T.C. Memo. 1997-251
UNITED STATES TAX COURT
JOHN L. GINGER MASONRY, INC., Petitioner v. COMMISSIONER
OF INTERNAL REVENUE, Respondent
Docket No. 1695-95. Filed June 4, 1997.
Gary E. Reddish and Scott R. Heil, for petitioner.
Maria D. Murphy and Margaret Kuo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
CLAPP, Judge: Respondent determined the following
deficiencies in petitioner's Federal income taxes:
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FYE
June 30 Deficiency
1990 $227,677
1991 52,981
1992 72,081
The issue for decision is whether the compensation paid to
petitioner's shareholder in its fiscal years ending 1990 and 1992
is deductible by petitioner as reasonable compensation under
section 162(a)(1). We hold that it is.
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
FINDINGS OF FACT
We incorporate by reference the stipulation of facts and
attached exhibits. John L. Ginger Masonry, Inc. (petitioner), is
a California corporation whose principal place of business was in
Riverside, California, when the petition was filed. Petitioner
operates on a fiscal year ending June 30. The deficiency
determined by respondent for the fiscal year ended June 30, 1991,
stems solely from adjustments tied to the fiscal years ended June
30, 1990, and June 30, 1992.
A. Petitioner
Petitioner is a masonry contractor that specializes in
brick, stone, and block masonry. Petitioner's founder, John L.
Ginger (Ginger), has spent his entire career in the construction
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business. Ginger's father was a contractor, and Ginger worked
for him during the summers. Ginger had no formal education past
high school. When Ginger completed high school, he began working
full time for his father. Ginger worked for other contractors
before starting his own masonry contracting business as a sole
proprietorship in 1978 with a capital investment of $500 and one
employee.
In September 1984, Ginger formed petitioner with a capital
investment of $15,000. Ginger and his wife, Toni S. Ginger (Mrs.
Ginger), owned equally all of petitioner's issued and outstanding
shares of stock. Ginger and Mrs. Ginger serve as petitioner's
board of directors. During the fiscal years ending 1985 through
1992, Ginger served as petitioner's president, and Mrs. Ginger
served as petitioner's corporate secretary. Mrs. Ginger had no
role with petitioner other than being a member of the board and
the corporate secretary.
Ginger quickly developed a reputation as an honest and
no-nonsense operator. Immediately after forming petitioner,
Ginger negotiated with vendors and asked them to help finance
petitioner's purchases. If petitioner was out of cash, Ginger
would call the owner of the creditor company, tell him that
petitioner could not pay the bill that month, and explain what
was being done to remedy the situation.
B. Ginger's Strategy When He Formed Petitioner
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While working for other contractors, Ginger noticed that the
masonry business was divided into contractors that worked on
commercial projects and contractors that worked on residential
projects. The commercial masonry contractors were large
companies that handled the large commercial jobs, such as high-
rise buildings, office buildings, and shopping centers. The
commercial masonry contractors were very professional. They had
solid reputations and had established working relationships with
the large developers overseeing the commercial construction
projects.
The residential masonry contractors, on the other hand,
consisted of mostly smaller companies that bid on projects in a
very limited geographic area. These contractors did not have
working relationships with the developers. Competition for jobs
was stiff, and the contractors would try and squeeze as much
profit from a job as possible, and often quality would suffer as
a result.
Ginger developed a strategy that would enable petitioner to
penetrate the residential masonry market. Ginger wanted to enter
that market with the same professionalism found in commercial
masonry. Ginger wanted to avoid an adversarial posture between
petitioner and the customers (i.e., the developers). Rather, he
wanted to work with the developers to make sure that they were
satisfied with petitioner's work. Ginger reasoned that if
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petitioner provided high-quality work, the developers would
continue to hire petitioner year after year.
Ginger realized that working with the large developers was
essential to petitioner's success. The large developers were
building entire housing tracts, and they were the most reliable
source for a steady volume of masonry projects. Ginger also
realized that, in order to work with large developers, petitioner
would need a lot of equity to meet its operating expenses.
Ginger knew that some large developers would wait 90 to 100 days
before paying the masonry contractor. The large developers
wanted contractors on the job that could complete the project, on
time, without problems. As a result, the developers avoided
contractors with insufficient resources. Ginger consulted with
petitioner's accountant, Gary Christenson (Christenson).
Christenson advised Ginger that petitioner would have to
accumulate substantial amounts of working capital and maintain
strong financial statements before it could work with the large
developers. Thus, in the years 1985 through 1989, Ginger's first
priority was to grow petitioner to an acceptable size; to this
end, he took less compensation in order to speed the process of
reaching petitioner's capitalization goals.
Ginger's insight proved accurate, and petitioner began to
develop a good reputation among the residential developers.
After winning the trust of the residential developer, the
developer would often contact Ginger directly to get a
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preliminary cost estimate. The developer would use the
preliminary estimate to develop a budget on a project. In
essence, Ginger served as consultant to the residential
developer, providing information such as the type of products the
developer should use or a cost-saving approach to a problem.
When the preliminary work was finished and the job was set
to go forward, the residential developer would want petitioner to
get the job because Ginger already was familiar with it. As a
result, the residential developer would be more lenient with
petitioner in the bidding process than might otherwise be the
case. This proved crucial to petitioner's success because it
gave Ginger the opportunity to negotiate a final bid with the
developer. This was not standard practice in the industry.
Typically, the subcontractor submitting the lowest bid would get
the job, but petitioner generally was not the lowest bidder. In
fact, Ginger did not want petitioner to be the lowest bidder.
Because of Ginger's good working relationship with the
developers, they were willing to pay petitioner a premium since
they trusted that Ginger would deliver superior quality and
service. Ginger considered this a key to petitioner's success.
Once petitioner began working with the large developers,
Ginger took advantage of economies of scale and negotiated
excellent terms on the purchase of materials. Petitioner grew
and developed a backlog of pending projects equal to 3-5 months
of work. The backlog helped petitioner retain quality workers
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because they knew that a steady supply of work existed. The
ability to maintain experienced crews enabled petitioner to
deliver the highest quality masonry work.
C. Petitioner's Operations
Petitioner typically became involved in a job when the
developer called Ginger directly. Ginger would go to the
developer's office, review the plans, discuss the details for the
job, and suggest cost saving alternatives. Ginger would then
take the plans to his office and review the plans with
petitioner's estimator, Gary Sawhill (Sawhill).
Ginger and Sawhill would work through the plans and come up
with a bid. Ginger assisted Sawhill with matters such as profit
percentages, overhead, cost of labor, material cost, production
rates, and anything out of the ordinary. On an annual or
semiannual basis, Ginger would set the appropriate rates that
petitioner would use to bid a job. During the recession in 1990-
92, Ginger revised petitioner's rates every quarter.
Sawhill used the current figures to calculate the bid, which
was then given to Ginger. Ginger reviewed the entire bid before
it was sent to the developer. After the bid was submitted,
Ginger contacted the developer and offered to discuss the bid
further if the developer believed it to be too high. This often
would lead to further negotiations between the developer and
Ginger.
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When a developer accepted a bid, Ginger provided
petitioner's superintendent with the details of the job. On a
small job, only one person would travel to the jobsite, and that
would be the job foreman. The foreman would travel to the site
with his equipment and his materials and complete the job. On
larger jobs, the foreman would oversee a crew on the jobsite.
During the fiscal years 1990 through 1992, petitioner
employed approximately 80 to 100 people and had as many as 150
jobs in progress at any given time. Ginger separated
petitioner's operations into two categories: Brick and stone
masonry and block masonry. Ginger employed a superintendent on
the block masonry side of the business. The superintendent would
visit the jobsites, talk with the job foreman, see how the work
was progressing, and then report the progress to Ginger at the
end of the day. Since 1990, Steve Adams (Adams) has been the
superintendent of petitioner's block masonry division. Until
1992 or 1993, Ginger, himself, worked as the superintendent on
the brick and stone masonry side of the business.
Although the superintendent or foreman supervised the job
once work began on the jobsite, Ginger resolved any significant
problems that developed on the jobsite, such as quality,
manpower, labor, etc. When a significant problem developed,
typically the developer would contact Ginger directly, and Ginger
resolved the problem.
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As for hiring, Ginger had sole authority over whether the
company needed a new employee. Petitioner had very low turnover,
and Ginger discouraged hiring additional staff because he wanted
to keep overhead as low as possible. Every applicant completed
an application and a health screening. Ginger frequently made
the final hiring decision, but Adams also had the authority to
hire a new employee who would be working on a site that he
supervised. Adams had the authority to fire new employees
working on the sites that he supervised. He did not, however,
have the authority to fire an established employee. Ginger
decided whether to fire an established employee.
During the years in issue, Cheri Lawrence (Lawrence),
Ginger's sister, worked as petitioner's bookkeeper. She does not
have a degree in accounting. Lawrence entered the accounts
payable and accounts receivable, prepared quarterly reports
submitted to the Internal Revenue Service, and made entries into
the general ledger. Lawrence reviewed the financial statements
for accuracy, but she did not set petitioner's financial policy.
Kay Peterson (Peterson), Ginger's mother, worked as an office
manager and paid minor expenses, such as utilities, phone, and
office supplies. Peterson and Ginger were the only persons with
signatory authority on petitioner's checking account.
Ginger made all of petitioner's financial decisions and set
financial policy. The bookkeeper entered the numbers, and, with
Ginger's help, assembled a monthly report. Ginger reviewed the
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accounting and bookkeeping work, in addition to all of the
estimates for jobs over $1,000. Ginger personally reviewed any
invoice over $200. Ginger would interpret the contracts for work
in progress, verify the amount of work actually completed, and
assemble a rough draft of the invoice. Ginger reviewed the final
draft of every invoice. If a change order was required, Ginger
was the one who told the developer that the project was going to
cost more money.
Ginger made all compensation decisions, and petitioner paid
its employees above the market rate in an attempt to reduce
turnover. Ginger made all decisions regarding the use of
accountants, lawyers, and other professionals. Ginger handled
all financial management and credit management. Ginger
considered petitioner's cash flow crucial to survival, and he
managed the collection of past due invoices on a daily basis.
Every month Ginger would sit down with the bookkeeper and review
every job in progress. Ginger typically worked 13 hours a day,
and, at times up to 15.5 hours a day. Ginger served as
petitioner's only marketing person, and he often spent his
weekends and evenings building relationships with customers or
potential customers. Ginger joined and participated in local
organizations related to the construction industry in an attempt
to generate business for petitioner. He also joined
organizations that gave him access to executives and
entrepreneurs from other industries.
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Petitioner's financial statements reflect the following:
FYE Gross Net Retained
June 30 Revenue Profit Income Earnings
1985 $3,727,655 1,098,482 256,644 256,644
1986 4,817,376 1,037,224 66,943 323,587
1987 5,427,047 1,428,669 230,224 553,811
1988 5,162,114 1,247,098 245,153 798,964
1989 8,607,196 2,293,224 549,984 1,279,4271
1990 8,937,324 2,063,142 18,063 1,297,490
1991 5,012,347 929,136 (149,901) 1,147,589
1992 6,995,774 1,429,611 22,726 1,170,315
Petitioner has never paid dividends. Ginger's total compensation
was as follows:
FYE Total Disallowed by Allowed by
June 30 Compensation Respondent Respondent
1985 $249,145 -- --
1986 383,290 -- --
1987 390,724 -- --
1988 280,000 -- --
1989 516,371 -- --
1990 1,069,001 818,756 250,245
1991 132,000 -- 132,000
1992 396,698 186,825 209,873
Petitioner's shareholders' equity, as contained in petitioner's
financial statements, is as follows:
FYE Shareholders'
June 30 Equity
1985 $271,644
1986 338,587
1987 568,811
1988 813,964
1
Due to an error in recording, the June 30, 1989, retained
earnings figure was restated on June 30, 1990, from $1,348,948 to
$1,279,427.
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1989 1,294,4272
1990 1,312,490
1991 1,162,589
1992 1,185,315
Petitioner claimed deductions for officer's compensation in
the amounts of $1,069,001 and $396,698 for the fiscal years 1990
and 1992, respectively.
D. Others Familiar With Petitioner
Christenson, petitioner's accountant, assisted in the
formation of petitioner in 1984, and his accounting firm has
reviewed petitioner's financial statements since 1985.
Approximately 90 percent of Christenson's clients are in the
construction industry.
Christenson considered Ginger the sole marketing person for
petitioner, and he characterized Ginger's sales and marketing
abilities as "amazing". Christenson noticed that Ginger had an
"intuition" in matters, such as profitability, overhead
management, and the need to maintain volume to break even.
Ginger was a rare client in that he invited Christenson to
economic forecast luncheons.
Petitioner's banker, Greg Adamson (Adamson), talked with
petitioner's vendors, customers, and competitors. Such contacts
were common during Adamson's management of a client's portfolio.
Adamson concluded that petitioner had a very solid reputation in
2
We have adjusted the shareholders' equity figure for the
fiscal year ended June 30, 1989, to account for the recording
error entered supra note 1.
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the industry. With respect to profitability, petitioner ranked
near the top of Adamson's client portfolio. Adamson considered
petitioner to be a high performer with gross profit margins often
exceeding 20 percent.
Rick Muth (Muth), an owner of Orco Block Co., characterized
Ginger's sales and marketing expertise as "outstanding". Muth
considered petitioner a low credit risk, and he ranked petitioner
at the top of its field in quality.
E. The Recession
In late 1989 and early 1990, economic experts had predicted
a slowdown in the construction industry with a corresponding
"soft landing" for the Southern California residential housing
market. There was no soft landing. Petitioner did well through
July of 1990, and then in August 1990 petitioner's business "fell
apart".
In August 1990, the California housing market suffered a
severe setback. When this happened, petitioner's customers, the
large housing developers, reevaluated their positions. Ginger
estimated that 50 to 60 percent of petitioner's substantial
contract backlog that existed in July of 1990 was canceled within
60 days. Developers called Ginger about building contracts
already entered into by petitioner. The developers told Ginger
that the jobs were canceled unless petitioner would lower its
bids by 8 to 10 percent. Ginger renegotiated his material
purchases and slashed his bid prices just to stay in business.
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Petitioner's strength revealed itself during the economic
slowdown. Ginger had aligned petitioner with the large
developers, the most likely candidates to build during the
downturn. By this time, however, bid prices were critical in
obtaining work. Ginger studied the jobsites of his competitors
and talked to their customers and suppliers in an attempt to
determine whether a competitor could bid a lower price than
petitioner. These were additional duties that Ginger took on as
a result of the economic slowdown. In addition, Ginger reviewed
an industrywide credit report that indicated whether petitioner's
competitors were experiencing credit problems.
Many other construction-related companies lost business
during the fall of 1990 and some went out of business entirely.
John Connors (Connors), vice president of a construction
materials supply company, held an emergency meeting with the
executives of his company in September 1990 to address the
economic downturn. Connors' stores suffered a 40-percent to 60-
percent drop in sales. Connors' company reduced its staff from
145 to 80 and reduced salaries across the board by 10 percent.
OPINION
Section 162(a)(1) allows a corporation to deduct "a
reasonable allowance for salaries or other compensation for
personal services actually rendered" as a business expense. To
come within the ambit of section 162(a)(1), the compensation must
be both reasonable in amount and in fact paid purely for
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services. Sec. 1.162-7(a), Income Tax Regs. Although framed as
a two-prong test, the inquiry under section 162(a)(1) has
generally turned on whether the amounts of the purported
compensation payments were reasonable. Elliotts, Inc. v.
Commissioner, 716 F.2d 1241, 1243-1244 (9th Cir. l983), revg. and
remanding T.C. Memo. 1980-282. What constitutes reasonable
compensation to a corporate officer is a question of fact to be
determined on the basis of all the facts and circumstances of a
case. Pacific Grains, Inc. v. Commissioner, 399 F.2d 603, 605
(9th Cir. 1968), affg. T.C. Memo. 1967-7. Petitioner has the
burden of proving that the payments to Ginger were reasonable.
Rule 142(a). Respondent has conceded that petitioner is entitled
to a deduction for compensation paid to Ginger in the amounts of
$300,000 and $209,873 for the fiscal years 1990 and 1992,
respectively.
Many factors are relevant in determining the reasonableness
of compensation, and no single factor is decisive. Mayson
Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.
1949), revg. a Memorandum Opinion of this Court. The Court of
Appeals for the Ninth Circuit has divided the factors relevant to
the reasonable compensation determination into the following five
broad categories for analytical purposes.
1. Roles in Company
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The first category of factors identified by the Court of
Appeals for the Ninth Circuit concerns the employee's role in the
company. Relevant considerations include Ginger's
qualifications, hours worked, duties performed, as well as his
general importance to petitioner's success. American Foundry v.
Commissioner, 536 F.2d 289, 292-293 (9th Cir. 1976), affg. in
part and revg. in part 59 T.C. 231 (1972).
Ginger was a highly motivated employee working as much as
15.5 hours a day. His evenings and weekends were often spent
marketing petitioner's services to existing customers and
potential customers.
Despite his lack of formal business training, Ginger
acquired the skills necessary to manage every facet of
petitioner's operations. He attended economic forecast
luncheons. He joined organizations that gave him access to other
business executives and entrepreneurs, and he sought advice from
these individuals.
Ginger handled all of petitioner's executive and managerial
duties. Other employees assisted Ginger, but petitioner had no
other managers or executives. Ginger received assistance in the
areas of bookkeeping, field supervision, and estimating, but that
assistance extended only to routine matters. Ginger devised and
implemented petitioner's corporate strategy of targeting the
large residential developers. Ginger's financial discipline and
marketing abilities brought petitioner's corporate strategy to
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fruition. Ginger reviewed all of petitioner's expenditures,
ensured low overhead, resisted adding new employees, and insisted
that petitioner grow through retained earnings. Ginger
continually marketed petitioner's services. Ginger's sales and
marketing abilities were described as "amazing" and
"outstanding". Petitioner grew steadily from its inception in
1984, weathered the economic downturn in 1991, and began a
recovery in 1992. Ginger served as the catalyst for petitioner's
growth and success.
2. External Comparison
We also compare the employee's salary with the salaries paid
by similar companies for similar services. Sec.1.162-7(b)(3),
Income Tax Regs. Both parties offered expert testimony as to
what a like company would pay for like services. Both experts
considered surveys of financial data on numerous organizations,
including developers, builders, residential building contractors,
and construction contractors in specialty trades.
a. Respondent's Expert
Respondent presented expert testimony from Scott D. Hakala
(Hakala). Hakala reviewed the surveys of financial data and
concluded that it was not very "satisfying". As a result, he
relied less on the market data than he would prefer for the final
conclusion. Instead, Hakala derived a formula to calculate
Ginger's compensation; the formula does incorporate one aspect of
the survey data.
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Hakala's formula consists of a base salary of $90,000
increasing at a nominal rate of 2 percent for each year of the
term, plus a variable component equal to 20 percent of operating
income before officers' compensation.
As for the base salary figure, Hakala used data on
contractor executive compensation compiled by Personnel
Administration Services (PAS survey). Hakala felt the PAS survey
was the most accurate under the circumstances of this case.
Hakala used the median, 50th percentile, salary of $144,000, and
broke this down into a median base salary of $90,000 plus a
$54,000 bonus. Hakala explained that $90,000 is the median base
salary for someone working in a firm with between $5 million and
$20 million in sales on the west coast. For companies in the
75th percentile, compensation climbed to $200,000. The top
officer also received additional benefits with a cash value of up
to $50,000.
As for the variable component, the 2-percent figure accounts
for the slow growth in the real estate market in addition to an
inflation factor. Hakala calculated the 20-percent bonus figure
using financial projections for 1993 and 1994 and an intended
return on equity. Hakala concluded that 20 percent was "the most
bonus" the executive could be paid and still allow some kind of
reasonable return expectation to the shareholder. Hakala opined
that Ginger's compensation for the fiscal years ended June 30,
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1990 and 1992 should be no more than $300,000 and $200,000,
respectively.
Hakala also opined that a median compensation for the second
highest corporate officer for companies in the building trades
was $100,000, while compensation at the 75th percentile was
$129,000. The second highest corporate officer also received
additional benefits with a cash value slightly under $30,000.
b. Petitioner's Expert
Petitioner presented the testimony of Sidra Wieder (Wieder),
who specializes in employee compensation and employee benefits.
Wieder focused on the duties performed by Ginger as well as the
duties performed by petitioner's other employees. Wieder
specifically reviewed Ginger's responsibilities and scope of
authority. Two of the factors Wieder used to determine Ginger's
compensation were the payroll amounts that petitioner saved by
having Ginger serve many roles and the amount that Ginger should
be paid for the various duties he performed for petitioner.
Wieder concluded that Ginger served as petitioner's chief
executive officer, chief operations/administrative officer, and
marketing executive. Wieder concluded that Ginger also served as
petitioner's chief financial officer. She did not, however,
include the chief executive officer as a separate position
because she concluded that those duties would be subsumed within
Ginger's other executive duties. Based on the data reviewed by
Wieder, she opined that the total compensation paid to a
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comparable company's chief executive officer, chief
operations/administrative officer, and marketing executive ranged
between $476,949 and $1,910,740 in 1990 and between $555,029 and
$776,349 in 1992. Wieder opined that the compensation petitioner
paid Ginger in 1990 and 1992 was reasonable.
c. Discussion
Respondent and respondent's expert have understated the
services provided by Ginger and have overstated the services
provided by Sawhill, Lawrence, Peterson, and Adams. Respondent
contends that the latter individuals were responsible for
petitioner's day-to-day operations. We do not agree with
respondent's characterization. The record indicates that Ginger
played the crucial role in petitioner's operations. Sawhill,
Lawrence, and Peterson completed relatively routine matters that
Ginger had delegated to them. They discussed anything out of the
ordinary with Ginger. Adams had limited authority over the
jobsites that he supervised, including the authority to hire and
terminate new employees on those sites. Ginger made all other
personnel decisions.
Petitioner did not have a strong managerial infrastructure
other than Ginger. Ginger effectively performed the roles of
chief executive officer, chief financial officer, chief
operations/administrative officer, and marketing executive.
Ginger's compensation should reflect the combined salaries of the
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job positions he performed. Elliotts, Inc. v. Commissioner, 716
F.2d at 1246.
3. Character and Condition of Company
This factor requires us to focus on petitioner's size as
indicated by its sales, or capital value, the complexities of the
business, and the general economic conditions. Elliotts, Inc. v.
Commissioner, supra at 1246. In a relatively short time,
petitioner became a top performer in a highly competitive market.
Petitioner maintained a high gross profit ratio. Petitioner
penetrated the residential masonry market and won contracts with
some of the largest residential developers in the area.
Furthermore, petitioner survived the economic downturn that began
in 1990. Petitioner's survival was due, in part, to its
financial strength and its ability to obtain work in a declining
market. Ginger was the architect of petitioner's growth
strategy, and he provided the tools necessary to implement that
strategy. Ginger also charted petitioner's path through the
economic decline.
4. Conflict of Interest
The primary issue in considering factors indicating a
conflict of interest is whether some relationship exists between
the company and the employees which might permit the former to
disguise nondeductible corporate distributions of income as
salary expenditures deductible under section 162(a)(1). "Such a
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potentially exploitable relationship may exist where, as in this
case, the * * * [employees are] the taxpaying company's sole or
controlling shareholder[s]". Elliotts, Inc. v. Commissioner,
supra at 1246.
The relationship in this case, where Ginger and his wife
were petitioner's sole shareholders, warrants scrutiny. Id. The
mere existence of such a relationship, coupled with an absence of
dividend payments, however, does not necessarily lead to the
conclusion that the amount of compensation is unreasonably high.
Id. They are relevant factors but are not to be viewed in
isolation. Id. at 1247. Furthermore, we shall not presume a
disguised dividend from the bare fact that a profitable
corporation does not pay dividends. Id. at 1244; Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1326-1327 (5th
Cir. 1987), affg. T.C. Memo. 1985-267.
The Court of Appeals for the Ninth Circuit formulated the
inquiry in such a situation by evaluating the compensation
payments from the perspective of a hypothetical independent
investor. The prime indicator is the return on its investors'
equity. Owensby & Kritikos, Inc. v. Commisisoner, supra at 1326-
1327. If the company's earnings on equity after payment of the
compensation remain at a level that would satisfy an independent
investor, there is a strong indication that management is
providing compensable services and that profits are not being
siphoned out of the company disguised as salary. Elliotts, Inc.
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v. Commissioner, supra at 1247. The Court of Appeals for the
Ninth Circuit, in Elliotts, Inc., calculated the return on equity
using the yearend shareholder's equity. We follow that approach.
See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. on another
issue 445 F.2d 985 (10th Cir. 1971). Dividing petitioner's net
profit (after payment of compensation and a provision for income
taxes) by the yearend shareholders' equity, as reflected in its
financial statements, yields the following:
FYE Percentage Return
June 30 on Equity
1985 94
1986 20
1987 40
1988 30
1989 42
1990 1
1991 (13)
1992 2
Under the circumstances of this case, we find that the
return on equity for the years at issue (1990-92) is not a
reliable indicator of the reasonableness of Ginger's
compensation. See Elliotts, Inc. v. Commissioner, supra at 1247
n.5. We doubt that the 1-percent return on equity for the year
ended June 30, 1990, would satisfy an independent investor;
however, there is probative evidence that Ginger had forgone
compensation in prior years in an attempt to enlarge petitioner's
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capital base in order to satisfy the demands of the large
developers. Increasing petitioner's capital base in the early
years was central to petitioner's ability to penetrate the
residential masonry market. Indeed, the percentage return-on-
equity figures for the years 1985 through 1989 indicate that
petitioner could have paid additional officer compensation and
maintained a satisfactory return on equity. Under these
circumstances, isolating the return-on-equity figure for the
fiscal year ended June 30, 1990, would ignore petitioner's
successful corporate strategy and the steps taken to implement
that strategy.
The percentage return-on-equity figures for the years 1991
and 1992 must be viewed in light of the precipitous drop in the
residential housing market in late 1990. Given the severity of
that economic decline, the return-on-equity figures are not a
good indicator of petitioner's performance or the reasonableness
of compensation that petitioner paid Ginger.
5. Internal Consistency
Internal inconsistency in petitioner's treatment of payments
to employees may indicate that the payments to Ginger were not
reasonable. Elliotts, Inc. v. Commissioner, 715 F.2d at 1247.
Bonuses that have not been awarded under a formal and
consistently applied program are suspect. Nor-Cal Adjusters v.
Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), affg. T.C. Memo.
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1971-200. However, it is permissible to pay and deduct
compensation for services performed in prior years. Lucas v. Ox
Fibre Brush Co., 281 U.S. 115, 119 (1930).
a. Compensation for Services in Prior Years
Financial stability was a crucial element in petitioner's
growth strategy. Ginger knew that petitioner would need strong
financial statements and considerable equity in order to work
with the large developers. To this end, Ginger received less
compensation in years prior to the years in issue. Petitioner,
as a result, retained a significant portion of its earnings and
increased its equity base. After petitioner reached its
financial goals and secured a working relationship with the large
developers, petitioner compensated Ginger for the extraordinary
services he provided petitioner from 1984 to 1989.
b. Compensation Paid to Other Employees
Wieder concluded that petitioner's other employees, such as
superintendent, bookkeeper, and administrative assistant, were
all paid above-average compensation from 1986 to 1992 with above-
average pay increases most of those years. Hakala concluded that
petitioner's other employees, specifically Sawhill and Adams,
were undercompensated. Hakala opined that an estimator,
Sawhill's position, would earn $70,000 and up to $100,000 in a
very good year. Included in the $100,000 figure is a bonus of up
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to $20,000. Hakala opined that Adams' compensation in 1990
should have exceeded $70,000, which it did not.
As explained above, respondent has attributed to
petitioner's other employees services actually performed by
Ginger. Ginger filled the critical roles in petitioner's
operations. Ginger worked closely with Sawhill. Sawhill
performed the calculations necessary to produce a bid, but Ginger
determined the substantive financial data that was incorporated
into a bid, such as profit percentages, overhead, cost of labor,
material cost, and production rates. The accuracy of the
substantive financial data was essential to petitioner's
profitability. After petitioner submitted a bid, Ginger
contacted the developer and negotiated an agreement. When
discussing hours worked by various employees, Hakala stated that
the marketing and salesperson is usually the estimator. But this
was not the case with petitioner. Ginger served as petitioner's
marketing and salesperson.
Adams served as the superintendent on the block masonry side
of petitioner's business. However, Ginger resolved significant
problems on all of the jobsites, including the sites supervised
by Adams. Indeed, when a significant problem developed on one of
petitioner's jobsites, the developer typically would contact
Ginger directly. Ginger, himself, worked as the superintendent
on the brick and stone masonry side of the business.
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Ginger served as the central figure in petitioner's growth
and success. Ginger effectively discharged the responsibilities
of several corporate executives. He did so through long hours,
consultation with others, and efficient use of petitioner's other
employees. Petitioner's success was due to Ginger's significant
efforts and contributions, and we conclude that the compensation
paid to Ginger during the years in issue was reasonable.
To reflect the foregoing,
Decision will be entered
under Rule 155.