioner.
Lisa W. Kuo and T. Elizabeth Stetson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined a deficiency in
petitioner's Federal income tax of $307,671 for 1987.
Petitioner is an S corporation. An S corporation is liable
for tax on net recognized built-in gain if that gain exceeds 50
percent of its taxable income for the year in issue. Sec.
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1374(a).1 Respondent determined that petitioner is liable for
tax under section 1374(a).
Petitioner realized capital gains of $929,915 in the year in
issue. That amount is $12,762 more than 50 percent of the amount
of petitioner's revised taxable income for the year in issue.
Petitioner seeks to increase its taxable income so that its
capital gains are less than 50 percent of its taxable income.
Thus, petitioner has adopted positions which, if successful,
would increase its taxable income. Petitioner contends (1) that
it paid unreasonable compensation to its officers during the year
at issue, and (2) that it improperly deducted bonuses it paid to
its officers in the year at issue (when petitioner declared the
bonuses) instead of the following year (when petitioner paid the
bonuses).
We must decide the following issues:
1. Whether reasonable compensation for petitioner's
officers for the year in issue is $618,295 as respondent contends
and as petitioner reported on its return, $421,938 as petitioner
contends, or some other amount. We hold that $618,295 is
reasonable.
2. Whether, as respondent contends, petitioner must have
respondent's consent to delay deductions for bonuses from the
1
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.
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year petitioner declared the bonuses to the following year when
the bonuses were paid because it is a change in accounting method
under section 446(e). We hold that it must.
3. Whether petitioner's net recognized built-in gain was
more than 50 percent of its taxable income in the year in issue.
We hold that it was.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Petitioner
Petitioner is a California corporation which was
incorporated on August 30, 1960. Its principal place of business
was in Orange County, California, when it filed the petition in
this case.
Petitioner manufactured and installed flashing, vents,
pipes, and light-gauge sheet metal for housing projects in
southern California. Ninety percent of petitioner's business was
sheet metal installation, and 10 percent was sheet metal
fabrication. There were 8 to 10 other companies in Orange County
also doing that work. Petitioner served a large part of southern
California, including the counties of San Diego, Orange, Los
Angeles, and Riverside.
Petitioner's fiscal years ended on June 30 in 1964, 1966 to
1975, 1977, 1978, 1980 to 1982, 1984, and 1985. In 1986,
petitioner changed the end of its fiscal year from June 30 to
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September 30. Petitioner's fiscal year ended on September 30 in
1986 and 1987. In 1987, petitioner changed its fiscal year to
end on December 31.
Petitioner had an initial capital investment of $65,579 in
1960 and had total assets of $4,183,222 on September 30, 1987.
Petitioner made a profit every year from 1960 to the year in
issue. Petitioner had more jobs under contract in the year in
issue than in previous years. The number of petitioner's
employees increased greatly from 1984 to 1990.
Petitioner's financial situation in fiscal years 1986 and
1987 was as follows:
FY 1986 FY 1987
Total sales $6,666,643 $8,621,838
Gross profit 2,746,670 3,560,057
Ordinary income
before taxes 803,997 893,236
Beginning total assets 3,407,735 3,761,574
Ending total assets 3,761,574 4,183,222
Beginning total equity 1,822,375 2,020,646
Ending total equity 2,020,646 3,391,012
Beginning total capital stock
and paid-in stock or surplus
less paid treasury stock 50,446 50,446
Ending total capital stock
and paid-in stock or surplus
less cost of treasury stock 50,446 50,446
Beginning accumulated
adjustments account 636,158 824,587
Ending accumulated
adjustments account 824,587 2,190,307
Beginning retained earnings 1,135,771 1,135,771
Ending retained earnings 1,135,771 1,135,591
Petitioner's success in the year in issue resulted in part
from an increase in housing construction in southern California.
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Petitioner has used the accrual method of accounting since
1964. Petitioner paid administrative salaries of $192,079 and
cost of labor of $2,901,375 during the year in issue.
B. Petitioner's Shareholders and Officers
1. Milton J. Chasin
Milton J. Chasin has a bachelor of science degree in
accounting. He was licensed as a public accountant in 1948 or
1949. He was employed as an auditor with the California State
Board of Equalization in the late 1940's.
Chasin cofounded petitioner in 1960 with Morley Weis (not
otherwise described in the record) and Donald Hanson. Gale
Searing became a one-third shareholder of petitioner in 1964
after Weis died. Chasin was responsible for the administration
of petitioner. He established and was responsible for
petitioner's books and records. He kept accurate records for
petitioner from 1960 through the year in issue. He negotiated
loans and bought material and equipment for petitioner. He
negotiated a line of credit for petitioner with Metropolitan Bank
in the year in issue. Chasin always had an assistant to help him
with the administrative duties.
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Chasin worked about 35 hours per week and took about 5 weeks
of vacation in the year in issue.
2. Donald Hanson
Hanson graduated from high school. He has no professional
licenses. He has owned one-third of petitioner since 1960. He
was petitioner's president in the year in issue.
Hanson was more directly involved with petitioner's
operations in petitioner's early years than he was during the
year in issue. His duties in the early years included
fabricating in the shop, installing, and bidding.
During the year in issue, Hanson was responsible for
estimating jobs, running the production shop, overseeing union
contracts, and supervising petitioner's union employees. His
primary duty was to get jobs for petitioner. He was the person
primarily responsible for doing this. He reviewed the contracts
in which petitioner agreed to provide materials and perform
services. Petitioner's shop foreman and two estimators reported
to him. Petitioner had no union problems during the year in
issue.
Hanson worked for petitioner about 8 hours per day, 50 weeks
per year during the year in issue. He also worked for Summit
Supply Co., which was owned by Chasin, Hanson, and Searing. He
took 4 to 5 weeks of vacation each year.
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3. Gale Searing
Searing did not have a high school education. He was a
sheet metal apprentice for 3½ years in the early 1950's, after
which he received a journeyman's card. He did not have a
professional license. He was petitioner's field superintendent
during the year in issue.
In the year in issue, Searing was responsible for
petitioner's metal work installation. He supervised installers’
supervisors and coordinated installation of petitioner's product.
He was responsible for petitioner's laborers.
Searing, Chasin, and Hanson knew each other's duties but did
not know how to perform them. Searing worked 8 hours per day, 50
weeks per year for petitioner and took about 10 days of vacation
during the year in issue. He also worked for North County
Builders and Summit Supply Co. Searing received cash
distributions, but not wages, from Summit Supply Co.
4. Petitioner's Board of Directors and Officers
Chasin, Hanson, and Searing were the only members of
petitioner's board of directors from 1964 to the year in issue.
They have each owned one-third of petitioner's stock since 1964.
During the year in issue, Hanson was president, Chasin was vice
president and chief financial officer, and Searing was secretary.
Chasin, Hanson, and Searing consulted with each other before
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making important decisions for petitioner. Chasin, Hanson, and
Searing never had a written employment contract with petitioner.
During the year in issue, petitioner paid salaries of $108,575 to
Chasin, $131,360 to Hanson, and $131,360 to Searing. Petitioner
had a retirement plan for its nonunion employees including
Chasin, Hanson, and Searing. Petitioner contributed $30,000 to
its retirement plan in the year in issue for each of its three
shareholders.
Each of the three shareholders had authority to sign
petitioner's checks during the year in issue without having them
cosigned by another shareholder. Chasin, Hanson, and Searing
reported their income and expenses on a calendar year basis and
used the cash method of accounting.
Petitioner had a $50,000 group term life insurance policy
for each shareholder.
5. Summit Supply Co. and North County Builders
Chasin, Hanson, and Searing were equal partners of Summit
Supply Co., a California general partnership, in 1986 and 1987.
Summit Supply Co. bought, developed, and sold real estate.
Summit Supply Co. did not pay Chasin, Hanson, or Searing for
their services to Summit Supply Co., which consisted of helping
to buy, develop, and sell real estate. Chasin, Hanson, and
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Searing each received equal amounts of the net profits from
Summit Supply Co.
Chasin, Hanson, and Searing owned North County Builders with
Sherman and Harris (neither of whom is otherwise described in the
record). North County Builders was developing an apartment house
project in the year in issue.
C. Bonuses Paid to Chasin, Hanson, and Searing
1. Petitioner's Bonus Payment Procedures
Petitioner authorized bonuses each year for its officers for
their services. Petitioner's board of directors (Chasin, Hanson
and Searing) authorized the bonuses to be paid when petitioner's
cash position reasonably permitted, but not later than September
15 of each taxable year from 1966 to 1986 except 1971 and 1972.
In taxable years 1971 and 1972, petitioner's board of directors
authorized an approximate amount for a combined salary and bonus
for each officer.
Chasin, Hanson, and Searing met each year to consider
factors such as petitioner's success, development, profits,
needs, and tax considerations and their own tax considerations in
deciding the amount of the bonuses. Chasin, Hanson, and Searing
agreed unanimously on the amounts of their bonuses each year,
including the year in issue. Each year, Chasin, Hanson, and
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Searing signed a corporate resolution stating what they decided
about their bonuses.
2. Timing of Petitioner's Bonus Payments
Petitioner paid the bonuses after the end of each of its
fiscal years before the year in issue, but not later than
September 15 of each year, except the year in issue. For those
years, the resolution authorizing the bonuses said:
NOW, THEREFORE, BE IT RESOLVED, that a bonus of
[amount for each year for each officer] * * * to each
of the * * * [officers] be and the same hereby is
granted and awarded, the same to be paid to said
persons as soon hereafter as the cash position of the
corporation reasonably permits, but in any event on or
before September 15, * * * [year bonuses are
authorized].
Petitioner paid the bonuses after the end of its fiscal
years ending on September 30 in 1986 and 1987 and before December
15 of those years.
Chasin, Hanson and Searing unanimously approved the
following resolution on September 16, 1987:
WHEREAS, the success and development of the
business of this corporation during the fiscal
year to end September 30, 1987 is largely the
result of the efforts of certain of the key
personnel of this corporation; and
WHEREAS, it is deemed to be to the best interests
of this corporation to provide for a special
reward for the efforts of said key personnel in
order that said key personnel be furnished with a
continuing incentive; and
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WHEREAS, DONALD HANSON, President of this
corporation, MILTON J. CHASIN, Vice President of
this corporation, GALE SEARING, Secretary of this
corporation, have each contributed in a special
degree to the success of this corporation; and
WHEREAS, PAUL HARDIE, Estimator, HERMAN AUSLANDER,
Field Superintendent, TOM KRAEMER, Assistant Field
Superintendent, GEORGE KARSTEN, Shop
Superintendent, BILL BUSHEY, Estimator, and LINDA
SANDS, Bookkeeper, are also worthy of special
recognition;
NOW, THEREFORE, BE IT RESOLVED, that the following
bonuses be paid by the corporation on or before
December 15, 1987:
Employee Amount of Bonus
Herman Auslander $46,000
Bill Bushey $ 7,200
Paul Hardie $47,000
George Karsten $46,000
Tom Kraemer $25,000
Linda Sands $ 6,000
Officer Amount of Bonus
Milton J. Chasin $75,000
Donald Hanson $75,000
Gale Searing $97,000
The resolution for the year in issue required petitioner to
pay the bonuses by December 15, 1987. Chasin, Hanson, and
Searing could not have been paid the bonuses in the year in issue
without the consent of all of them.
3. Payment of the Bonuses in 1987
On September 30, 1987, pursuant to the board's resolution,
petitioner debited its payroll expense--officers account by
$247,000 for bonuses it declared that year. Chasin recorded
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petitioner’s accrued liability for wages in a document entitled,
"Summit Sheet Metal Company, Inc. Accrued Wages”. Chasin entered
each officer's bonus on that document on September 30, 1987.
Petitioner paid the bonuses on December 15, 1987, by paying
Federal and State payroll taxes for its officers in the following
amounts: $75,000 for Chasin, $75,000 for Hanson, and $97,000 for
Searing.
4. Summary of Petitioner's Practices Relating to Bonuses
It Paid to Its Officers
Petitioner declared bonuses for its three officers near the
end of each of its fiscal years from 1966 to the year in issue
and paid the bonuses in the first 75 days following the end of
the fiscal year in which they were declared. Petitioner accrued
the deduction for the bonuses in the year the bonuses were
declared in its fiscal years from 1966 through 1987.2
D. Building Sale
Petitioner sold a building on May 1, 1985, and realized a
net capital gain of $1,160,069. Petitioner reported the gain
under the installment method. Petitioner received the final
2
This fact is established for 1984 to 1987 by petitioner's
tax returns; for 1966 to 1983 we infer that petitioner's practice
was the same because petitioner's practice of declaring and
paying bonuses was consistent from 1966 to 1987, and because
neither party contends otherwise.
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payment of $1.2 million in the year in issue. Of that amount,
$929,915 was taxable.
E. Petitioner's S Corporation Election and Income Tax Returns
Petitioner was a subchapter C corporation from August 30,
1960, to June 30, 1985. On July 1, 1985, petitioner elected to
be taxed under subchapter S.
Petitioner deducted $247,000 for bonuses it paid to its
officers as part of the compensation of $618,295 it paid to the
officers (not counting fringe benefits) for the year in issue.
Petitioner reported the following on a Schedule K attached
to its S corporation return for the year in issue:
Ordinary income $893,236
Income from rental real
estate activity 38,033
Long term capital gain 929,915
Charitable contributions (2,845)
Total $1,858,339
Petitioner did not include the $929,915 gain on its tax
return for 1987. However, petitioner reported each officer's
share on his respective Schedule K-1. Petitioner allocated the
gain to Chasin, Hanson, and Searing, each of whom reported one-
third of the gain on his individual income tax return for 1987.
Petitioner seeks to delay the year of its deduction of
bonuses for its officers from the year in issue to the following
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year. Petitioner did not ask respondent for permission to change
its method of accounting for the year in issue.
Petitioner overstated its ending inventory on its return
for 1987 by $24,033.
OPINION
A. Background
Petitioner realized a $1,160,069 net capital gain from the
sale of a building in May 1985. At that time, petitioner was a C
corporation. Petitioner reported the gain on the installment
method, thereby postponing recognition of $929,915 of the gain
until 1987 when it was to receive the last installment. Sec.
453(c).
On July 1, 1985, petitioner elected to be taxed as an S
corporation. At that time, petitioner had a realized but
unrecognized capital gain of $929,915 from the sale. That amount
is $12,762 more than 50 percent of the amount of petitioner's
revised taxable income for the year in issue (before deciding the
issues in dispute here).3 An S corporation must pay tax if its
net recognized built-in gain is more than 50 percent of its
taxable income. Sec. 1374(a).
3
This takes into account petitioner's inadvertent $24,033
understatement of its ending inventory.
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Respondent determined a deficiency in petitioner's income
tax of $307,671 for 1987. Respondent’s determination is presumed
to be correct, and petitioner bears the burden of proving
otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).
B. Whether Petitioner Paid Unreasonable Compensation to its
Officers in the Year in Issue
Petitioner contends that it deducted an unreasonable amount
for officers’ compensation for the year in issue. Petitioner
contends that a total of no more than $421,938 is reasonable
compensation for its three officers. Respondent contends that
the compensation petitioner paid and deducted ($618,295) was
reasonable.
1. Whether All of the Compensation Was Paid for Services
Provided to Petitioner
A corporation may deduct "a reasonable allowance for
salaries or other compensation for personal services actually
rendered". Sec. 162(a)(1). Reasonable compensation must be
purely for services provided to the company which provides the
compensation. 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.
Petitioner contends that Searing and Hanson spent a
substantial amount of time in the years in issue working for
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North County Builders, which were businesses other than
petitioner. Hanson testified that he worked about 25 hours a
week for petitioner. Searing testified that he worked for
petitioner from 2 to 10 hours a week. Respondent contends that
petitioner paid its officers exclusively for services performed
for petitioner.
We agree with respondent. Petitioner's interrogatory
answers conflict with Hanson's and Searing's testimony. In
supplemental interrogatory response for petitioner, Chasin stated
that Searing and Hanson "rendered services for petitioner based
upon an 8-hour day for 50 weeks per year." The supplemental
response suggests that the officers provided substantial services
for petitioner. Chasin testified that the supplemental response
included services for business ventures other than petitioner.
Chasin's explanation is contrary to the language in the
supplemental response, which states that the services were for
petitioner.
North County Builders had five owners, including
petitioner's three officers. It is implausible that petitioner
would pay salaries that North County Builders owed.
Petitioner's board of directors adopted written resolutions
which stated that petitioner declared the bonuses because its
officers contributed substantial services to petitioner.
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Petitioner contends that this language from its resolutions means
nothing because it used the identical language for many years as
boilerplate. We do not believe that the board of directors took
the decisions to pay the bonuses and the resolutions approving
them as lightly as petitioner suggests.
We conclude that petitioner paid the compensation at issue
for services performed by its officers for petitioner.
2. Whether the Compensation Was Reasonable in Amount
Whether the amount of compensation is reasonable is a
question of fact. Botany Worsted Mills v. United States, 278
U.S. 282, 289-290 (1929); Estate of Wallace v. Commissioner, 95
T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992).
Factors to consider in deciding whether compensation is
reasonable include (a) the employee's qualifications; (b) the
nature, extent, and scope of the employee's work; (c) the size
and complexity of the business; (d) a comparison of salaries paid
with sales, net income, gross income, and capital value; (e)
general economic conditions; (f) the taxpayer's salary policy to
all employees; (g) the taxpayer's financial condition; (h)
prevailing rates of compensation for comparable positions in
comparable companies; (i) compensation paid in prior years; and
(j) whether the employee and the taxpayer dealt at arm's length.
Elliotts, Inc. v. Commissioner, supra at 1245-1248; Kennedy v.
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Commissioner, 671 F.2d 167, 173-174 (6th Cir. 1982), revg. and
remanding 72 T.C. 793 (1979); Mayson Manufacturing Co. v.
Commissioner, 178 F.2d 115, 119 (6th Cir. 1949); R.J. Nicoll Co.
v. Commissioner, 59 T.C. 37, 48 (1972). No single factor
controls. Mayson Manufacturing Co. v. Commissioner, supra.
Petitioner called an expert, Edwin A. Scott, Jr. (Scott), to
testify about the reasonable compensation issue. Respondent did
not call an expert to testify. Expert witnesses' opinions may
help the Court understand an area requiring specialized training,
knowledge, or judgment. Snyder v. Commissioner, 93 T.C. 529, 534
(1989). We may be selective in deciding what part of an expert's
opinion we will accept. Helvering v. National Grocery Co., 304
U.S. 282, 295 (1938); Silverman v. Commissioner, 538 F.2d 927,
933 (2d Cir. 1976), affg. T.C. Memo. 1974-285; Parker v.
Commissioner, 86 T.C. 547, 561-562 (1986).
a. Employees' Qualifications
An employee's superior qualifications for a position may
justify high compensation. See, e.g., Home Interiors & Gifts,
Inc. v. Commissioner, 73 T.C. 1142, 1158 (1980); Dave Fischbein
Manufacturing Co. v. Commissioner, 59 T.C. 338, 352-353 (1972).
Each of petitioner's officers was well qualified for his
position. All three officers performed successfully for
petitioner.
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Petitioner contends that a suitable replacement could
perform the job of each officer. Petitioner’s point does not
establish much because it does not address how difficult it would
be or what amount of pay would have been required to find someone
suitable.
This factor tends to show that the compensation at issue was
reasonable.
b. Nature, Extent, and Scope of Duties
The position held by the employee, hours worked, and duties
performed may justify high compensation. Mayson Manufacturing
Co. v. Commissioner, supra; see, e.g., Elliotts, Inc. v.
Commissioner, supra 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); Home Interiors &
Gifts, Inc. v. Commissioner, supra at 1158.
Petitioner contends that its officers had minimal
responsibilities. We disagree. Each officer was responsible for
an important part of petitioner's operations. Petitioner's
officers did not know how to perform each other's jobs. This
made each of them less valuable to petitioner. By the year in
issue, petitioner was a well-established and stable business.
Petitioner's officers were no doubt required to work less than if
petitioner had been a new business.
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On balance, this factor tends slightly to show that the
compensation at issue was reasonable.
c. Size and Complexity of Taxpayer
The size and complexity of a taxpayer's business can
indicate whether compensation is reasonable. Elliotts, Inc. v.
Commissioner, 716 F.2d 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, supra.
Petitioner's witnesses testified that petitioner's business was
straightforward and routine. However, petitioner had sales in
the year in issue of more than $8.6 million. It had assets of
$3.8 million at the start of the year in issue and $4.2 million
at the end. Petitioner served a large part of Southern
California, including the counties of San Diego, Orange, Los
Angeles, and Riverside.
Considering both the testimony and the other evidence of
petitioner's business, we conclude that this factor tends to show
that the compensation at issue was reasonable.
d. Comparison of Salaries Paid With Sales, Net
Income, Gross Income, and Capital Value
Courts have compared compensation to sales and gross and net
income in deciding whether compensation is reasonable. Elliotts,
Inc. v. Commissioner, supra at 1246; Mayson Manufacturing Co. v.
Commissioner, supra.
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Petitioner's compensation of officers was 7.2 percent of
sales. In Mayson Manufacturing Co., the Court found compensation
that was more than 25 percent of sales to be reasonable. Mayson
Manufacturing Co. v. Commissioner, supra at 120. Petitioner's
officers' compensation was 41 percent of petitioner's ordinary
income before taxes and deduction of officers' compensation. We
have found that compensation equal to 43 percent of gross profit
is reasonable for a company comparable in size to petitioner.
L & B Pipe & Supply Co. v. Commissioner, T.C. Memo. 1994-187.
This factor tends to show that the compensation at issue
was reasonable.
e. General Economic Conditions
General economic conditions may affect a company's
performance and, thus, show the extent, if any, of an employee's
effect on the company. Elliotts, Inc. v. Commissioner, supra;
Mayson Manufacturing Co. v. Commissioner, supra.
Petitioner's sales increased more than 70 percent in the 2
years before the year in issue. Petitioner's officers testified
that petitioner succeeded because there was an economic boom in
Southern California before and during the year in issue.
Respondent did not effectively challenge their testimony on this
point. This factor tends to show that the compensation at issue
was unreasonable.
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f. Taxpayer's Salary Policy to All Employees
Courts have considered the taxpayer's salary policy for its
other employees in deciding whether compensation is reasonable.
Home Interiors & Gifts, Inc. v. Commissioner, supra at 1159.
There is no evidence that petitioner has a formal policy for
setting salaries for its officers or other employees. Because
the record is not clear on this point, we do not apply this
factor.
g. Taxpayer's Financial Condition
The past and present financial condition of the company is
relevant to deciding whether compensation is reasonable. Id. at
1157-1158.
Petitioner grew from total equity (capital stock and paid-in
surplus) of $65,579 to $2,020,646 for the year in issue.
Petitioner always made a profit. For the year in issue,
petitioner's gross profit was 41 percent of gross income, return
on sales was 10.3 percent, return on assets was 22.5 percent, and
return on equity was 33 percent. Petitioner's officers'
compensation decreased 16.3 percent as a percentage of net sales
from the year before the year in issue to the year in issue while
its sales and gross profit increased nearly 30 percent.
Petitioner points out that a survey by the Sheet Metal and
Air-Conditioning Contractors' National Association (SMACNA) dated
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October 26, 1988, shows that petitioner's compensation of its
officers exceeds the average amount paid by similar firms.
However, this does not establish that the compensation of
petitioner's officers was unreasonable because the SMACNA survey
also shows petitioner performed considerably better financially
than the SMACNA survey respondents.
SMACNA sent each member a questionnaire asking for financial
information, such as gross profit, gross sales, and executive
compensation. Forty-one SMACNA survey respondents had sales of
more than $8.2 million. The following chart compares the SMACNA
survey results for these respondents with data for petitioner for
the year in issue.
SMACNA survey respondents
with sales over $8.2 Million
Net income SMACNA
before tax as a -- average Petitioner
Percent of sales 3.5 10.3
Percent of assets 9.3 22.5
Percent of net worth 25.0 33.0
The 41 respondents had an average gross profit margin of
18.8 percent of sales; petitioner had 41 percent in the year in
issue. Petitioner's financial performance was superior to that
of SMACNA survey respondents which had sales exceeding $8.2
million.
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This factor tends to show that the compensation at issue was
reasonable.
h. Prevailing Rates of Compensation for Comparable
Positions in Comparable Companies
In deciding whether compensation is reasonable, we compare
it to compensation paid for comparable positions in comparable
companies. Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th
Cir. 1983); Mayson Manufacturing Co. v. Commissioner, 178 F.2d
115 (6th Cir. 1949). Scott points out that petitioner's officers
were paid more than the average paid to officers of companies
that responded to the SMACNA and Contractor magazine surveys.
While both surveys have flaws for our purposes, respondent
offered no evidence on salary comparability. We conclude that
this factor tends to show that the compensation was unreasonable.
i. Compensation Paid in Prior Years
An employer may deduct compensation paid in a year even
though the employee performed the services in a prior year.
Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); R.J.
Nicoll Co. v. Commissioner, 59 T.C. at 50-51.
Petitioner's officers testified that petitioner may have
underpaid them in the early years, but that petitioner caught up
at least 10 years before the years in issue. Respondent points
out that petitioner offered no documentary evidence on this
factor; however, respondent offered no evidence that contradicts
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the testimony of petitioner's officers. Their testimony was
credible on this point. We conclude that none of the
compensation in the year at issue was paid for services performed
in prior years. This factor tends to show that the compensation
was unreasonable.
j. Whether the Employee and Employer Dealt at Arm's
Length
We closely scrutinize compensation if the employee controls
the employer to see whether it is unreasonable in amount or
payment 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 1246; Charles Schneider & Co. v.
Commissioner, 500 F.2d 148, 152-154 (8th Cir. 1974), affg. T.C.
Memo. 1973-130.
Chasin, Hanson, and Searing owned 100 percent of
petitioner's stock. That leads us to consider whether an
independent investor would have approved the compensation in view
of the nature and quality of the services performed and the
effect of those services on the investor's return on his or her
investment. Owensby & Kritikos, Inc. v. Commissioner, supra at
1326-1327; Elliotts, Inc. v. Commissioner, supra at 1246-1247.
An independent investor would have received a 33-percent return
on equity. We believe that an independent investor would approve
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petitioner's officers' compensation because of the officers'
successful leadership of petitioner.
This factor tends to show that the compensation at issue for
services to petitioner was reasonable.
3. Conclusion
We conclude that the compensation of petitioner's officers
in the year in issue was reasonable because of their
qualifications and the scope of their duties, petitioner's size,
growth, and financial success, the officers' compensation in
relation to petitioner's sales, and the fact that, according to
the SMACNA survey, the taxpayer performed well compared to other
reasonably comparable firms.
C. Whether Petitioner May Change the Year It Deducts Bonuses
Without Respondent's Consent
1. Contentions of the Parties
Petitioner seeks to change the year it deducts its officers'
bonuses from the year it authorized them, as petitioner reported
on its return, to the following taxable year, in which the
officers received and reported the bonuses.
Respondent contends that petitioner needed but did not have
respondent's permission to change the year it deducted its
officers' bonuses.4 Sec. 446(e).
4
Petitioner contends that respondent’s contention that
(continued...)
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Petitioner contends that changing the year it deducts its
officers' bonuses is not a change of accounting method, and that
it is a correction required to comply with section 267(a).
Section 267(a)(2), which was enacted in 1984, bars a taxpayer
from deducting a payment to a related taxpayer before the related
taxpayer includes the payment in income. Petitioner contends
that its accrual of a deduction for the bonuses in the year they
are awarded (before they are paid) violates section 267(a)(2)
because petitioner's officers included the bonuses in income in a
later year. Petitioner contends that it does not need
respondent's consent to change to comply with section 267(a)(2).
4
(...continued)
petitioner must have consent under sec. 446(e) is new matter on
which respondent bears the burden of proof. We agree.
Respondent first raised this issue in the amended answer. A new
theory that is presented to sustain a deficiency is treated as a
new matter when it either increases the original deficiency or
requires the taxpayer to present different evidence. Wayne Bolt
& Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989); Achiro v.
Commissioner, 77 T.C. 881, 890-891 (1981). This issue is a new
matter because the evidence relevant to it differs from that
relevant to the original determination. Respondent bears the
burden of proof for any new matter. Rule 142(a).
Petitioner contends that respondent failed to carry the
burden of proof. We disagree. The parties do not dispute that
petitioner had a longstanding practice of deducting the bonuses
in the year it authorized them and paying them in the following
year, that petitioner seeks to change the year it deducts the
bonuses for its officers from the year in issue to the next
taxable year to comply with sec. 267(a) several years after the
law changed, and that petitioner does not have respondent's
consent to do so. We decide this issue based on those facts.
Thus, the burden of proof does not affect our decision on this
issue.
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Similarly, petitioner contends that it does not need respondent's
consent to change from treating the bonuses incorrectly to
treating them correctly.5
Respondent does not dispute that Chasin, Hanson, and Searing
are related for purposes of section 267(a). However, even if
section 267(a) applies, we conclude for reasons discussed next
that petitioner would need respondent's consent to change the
year it deducts the officers' bonuses.
2. Whether Changing the Year Petitioner Deducts Bonuses Is
a Change of a Material Item for Purposes of Section
446(e)
We first decide whether changing the year petitioner deducts
its officers' bonuses is a change in the treatment of a material
item for purposes of section 446(e).
A taxpayer generally must have the consent of the Secretary
to change the method of accounting it uses for material items.
Sec. 446(e); Pacific Enters. & Subs. v. Commissioner, 101 T.C. 1,
18 (1993); Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 509
(1989); Standard Oil Co. v. Commissioner, 77 T.C. 349, 380
(1981); secs. 1.446-1(e)(2)(ii)(a), 1.481-1(a)(1), Income Tax
5
Respondent alternatively contends that petitioner complied
with sec. 267(a)(2) because petitioner's officers constructively
received their bonuses in the year in issue. We need not decide
this issue because we conclude that sec. 267(a) does not apply,
and if it did, petitioner requires respondent's consent to change
the year it deducts its officers' bonuses.
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Regs. An item is material for purposes of section 446(e) if the
time for including it in income or deducting it is at issue.
Knight-Ridder Newspapers v. United States, 743 F.2d 781, 798
(11th Cir. 1984); Wayne Bolt & Nut Co. v. Commissioner, supra at
510; sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.
Petitioner's officers' bonuses are material items for
purposes of section 446(e) because petitioner seeks to change the
year it deducts the bonuses from the year it declared them to the
following year. Wayne Bolt & Nut Co. v. Commissioner, supra at
509-510; H.F. Campbell Co. v. Commissioner, 53 T.C. 439, 447
(1969), affd. 443 F.2d 965 (6th Cir. 1971); Fruehauf Trailer Co.
v. Commissioner, 42 T.C. 83, 103 (1964), affd. 356 F.2d 975 (6th
Cir. 1966); sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.
3. Whether Petitioner May Change Its Accounting Method
Without Respondent's Consent Based on a Change in Law
Before raising the section 267(a)(2) issue here, petitioner
had consistently deducted its officers' bonuses in the year it
authorized them. A change in the consistent treatment of a
material item generally requires the Commissioner's consent under
section 446(e). Witte v. Commissioner, 513 F.2d 391, 393-394
(D.C. Cir. 1975), revg. T.C. Memo. 1972-232; H.F. Campbell Co. v.
Commissioner, supra; Fruehauf Trailer Co. v. Commissioner, supra.
Petitioner contends that an accounting change made to comply
with section 267(a)(2) does not require respondent's consent.
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Petitioner relies on Douthit v. United States, 299 F. Supp. 397
(W.D. Tenn. 1969), revd. on other grounds 432 F.2d 83 (6th Cir.
1970). On May 13, 1960, Congress enacted the Dealer Reserve
Adjustment Act of 1960, Pub. L. 86-459, 74 Stat. 124. That act
required the taxpayers in Douthit to change their method of
accounting. The taxpayers in Douthit sought to comply with the
new law on their tax return for 1961.
The court in Douthit said: "Section 446(e) requiring
consent of the Commissioner is not applicable to a change in
accounting required by law." Douthit v. United States, supra at
403. In Douthit, the taxpayers changed their treatment of an
item in the tax return they filed for the first year in which the
law was effective. Id. at 400. In the instant case, the change
in law on which petitioner relies occurred in 1984 and was
effective for taxable years beginning after December 31, 1983.
Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 174(a)(1) and
(b)(2)(A), 98 Stat. 494, 704, 708. Petitioner first cited
section 267(a) in this case in 1994 after the audit of its 1987
return and while this case was pending. Petitioner does not
contend that it raised this issue with respondent before that
time. The rationale for allowing a taxpayer to change an
accounting method immediately after the law is changed, e.g., to
simplify prompt compliance by a large number of taxpayers, is
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missing when a taxpayer does not act for several years, and acts
only after being audited and commencing a Tax court case for the
year at issue. Douthit is not controlling authority for
petitioner.
In United States v. Kleifgen, 557 F.2d 1293, 1297 n.9 (9th
Cir. 1977), a case decided by the U.S. Court of Appeals for the
Ninth Circuit, the court to which this case is appealable, the
court said:
The Commissioner’s consent to a change in
accounting methods is required regardless of whether
the change is from one proper method to another proper
method or from an improper method to a proper one.
Witte v. Commissioner, * * * 513 F.2d 391 (1975). See
Treas Reg. §1.446-1(e)(2).
In Southern Pac. Transp. Co. v. Commissioner, 75 T.C. 497,
682 (1980), supplemented by 82 T.C. 122 (1984), we said:
In addition, consent is required when a taxpayer,
in a court proceeding, retroactively attempts to alter
the manner in which he accounted for an item on his tax
return. If the alteration constitutes a change in the
taxpayer's method of accounting, the taxpayer cannot
prevail if consent for the change has not been secured.
[Citations omitted.6]
6
In dicta, the Court in Southern Pac. Transp. Co. v.
Commissioner, 75 T.C. 497, 685 (1980), said that it was not a
case in which the taxpayer was changing from an incorrect to a
correct method, but that if it were, it might be inclined, under
some decisions of this Court, to not require the Commissioner's
consent. We need not consider those dicta further in light of
the position of the U.S. Court of Appeals for the Ninth Circuit
in United States v. Kleifgen, 557 F.2d 1293, 1297 n.9 (9th Cir.
1977).
- 32 -
Petitioner points out that a taxpayer may recharacterize
interest or salary as dividends without being considered to have
changed its method of accounting. Section 1.446-1(e)(2)(ii)(b),
Income Tax Regs., does not apply here because the issue here is
the timing, not the character, of the deduction.
Petitioner relies on Evans v. Commissioner, T.C. Memo. 1988-
228, and Gimbel Bros., Inc. v. United States, 210 Ct. Cl. 17, 535
F.2d 14, 23 (1976). Both cases held that the taxpayer may
correct the treatment of an item without the Commissioner's
consent. Unlike those in the instant case, the taxpayers and the
corporation in Evans made the correction on their returns for the
year in issue.
In Gimbel Bros., Inc. v. United States, supra, the taxpayer
elected to use the installment method of accounting to report
income from installment sales but applied it erroneously. Id. at
15. The taxpayer filed amended returns to correct the error
apparently before the Commissioner audited the year in issue.
Unlike the taxpayers in Evans and Gimbel Bros., petitioner did
not seek to change how it treats the bonuses on a tax return or
an amended return. Rather, petitioner did so as part of this
case after respondent's audit.
Petitioner has cited other cases relating to a taxpayer's
change in accounting methods. We have considered all of those
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cases; the cases discussed above are those that most closely
resemble the instant case.
D. Conclusion
We hold that petitioner must have respondent's consent under
section 446(e) to change the year it reports payment of the
bonuses. Petitioner does not have respondent's consent. Thus,
petitioner may deduct its officers' bonuses only in the year in
issue as it reported on its return.
For the foregoing reasons, we conclude that petitioner is
liable for the tax under section 1374(a) on the $929,915 net
capital gain because the net capital gain is more than 50 percent
of petitioner's taxable income.
To reflect the foregoing and concessions,
Decision will be
entered under Rule 155.