Tricon Metals & Servs. v. Commissioner

T.C. Memo. 1997-360

UNITED STATES TAX COURT

TRICON METALS & SERVICES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4963-95. Filed August 6, 1997.

Joseph G. Stewart, Abbot Brand Walton, Jr., and David A.

Elliott, for petitioner.

Robert W. West, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KÖRNER, Judge: Respondent determined the following

deficiencies in petitioner's Federal income taxes:
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FYE Aug. 31 Deficiency
1990 $173,346
1991 226,072
1992 326,591

The issue for decision is whether the compensation paid to

petitioner's majority shareholder in its fiscal years ending

1990, 1991, and 1992 is deductible by petitioner as reasonable

compensation under section 162(a)(1). We hold that it is to the

extent stated herein.

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. Tricon Metals & Services, Inc. (petitioner),

is an Alabama corporation whose principal place of business was

Jefferson County, Alabama, when the petition was filed.

Petitioner operates on a fiscal year ending August 31.

1. Petitioner

Petitioner buys, warehouses, and sells high-strength steel

products. Petitioner's founders, James L. Bell (Bell), Walter H.

Ferguson (Ferguson), and W. Warren Wood (Wood), worked as

salesmen for other companies in the steel business prior to

organizing petitioner.
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Bell, Ferguson, and Wood organized petitioner in November

1968, and they each owned one-third of petitioner's outstanding

shares of stock. Initially, Bell, Ferguson, and Wood served as

petitioner's entire sales force, and each one was responsible for

a particular sales territory. In its first full year of

operation, petitioner employed six people, which included the

three founders, had gross sales of $225,199, and had net income

after taxes of $14,838.

Petitioner prospered in the 1970's. It soon outgrew the

rented warehouse where its operations began and moved to a

warehouse and office facility in Irondale, Alabama, a suburb of

Birmingham. By the end of 1979, petitioner employed 33 people

and had gross sales of $4,455,133.

In 1979, Bell and Ferguson discovered that Wood had

organized a corporation in Jacksonville, Florida, to compete with

petitioner. At the time, Wood was still an officer, director,

and employee of petitioner. Bell and Ferguson, as a majority of

petitioner's board of directors, fired Wood and sued him for

breach of fiduciary duty. Wood counterclaimed against

petitioner, and they eventually settled the litigation. Although

Wood's employment with petitioner was terminated, he remained a

shareholder. From 1979 through January 1988, Wood owned

approximately 33 percent of petitioner's outstanding shares of

stock.
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After Bell and Ferguson discovered that Wood had organized a

competitor, they established a salary structure for themselves

based on a percentage of petitioner's net sales. Bell, who was

serving as petitioner's president at the time, was to receive 2.4

percent of petitioner's net sales. Ferguson, who was serving as

petitioner's vice president, was to receive 1.6 percent of

petitioner's net sales.

2. Petitioner's Operations

During most of the 1980's, Bell and Ferguson were officers

of petitioner, sharing administrative duties and acting as

commissioned salesmen. Bell had served as petitioner's president

since 1974. In 1987, Bell became ill with cancer, and he died in

January 1988. Petitioner redeemed Bell's stock pursuant to a

buy-sell agreement executed by the founders in April 1970.

After Bell's death, Ferguson became president of petitioner.

Ferguson's salary as president was set at 2.6 percent of net

sales.

In 1988, Wood filed a lawsuit against petitioner and

Ferguson in an unsuccessful attempt to gain control of

petitioner. At the time, Wood owned just over 40 percent of

petitioner's outstanding shares of stock, and Ferguson owned just

over 50 percent of petitioner's outstanding shares of stock. In

response to Wood's lawsuit, petitioner and Ferguson entered into

a 5-year employment agreement (employment agreement) to protect

Ferguson in the event that Wood gained control of petitioner.
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Pursuant to the employment agreement, Ferguson's salary was set

at 2.4 percent of net sales, the same percentage of net sales

that Bell had received prior to his death.

Wood's attempt to gain control of petitioner proved

unsuccessful, and after his defeat, Wood agreed to sell his stock

to petitioner. On August 1, 1990, Wood sold his stock to

petitioner for $2,850,000. After petitioner purchased Wood's

stock, Ferguson remained petitioner's majority shareholder,

owning approximately 75 percent of petitioner's outstanding

stock.

3. Petitioner's Financial Condition

Petitioner's financial statements reflect the following:

FYE Net Gross Net Retained
Aug. 31 Sales Profit Income Earnings

1981 $6,064,513 $1,638,818 $321,150 $1,695,161
1982 7,712,496 2,047,589 351,329 2,046,490
1983 8,180,434 2,313,607 419,665 2,466,156
1984 10,671,010 2,981,037 701,574 3,167,731
1985 11,423,805 3,143,870 563,557 3,731,288
1986 12,456,296 3,115,873 488,573 4,219,862
1987 13,969,335 3,904,553 714,492 4,986,1951
1988 17,394,166 5,053,862 861,683 7,290,7552
1989 20,895,754 5,012,259 1,013,195 6,515,293
1990 25,219,920 6,410,305 1,698,764 8,235,846
1991 24,769,390 6,591,585 1,564,964 6,957,810
1992 25,031,040 7,926,605 2,152,121 9,109,931

1
Due to an accounting adjustment, the 1987 retained
earnings figure was restated from $4,934,355 to $4,986,195.
2
This figure is set forth in the financial statements for
the period Aug. 31, 1987, through Aug. 31, 1988. Subsequent
financial statements show this figure as $7,290,577. This
discrepancy does not affect our analysis.
 - 6 -

Petitioner's shareholders' equity is as follows:

FYE Shareholders'
Aug. 31 Equity

1981 $1,719,074
1982 2,070,404
1983 2,490,070
1984 3,191,644
1985 3,755,202
1986 4,243,775
1987 4,958,268
1988 5,523,189
1989 7,260,559
1990 6,251,019
1991 7,815,983
1992 10,163,504

Petitioner has never paid dividends.

In the 1970's, petitioner and its shareholders borrowed

funds to expand petitioner's facilities. The terms of the

financing arrangement prohibited petitioner from paying dividends

to its shareholders. In 1985, and again in 1987, petitioner

entered into a bond guaranty agreement (guaranty agreement) with

AmSouth Bank N.A. in connection with another expansion of

petitioner's facilities. The guaranty agreement was operative

through 1992, and it prohibited petitioner from paying dividends

to its shareholders while the bonds were outstanding.

4. Ferguson's Executive Duties

Ferguson became petitioner's president and chief executive

officer (CEO) in 1988, after Bell's death. After becoming CEO,

Ferguson continued to serve as petitioner's treasurer. In

November 1988, petitioner created two additional vice president

positions, for a total of three vice presidents, and the three
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vice presidents assisted Ferguson in managing petitioner's

operations. Ferguson supervised the vice presidents.

Ferguson was a hands-on chief executive. He played a role

in purchasing and personnel decisions, although petitioner had

other employees that also worked in these areas. Ferguson played

a major role in selecting Elko, Nevada, as the site for

petitioner's western operations. Petitioner opened the Elko,

Nevada, site in June 1989. Ferguson also oversaw petitioner's

expansion into foreign markets such as Mexico, South America,

Canada, and Indonesia.

5. Ferguson's Sales Duties

During the years in issue, petitioner employed between 22

and 26 salesmen. Petitioner had two regional sales managers, one

that covered the Western United States and one that covered the

Northeastern United States.

After becoming CEO, Ferguson continued to serve petitioner

as a salesman. Ferguson's sales territory included southern

Alabama, Mississippi, and much of Louisiana. Ferguson personally

made sales calls to existing customers in his sales territory, as

well as any new customers within his territory. Like all of

petitioner's salesmen, Ferguson's sales duties forced him to

travel, at times, up to 4 days a week. Ferguson, like the other

salesmen, received a commission on the sales he generated.
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One crucial role that Ferguson filled was keeping

petitioner's super salesmen together. These were petitioner's

top performing salesmen, and they were extremely valuable

employees. Ferguson personally supervised 10 of petitioner's top

performers. The top performers could call Ferguson with a

problem any time, 7 days a week. Ferguson, in his capacity as

sales manager, received a commission on the sales generated by

the 10 salesmen that he supervised.

6. Ferguson's Compensation

Petitioner's management team set salaries and bonuses after

consulting with Louis Paul Kassouf (Kassouf). Kassouf has been a

certified public accountant since 1954, and he served as

petitioner's accountant from 1970 through the years in issue.

Kassouf consulted with petitioner on audit issues, corporate tax

planning, compensation, and tax return preparation.

When Ferguson took over as petitioner's president after

Bell's death, initially his salary was 2.6 percent of net sales.

Ferguson then entered into the employment agreement with

petitioner which set Ferguson's salary at 2.4 percent of net

sales. Kassouf had recommended a salary for Ferguson in excess

of 2.4 percent of net sales. Kassouf reasoned that Ferguson, in

addition to his existing duties, would be adding the duties

previously handled by Bell. However, Ferguson did not perform

all of the duties previously handled by Bell.
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In addition to salaries, petitioner paid bonuses to its

executives. Petitioner had no formal program for awarding

bonuses. Petitioner's management team would meet with Kassouf in

August, the month that petitioner's fiscal year closed, to

determine the bonuses to be paid. After considering petitioner's

performance and the effort put forth by the various employees,

Kassouf would recommend what he felt were reasonable bonuses for

the various employees. In 1990 and 1991, Kassouf recommended a

bonus for Ferguson slightly larger than the bonus that petitioner

paid Ferguson. The bonus that Ferguson received during the

fiscal year ending 1992 was for services rendered during that

year.

Ferguson received the following fringe benefits:3

Item 1990 1991 1992

Contributions to
profit sharing plan $11,352 $5,064 $8,849
Medical insurance 222 247 275
Life insurance 13,915 13,915 22,063
Disability insurance 1,056 1,056 1,056
Automobile 10,206 9,091 5,856
Club dues 3,282 3,462 3,462
Total 40,033 32,835 41,561

Ferguson's compensation (salary, sales commission, and

bonus) was as follows:

3
For purposes of this opinion, we use the term
"compensation" to refer to Ferguson's salary, sales commission,
and bonus. We take the fringe benefits into account as a factor
in determining whether that compensation was reasonable.
 - 10 -
FYE Sales Total Conceded by
Aug. 31 Salary Commissions Bonus Compensation Respondent

1990 $441,104 $167,493 $100,000 $708,597 $550,000
1991 603,926 139,392 120,000 863,318 600,000
1992 610,459 117,364 430,000 1,157,823 750,000

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

services. Sec. 1.162-7(a), Income Tax Regs. Although framed as

a two-prong test, the inquiry under section 162(a)(1) generally

has turned on whether the amounts of the purported compensation

payments were reasonable. Elliotts, Inc. v. Commissioner, 716

F.2d 1241, 1243-1244 (9th Cir. 1983), revg. and remanding T.C.

Memo. 1980-282. What constitutes reasonable compensation to a

corporate officer is a question of fact to be determined from all

the facts and circumstances of a case. Charles Schneider & Co.

v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974), affg. T.C.

Memo. 1973-130; Estate of Wallace v. Commissioner, 95 T.C. 525,

553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992). Petitioner has

the burden of proving that the payments to Ferguson were

reasonable. Rule 142(a). Respondent has conceded that

petitioner is entitled to a deduction for compensation paid to
 - 11 -

Ferguson in the amounts of $550,000, $600,000, and $750,000 for

the fiscal years ending 1990, 1991, and 1992, respectively.

Many factors are relevant in determining the reasonableness

of compensation, and no single factor is decisive. Charles

Schneider & Co. v. Commissioner, supra at 152; Mayson

Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.

1949), revg. a Memorandum Opinion of this Court. The courts have

used numerous factors to determine what constitutes reasonable

compensation. We address those factors below.

1. Roles in Company

The first category of factors concerns the employee's role

in the company. Relevant considerations include Ferguson's

qualifications, hours worked, and 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).

Ferguson served as petitioner's CEO and as a salesman. As

CEO, Ferguson selected the site for petitioner's operations in

the Western United States, and he also oversaw petitioner's

international sales. There is no evidence, however, that

petitioner's international operations were profitable.

Ferguson supervised three vice presidents that assisted in

petitioner's operations. Petitioner has not shown that it

engaged in highly technical or complex operations or that

Ferguson possessed managerial skills unique to petitioner's
 - 12 -

industry. See Miller Box, Inc. v. United States, 488 F.2d 695,

705 (5th Cir. 1974). Indeed, the record supports the finding

that sales remained Ferguson's focus during the years in issue.

Ferguson's customer contacts and his familiarity with the

steel industry made him a valuable salesman and sales manager.

Ferguson traveled, met with clients, and supervised 10 of

petitioner's super salesmen. Although the salesmen that Ferguson

supervised could contact him in the evenings, as well as on

weekends, petitioner presented no evidence that Ferguson worked

an inordinate number of hours.

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 companies.

A. Petitioner's Expert

Petitioner presented the testimony of James M. Otto (Otto).

Otto compared the compensation paid to the chief executive

officers of 12 publicly traded companies to the salary and bonus

paid to Ferguson. Otto did not include Ferguson's commissions

from sales when determining the reasonableness of Ferguson's

compensation as CEO. Otto reasoned that since Ferguson was paid

sales commissions on the same commission structure as

petitioner's other salesmen and since Ferguson's duties as
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salesman were separate and distinct from his duties as CEO, the

inclusion of Ferguson's sales commissions in the analysis of

Ferguson's compensation as CEO would be inappropriate. Within

these parameters, Otto concluded that Ferguson's compensation as

CEO was reasonable.

B. Respondent's Expert

Respondent presented expert testimony from David Neil Fuller

(Fuller). Fuller reviewed surveys of financial data of other

companies, and he also reviewed the compensation paid to

executives at nine companies that he considered comparable to

petitioner. The nine companies selected by Fuller had revenues

that were 15 to 20 times larger than petitioner's revenues, and

those companies were not necessarily in a line of business

comparable to that of petitioner.

When discussing petitioner's performance, Fuller

acknowledged that the U.S. economy was in a recession during the

years in issue. Fuller stated that the slow economy had a

negative impact on the steel industry in general, yet petitioner

suffered less from the recession than did the nine companies that

Fuller selected for comparison.

Fuller also acknowledged that Ferguson served as

petitioner's CEO and as a salesman. Yet in the compensation

analysis, Fuller grouped Ferguson's duties together under the

title of CEO. Fuller opined that a range of reasonable

compensation for Fuller would be $500,000-$600,000, $550,000-
 - 14 -

$650,000, and $700,000-$800,000 for the fiscal years ending 1990,

1991, and 1992, respectively.

C. Discussion

We have not found the opinion of either expert convincing.

It is not at all clear that the "comparable" companies used in

their analyses are comparable to petitioner. In addition,

neither expert focused on the duties that Ferguson actually

performed. The appropriate comparison is to the duties the

employee actually rendered rather than the titles held. See

Trinity Quarries, Inc. v. United States, 679 F.2d 205, 211 (11th

Cir. 1982). Thus, the usefulness of their analyses to determine

the "amount as would ordinarily be paid for like services by like

enterprises under like circumstances" is doubtful. Sec. 1.162-

7(b)(3), Income Tax Regs.

Otto testified that he considered the 12 companies he

selected to be comparable regarding return on equity and return

on assets, but he did not consider the companies necessarily

comparable with regard to overall sales or net asset value.

Furthermore, several of the companies that petitioner's expert

considered comparable to petitioner were conglomerates with

several lines of business, only one of which was similar to the

business operated by petitioner. We note also that in 1990,

Ferguson's total compensation (sales commissions, salary, and

bonus) exceeded the compensation paid to each of the CEO's of the

12 companies that petitioner's expert selected as comparable
 - 15 -

companies. In both 1991 and 1992, Ferguson's total compensation

(sales commissions, salary, and bonus) exceeded the compensation

paid to all but one of the CEO's of the 12 companies that

petitioner's expert selected as comparable companies.

We also do not agree with Otto's analysis regarding the

division of Ferguson's duties between CEO and salesman. Otto

limited his analysis to Ferguson's duties and compensation as

CEO. Otto testified that the amount of time Ferguson spent as a

CEO versus the time he spent as a salesman was irrelevant as long

as Ferguson performed the duties required by petitioner. We are

not convinced that Ferguson effectively filled the role of a

full-time CEO. Ferguson spent much of his time serving

petitioner as a salesman.

As for respondent's expert, we again question whether the

companies selected as comparable companies are indeed comparable.

The companies selected by Fuller were not necessarily in

petitioner's line of business, and they were not comparable to

petitioner in terms of size. The net sales for the comparable

companies selected by Fuller ranged from $50,040,000 to

$1,124,130,000 for 1990, $50,260,000 to $1,150,070,000 for 1991,

and $42,610,000 to $1,156,200,000 for 1992. Petitioner's net

sales during the years in issue ranged from a low of $24,769,390

in 1991 to a high of $25,219,920 in 1990.

Fuller viewed Ferguson's compensation as a single package

without considering Ferguson's sales duties. The focus should
 - 16 -

have been on the duties that Ferguson actually performed, and

some weight should have been given to Ferguson's sales ability

and his skill in motivating petitioner's super salesmen.

3. Character and Condition of Company

This category of factors 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, 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).

Petitioner performed well in a competitive business.

Respondent's expert indicated that petitioner had done well in

terms of growth and profitability during the years in issue.

Indeed, Fuller indicated that petitioner's growth and

profitability numbers were better than the numbers produced by

the companies that Fuller considered comparable to petitioner.

Courts also compare the compensation paid with the gross

profit and net income of the corporation. Pepsi-Cola Bottling

Co. v. Commissioner, supra at 179. Ferguson's compensation as a

percentage of gross profit (before deducting his compensation) is

approximately 10 percent, 13 percent, and 15 percent for the

fiscal years ending 1990, 1991, and 1992, respectively.

Ferguson's compensation as a percentage of net income (before

deducting his compensation) is approximately 29 percent, 36

percent, and 35 percent for the fiscal years ending 1990, 1991,
 - 17 -

and 1992, respectively. These percentages are reasonable given

Ferguson's contribution to petitioner's success during the years

in issue.

Courts have considered whether the corporation provides

fringe benefits such as pensions or profit sharing plans. Rutter

v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988), affg. T.C.

Memo. 1986-407. Ferguson participated in petitioner's profit-

sharing plan and received other fringe benefits as well. This

factor favors respondent.

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). Trinity

Quarries, Inc. v. United States, supra at 210. The relationship

in this case, where Ferguson was petitioner's majority

shareholder, warrants scrutiny. Levenson & Klein, Inc. v.

Commissioner, 67 T.C. 694, 711 (1977).

The corporation's dividend history is a relevant factor to

consider. Petitioner paid no dividends, yet the absence of

dividend payments does not necessarily lead to the conclusion

that the amount of compensation is unreasonably high. Elliotts,

Inc. v. Commissioner, 716 F.2d at 1246. We shall not presume a

disguised dividend from the bare fact that a profitable
 - 18 -

corporation does not pay dividends. Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1326-1327 (5th Cir. 1987), affg.

T.C. Memo. 1985-267. This is especially true in this case where

petitioner's financing arrangements prohibited the payment of

dividends. Furthermore, from 1979 through August 1, 1990, Wood

owned a large block of petitioner's stock and also owned and

operated a competitor. This may have had some impact on

petitioner's dividend policy.

Courts also evaluate the compensation payments from the

perspective of a hypothetical independent investor. The prime

indicator is the return on investors' equity. Id. 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.

v. Commissioner, supra at 1247. Respondent's expert calculated

returns on equity of 27.2 percent, 20 percent, and 21.2 percent

for the fiscal years ending 1990, 1991, and 1992, respectively.

We conclude that an independent investor would have been

satisfied with petitioner's earnings on equity during the years

in issue.

Courts also consider when bonuses were paid. Payment of

bonuses at the end of the fiscal year when a corporation knows

its revenue for the year may enable it to disguise dividends as
 - 19 -

compensation. Owensby & Kritikos, Inc. v. Commissioner, supra at

1329; Estate of Wallace v. Commissioner, 95 T.C. at 556.

Petitioner's management team met with Kassouf at the end of

petitioner's fiscal year to determine the annual bonuses to be

paid to petitioner's executives. This factor casts some doubt on

whether such payments were compensation. Trinity Quarries, Inc.

v. United States, 679 F.2d at 211.

5. Internal Consistency

Internal inconsistency in petitioner's treatment of payments

to employees may indicate that the payments to Ferguson were not

reasonable. Elliotts, Inc. v. Commissioner, 716 F.2d at 1247.

Petitioner had no formal program for awarding bonuses. 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. 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

Kassouf, petitioner's accountant, testified that

approximately $190,000 of the $430,000 bonus payment in 1992

consisted of "shortage amounts" due to Ferguson from the 2 prior

years. The record does not support Kassouf's testimony. The

bonus that Ferguson received during the fiscal year ending 1992

was for services rendered during that year.
 - 20 -

B. Compensation Paid to Other Employees

Petitioner paid Ferguson at the high end of the compensation

range. Petitioner presented no evidence that its other employees

were compensated at or near the high end of the compensation

range. Cf. Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C.

1142, 1162 (1980). This factor favors respondent.

Based on the factors outlined above, we conclude that

$650,000, $700,000, and $850,000 represent a reasonable amount of

compensation to Ferguson for petitioner's fiscal years ending

1990, 1991, and 1992, respectively.

To reflect the foregoing,

Decision will be entered

under Rule 155.