T.C. Memo. 1997-421
UNITED STATES TAX COURT
MAX BURTON ENTERPRISES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26467-95. Filed September 22, 1997.
James A. Jensen, Charles J. Ingber, and Joel P. Leonard,
for petitioner.
Robert S. Scarbrough, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Chief Judge: Respondent determined a deficiency of
$214,220 in petitioner’s Federal income tax for the tax year
ended June 30, 1990. The issue for decision is whether
deductions claimed by petitioner for salary and bonuses paid to
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its officers, who were also shareholders, exceeded reasonable
compensation.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference. At the
time the petition was filed, petitioner’s principal place of
business was in Tacoma, Washington. During the year in issue,
petitioner produced and sold stove-top grills, stove-top burner
covers, and other kitchen accessories.
Petitioner was incorporated in the State of Washington on
September 5, 1979, by Max Burton. Max Burton was the father of
Linda Burton (Ms. Burton) and Alfred Burton (Mr. Burton) and the
husband of Evelyn Burton. Ms. Burton was married to Robert
Denovan (Denovan).
From September 13, 1979, through June 30, 1983, Max Burton
served as president and treasurer, and Mr. Burton served as vice
president and secretary, of petitioner. From July 1, 1983,
through his death on July 3, 1997, Max Burton was president and
treasurer, Ms. Burton was vice president, and Mr. Burton was
secretary, of petitioner. From July 7, 1987, through June 30,
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1990, Ms. Burton was president, Denovan was vice president, and
Mr. Burton was secretary and treasurer, of petitioner.
Immediately prior to Max Burton’s death, the outstanding
shares of petitioner were owned as follows:
Owner Shares Owned
William Mueller 500
Max Burton 7,300
Linda Burton 500
Alfred Burton 1,100
Robert Denovan 600
Total 10,000
The 500 shares of stock owned by William Mueller were redeemed by
petitioner for $5,000 during the tax year ended June 30, 1990.
As of June 30, 1990, the outstanding shares of petitioner were
owned as follows:
Number of Percentage of
Shares Held Shares Held
Linda Burton 1,100 44%
Alfred Burton 1,100 44%
Evelyn Burton 150 6%
Robert Denovan 150 6%
In November 1985, Max Burton was diagnosed with cancer. He
underwent chemotherapy and surgery. During his illness,
petitioner’s business, as described by Ms. Burton, “pretty much
ran itself.” Attempts to sell the business had been
unsuccessful, and Max Burton was anxious to have the business
continue. Max Burton spoke to Ms. Burton, Mr. Burton, and
Denovan about continuing the business. Ms. Burton was initially
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reluctant but agreed only when Max Burton consented to her ideas
about increasing the level and scope of business activity.
In June 1986, Max Burton and Ms. Burton went to Korea, where
the burner covers that were sold by petitioner were manufactured.
They observed a cooking concept known as “bulgogi”, in which meat
was cooked on a metal plate placed over hot charcoal. As of
January 1, 1987, Ms. Burton took over the affairs of petitioner.
By 1987, petitioner, primarily through the efforts of Ms. Burton,
had adapted the bulgogi cooking concept to American stove
burners. The “Burton Stove Top Grill” was first sold in the U.S.
market in 1987.
Ms. Burton attended community college for 2 years after high
school. After taking over petitioner’s business, she attended
continuing education classes in finance for small businesses,
computers, advertising, letter writing, brochure writing, and
employee relations. Between 1976 and 1978, she worked with her
father as he started the burner cover business, but she was not
paid for that work. After completing her 2 years of college, she
worked for Alaska Airlines for a year. She then worked for the
Port of Seattle Police Department for 5 years, but she left there
in 1982 when she married Denovan, who was a sergeant with the
Port of Seattle Police Department.
In 1982, Ms. Burton was employed in petitioner’s business.
At that time, Ms. Burton made initial sales calls, developed
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sales promotional material, and developed an in-house system of
tracking customers to increase sales. Because of declining
business and differences with her father about business
decisions, Ms. Burton left petitioner in 1985 and began to work
for Continental Airlines.
Ms. Burton worked at Continental Airlines until 1987 and
remained as an employee on inactive status until 1990. While at
Continental Airlines, she was a customer service agent for about
6 months and then was promoted to a supervisory position. She
very much enjoyed that job and particularly the valuable travel
benefits available by reason of that employment.
After the death of Max Burton, no employee of petitioner had
executive responsibilities other than Ms. Burton, Mr. Burton, and
Denovan. Ms. Burton was responsible for the general management
of petitioner. She directly supervised the other two officers,
established company goals and philosophies, and directed
manufacturing quality control. She was responsible for seeking
overseas manufacturers, and she personally negotiated
manufacturing and shipping agreements with them. Many of the
contracts that were negotiated by Ms. Burton were with Korean
companies. She traveled to foreign countries, including Korea,
Taiwan, and China, in order to seek overseas manufacturers and to
negotiate manufacturing and shipping agreements.
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Ms. Burton established and was personally involved in the
operation of petitioner’s public relations division, creating
various advertising and sales-related literature and other
promotional materials. She designed the packaging material for
petitioner’s products and promoted petitioner to various national
and regional newspapers. As petitioner’s spokespersons and
goodwill ambassadors, Ms. Burton and Denovan planned and
personally participated in national trade shows to promote
petitioner’s products since 1987.
Ms. Burton implemented a strategic change in petitioner’s
marketing focus. Prior to her becoming president, petitioner had
sold its goods primarily to small giftware shops. She eliminated
petitioner’s catalog/retail sales and concentrated on selling
petitioner’s products on a wholesale basis. To implement the
change in marketing focus away from the small giftware shops to
the large national department stores, new sales representatives
were required.
Denovan replaced petitioner’s existing force of giftware
sales representatives with houseware sales representatives.
Denovan assembled a nationwide team of sales representatives,
managed through a network of sales organizations. Ms. Burton and
Denovan negotiated commission agreements with petitioner’s sales
representatives and agreed to pay the sales representatives a
commission of up to 15 percent. As a result of its change in
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marketing strategy, petitioner secured national department stores
including J.C. Penney’s, Bloomingdale’s, the Bon Marche, Dayton
Hudson, Marshal Field’s, and Dillards as new customers for
petitioner’s products.
When Ms. Burton became president of petitioner, petitioner
had a $60,000 line of credit with the Bank of Puget Sound. When
the Bank of Puget Sound refused to increase petitioner’s line of
credit, Ms. Burton approached other banks. SeaFirst Bank agreed
to provide petitioner with a $100,000 line of credit. From 1988
through 1990, Ms. Burton and Mr. Burton worked closely with
Robert Drugge, a vice president of SeaFirst Bank, to increase
petitioner’s line of credit to finance petitioner’s expansion.
SeaFirst Bank began providing letters of credit that were used by
petitioner and issued to manufacturers of petitioner’s products.
On or about June 1, 1990, SeaFirst Bank increased petitioner’s
line of credit to $2,700,000. During the relevant periods,
Ms. Burton, Mr. Burton, and Denovan signed personal guaranties to
guaranty the repayment of lines of credit extended by the Bank of
Puget Sound and SeaFirst Bank.
Mr. Burton, as secretary and treasurer of petitioner, was
responsible for all accounting functions of petitioner, prepared
financial plans and budgets, prepared loan applications, and was
in charge of relations with SeaFirst Bank. Mr. Burton studied
accounting and computer operations at a community college.
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Beginning in 1982, Mr. Burton designed, installed, and maintained
the computer system of petitioner. Part of that system included
a program that tracked customer responses to advertisements and a
program used for the company’s accounting. At all relevant
times, Mr. Burton also worked for a company known as Fiserv,
installing computer systems for banks.
As vice president of petitioner, Denovan developed and
executed sales and marketing strategies and was responsible for
organizing and managing petitioner’s national sales
representatives. He was responsible for hiring employees and was
in charge of the shipping of petitioner’s products from suppliers
to vendors. During the calendar year 1990, petitioner employed a
total of 30 employees. At all relevant times, Denovan was
employed full time by the Port of Seattle Police Department,
where he was responsible for training and scheduling special
teams of police.
Petitioner had gross receipts and retained earnings for its
tax years as follows:
1987 1988 1989 1990
Gross receipts $990,388 $975,254 $1,222,973 $4,675,219
Retained earnings 215,154 231,401 241,839 341,239
On June 29, 1990, bonus checks were issued by petitioner.
Bonuses were paid to Ms. Burton, Mr. Burton, and Denovan in the
amounts of $700,000, $200,000, and $100,000, respectively.
Twenty percent of these amounts was withheld and paid to the
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Internal Revenue Service as Federal income tax. The proceeds of
the bonus checks were immediately returned to petitioner in
exchange for promissory notes dated June 29, 1990. The bonuses
that were paid to petitioner’s employees during the calendar year
1990, other than amounts paid to its officers, were each less
than $1,000.
The total compensation (salary and bonus) deducted by
petitioner for its tax years was as follows:
1984 1985 1986 1987 1988 1989 1990
Linda
Burton $22,078 0 $ 600 $11,000 $24,000 $59,225 $751,750
Alfred
Burton 7,957 $2,625 4,800 8,950 7,000 7,100 217,750
Robert
Denovan 0 0 0 0 800 3,500 110,750
Petitioner had a group medical and life insurance plan for all of
its employees, including its officers. The officers decided to
take their compensation in the form of salary and bonuses and not
to adopt a pension or other retirement plan. Petitioner did not
pay dividends.
Respondent determined that the amount of compensation that
was paid to the above individuals was unreasonable. The salaries
that were claimed were allowed as reasonable compensation, but
bonuses were reduced as follows:
Ms. Burton’s salary $ 51,750
Bonus allowed 258,880
Total allowed $310,630
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Mr. Burton’s salary $ 17,750
Bonus allowed 88,890
Total allowed $106,640
Denovan’s salary $ 10,750
Bonus allowed 56,630
Total allowed $ 67,380
OPINION
Section 162(a)(1) allows as a deduction “a reasonable
allowance for salaries or other compensation for personal
services actually rendered”. Section 1.162-9, Income Tax Regs.,
provides that bonuses paid to employees are deductible “when such
payments are made in good faith and as additional compensation
for the services actually rendered by the employees, provided
that such payments, when added to the stipulated salaries, do not
exceed a reasonable compensation for the services rendered.”
Whether an expense that is claimed pursuant to section
162(a)(1) is reasonable compensation for services rendered is a
question of fact that must be decided on the basis of the
particular facts and circumstances. Paula Constr. Co. v.
Commissioner, 58 T.C. 1055, 1058-1059 (1972), affd. without
published opinion 474 F.2d 1345 (5th Cir. 1973). The burden is
on petitioner to show that it is entitled to a compensation
deduction larger than that allowed by respondent. Owensby &
Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1324 (5th Cir.
1987), affg. T.C. Memo. 1985-267.
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Under certain circumstances, prior services may be
compensated in a later year. Lucas v. Ox Fibre Brush Co., 281
U.S. 115 (1930); American Foundry v. Commissioner, 59 T.C. 231,
239 (1972), affd. in part and revd. in part 536 F.2d 289 (9th
Cir. 1976). However, in such instances, the taxpayer must
establish that there was not sufficient compensation in the prior
periods and that, in fact, the current year’s compensation was to
compensate for that underpayment. Estate of Wallace v.
Commissioner, 95 T.C. 525, 553-554 (1990), affd. on another
ground 965 F.2d 1038 (11th Cir. 1992).
The cases contain a lengthy list of factors that are
relevant in the determination of reasonableness, including: The
employee’s qualifications; the nature, extent, and scope of the
employee’s work; the size and complexities of the business; a
comparison of salaries paid with gross income and net income; the
prevailing general economic conditions; a comparison of salaries
with distributions to stockholders; the prevailing rates of
compensation for comparable positions in comparable concerns; the
salary policy of the taxpayer as to all employees; and the amount
of compensation paid to the particular employee in previous
years. Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115
(6th Cir. 1949), affg. a Memorandum Opinion of this Court; see
also Commercial Iron Works v. Commissioner, 166 F.2d 221, 224
(5th Cir. 1948). In Elliotts, Inc. v. Commissioner, 716 F.2d
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1241, 1245-1247 (9th Cir. 1983), revg. and remanding T.C. Memo.
1980-282, the Court of Appeals for the Ninth Circuit divided the
factors into five broad categories, to wit, the employee’s role
in the company; comparison of the employee’s salaries with those
paid by similar companies for similar services; the character and
condition of the company, including the complexities of the
business and general economic conditions; factors indicating a
conflict of interest, such as the employee’s shareholder status;
and internal consistency in a company’s treatment of payments to
employees. No single factor is determinative. Pacific Grains,
Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), affg.
T.C. Memo. 1967-7; Home Interiors & Gifts, Inc. v. Commissioner,
73 T.C. 1142, 1156 (1980). When the case involves a closely held
corporation with the controlling shareholders setting their own
level of compensation as employees, the reasonableness of the
compensation is subject to close scrutiny. Owensby & Kritikos,
Inc. v. Commissioner, supra; Elliotts, Inc. v. Commissioner,
supra at 1246.
Respondent relies on Maggio Bros. Co. v. Commissioner, 6
T.C. 999, 1006 (1946), and contends that the bonuses in question
were not paid during petitioner’s 1990 tax year. Respondent
argues that the payments by checks dated June 29, 1990, and
immediate loans back to petitioner “lacked economic substance and
were entered into solely for tax-avoidance purposes.” Respondent
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acknowledges that, because this argument was not set forth in the
statutory notice, respondent bears the burden of proof on this
issue. We are not persuaded that the evidence in the record
supports the conclusion that bonuses were not actually paid
during the tax year in issue. Respondent has not proven that
this case is comparable to Maggio Bros. Co. v. Commissioner,
supra at 1006, where “the stockholders had no intention of
receiving the proceeds of the bonus checks as salary payments in
the respective taxable years”. Id. We do, however, consider the
facts concerning those transactions as part of our analysis of
whether the compensation deducted by petitioner was reasonable.
A second area of dispute between the parties is whether the
bonuses that were paid for the fiscal year ended in 1990 were
intended to compensate the recipients of those bonuses for
undercompensation in earlier years. Ms. Burton, Mr. Burton, and
Denovan each testified credibly that they accepted minimal
compensation in the early developmental years in anticipation
that their efforts would be rewarded in later years. We are
persuaded that the bonuses that were paid in June 1990 were
intended in part to compensate for undercompensation in earlier
years.
Petitioner must also prove that its executive employees were
in fact undercompensated in earlier years. Respondent argues
that the executives were not undercompensated in earlier years
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based on limited sales and low or negative return on equity in
the earlier years. Each party presented expert testimony in
support of its positions on appropriate compensation levels. We
are not bound by the opinion of any expert when the opinion is
contrary to our own judgment. Bausch & Lomb, Inc. v.
Commissioner, 92 T.C. 525, 597 (1989), affd. 933 F.2d 1084 (2d
Cir. 1991). We may embrace or reject expert testimony, whichever
in our judgment is most appropriate. Helvering v. National
Grocery Co., 304 U.S. 282, 295 (1938). Thus, we are not
restricted to choosing the opinion of one expert over another but
may extract relevant findings from each in drawing on our own
conclusions. Estate of Hall v. Commissioner, 92 T.C. 312, 338
(1989). Here, the experts’ usefulness is primarily in the data
that they collected and analyzed rather than in their ultimately
subjective evaluations of petitioner’s officers.
Respondent’s expert, E. James Brennan III (Brennan),
determined “maximum” and “highest average” annual total
compensation levels for each position. He acknowledged that, in
comparison to other officers in similar businesses, petitioner’s
officers were undercompensated. He concluded that Ms. Burton was
entitled to a high level of compensation and that during fiscal
years 1988 and 1989 Ms. Burton was paid approximately $67,000
below the average total compensation amounts paid to chief
executive officers of bonus-paying companies of similar size.
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Brennan then attempted to justify the undercompensation by
referring to Ms. Burton’s limited relevant experience and lack of
formal credentials. He opined:
If Petitioner’s top financial and sales executives (who
worked only part-time * * *) were similarly credited
with half the highest average rates for experienced
full-time executives in same-size enterprises, that
would create approximately $45K in undercompensation in
FY88, and approximately $40K in FY89. Such amounts are
more than made up by granting them the highest averages
in FY90, when they were still part-time executives with
minimal objective credentials.
We agree that the executives’ limited experience and lack of
formal credentials could be factors to be taken into account.
There is, however, no evidence in the record of the experience or
credentials of those persons earning the salaries that the
experts used for comparison, and petitioner’s business is not of
the character requiring formal education. Thus perceived
deficiencies in formal training of the employees should not be
used as a direct offset from compensation determined by the use
of comparables.
Petitioner’s expert, Tracy A. Bean (Bean) of Arthur Andersen
LLP, did not address the limited experience and credentials of
the executives. Nor did she consider the lack of complexity of
the business operations of petitioner. She added $257,665 for
long-term incentives and $16,623 for retirement benefits to the
cash compensation averages of the comparable companies. We
believe that these additions are unwarranted without proof that
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petitioner’s employees could command such incentives in a
business controlled by outside investors. See Elliotts, Inc. v.
Commissioner, 716 F.2d at 1245.
Bean did not determine reasonable salaries for each of the
executives separately. Using comparisons at the 75th percentile,
she concluded that petitioner “could have paid compensation to
its executive team for 1987 to 1990 in the amount of $1,411,700.”
We are not persuaded that the amounts should be aggregated in
this manner. Rather, compensation to each officer should be
separately evaluated. Bean’s “team” approach inappropriately
treats all three executives as performing above average services.
Upon consideration of all of the data in the experts’
reports, the stipulated facts, and the testimony of petitioner’s
officers concerning the roles that they performed in petitioner’s
business, we conclude that Ms. Burton’s contributions were
extraordinary but that those of Mr. Burton and Denovan were not.
Thus Ms. Burton’s compensation should take into account Brennan’s
“highest maximum” ($378,260) and Bean’s 90th percentile
($312,905) compensation to chief executive officers and add
undercompensation acknowledged by Brennan for 2 years. In
addition to her role as chief executive officer, Ms. Burton
shared with Denovan many duties of a sales executive and is
entitled to a supplement for that role. See Elliotts, Inc. v.
Commissioner, supra at 1245.
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Mr. Burton’s compensation should take into account Brennan’s
“highest average” ($73,540) and Bean’s median ($68,741) for chief
financial officers as well as the undercompensation acknowledged
by Brennan for 2 years. Denovan’s compensation should take into
account Brennan’s “highest average” ($89,430) and Bean’s median
($81,937) for top sales executives and undercompensation
acknowledged by Brennan for 2 years. Petitioner has not
persuaded us that the undercompensation levels exceeded those
acknowledged by Brennan and thus has failed to meet its burden of
proving greater entitlements.
Using our best judgment on the entire record, we conclude
that, for the fiscal year ended June 30, 1990, reasonable
compensation, including compensation for earlier years, is
$525,000 for Ms. Burton and $160,000 for Mr. Burton. The amount
determined in the same manner for Denovan would exceed the amount
paid to him during that year, and petitioner’s deduction is
limited to the amount actually paid. To take account of these
conclusions,
Decision will be entered
under Rule 155.