T.C. Memo. 1999-211
UNITED STATES TAX COURT
EBERL'S CLAIM SERVICE, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12385-97. Filed June 25, 1999.
John D. Moats, for petitioner.
David J. Mungo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined deficiencies in
petitioner's Federal income tax and penalties as follows:
Penalty
FY1 Deficiency Sec. 6662(d)
1992 $1,374,783 $274,957
1993 637,712 127,542
1
Petitioner's 1992 fiscal year ended on May 31, 1993, and
its 1993 fiscal year ended on May 31, 1994.
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After concessions, the issues for decision are:
1. Whether petitioner may deduct as compensation for Kirk
Eberl $4,340,000 for fiscal year 1992 and $2,080,000 for fiscal
year 1993, as petitioner contends; $500,000 for fiscal year 1992
and $400,000 for fiscal year 1993, as respondent contends; or
some other amount. We hold that petitioner may deduct $2,340,000
for fiscal year 1992 and $1,080,000 for fiscal year 1993.
2. Whether petitioner is liable for the accuracy-related
penalty for substantial understatement under section 6662 for
fiscal years 1992 and 1993. We hold that it is not.
Section references are to the Internal Revenue Code in
effect during the years at issue. Rule references are to the Tax
Court Rules of Practice and Procedure.
I. FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Petitioner is a Colorado corporation that had its mailing
address in Lakewood, Colorado, when it filed the petition.
A. Kirk Eberl
1. General
Kirk J. Eberl (Eberl) is petitioner's founder, sole
shareholder, and president. Grace and Kirk Eberl have been
married since 1975.
Eberl's father, Gene Eberl, was a catastrophic claims
adjuster. Catastrophic claims adjusting is the process of
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determining the amount of damages suffered by an insured property
owner as the result of natural or man-made disasters such as
hurricanes, earthquakes, and fires. Catastrophic claims
adjusters inspect property for insurance companies after a
disaster and determine whether the property was damaged by the
catastrophe and the monetary amount of the damage. As a young
man, Eberl sometimes helped his father in catastrophic claims
adjusting activities.
2. Employment
In 1975, Eberl was 18 years old and bought his first house.
He repaired it and sold it for about twice the amount he had paid
for it. From 1975 to about 1985, Kirk and Grace Eberl bought,
lived in, repaired, and sold about 17 houses. Eberl also built
houses, self-storage units, and condominiums.
Before 1986, Eberl occasionally worked as a claims adjuster
for independent catastrophic claims adjusting companies. In
1986, Eberl began working full time as a catastrophic claims
adjuster for several independent catastrophic claims adjusting
companies.
B. Petitioner
1. Formation
In 1987, Eberl started an independent claims adjusting
business, which he operated as a sole proprietorship. Eberl knew
many claims adjusters before he formed petitioner. In 1988, he
incorporated petitioner. Eberl's only capital investment in
petitioner was $500.
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Eberl was the only member of petitioner's board of directors
from June 8, 1988, through the years in issue. Grace Eberl has
been petitioner's corporate secretary and treasurer since it was
incorporated.
2. Petitioner's Business
Petitioner provides the temporary services of independent
catastrophic claims adjusters to client insurance companies.
Petitioner has provided independent claims adjusters for several
major insurance companies, including State Farm Insurance Co.
(State Farm), Safeco, Aetna Travelers, USAA, Nationwide,
Prudential, National Farmers Union, and American Family.
Insurance companies pay independent claims adjusting
companies a negotiated fee for each claim adjusted by the
independent company. Independent companies subcontract the
adjusting work to individual claims adjusters.
Most major insurance companies have in-house claims
adjusters. They use independent adjusters only when major
disasters occur. In 1990, State Farm decided to use only its own
claims adjusters. However, 10 days after Hurricane Andrew struck
in 1992, State Farm decided to use independent adjusters because
its own adjusters could not handle all of the claims. State Farm
accounted for 60-70 percent of petitioner's business in fiscal
years 1992 and 1993. The rest of petitioner's work was
distributed fairly evenly among other companies. Insurance
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companies' in-house claims adjusters performed about 70 percent
of all claims adjusting in 1993 and more than half in 1994.
Petitioner contracted with independent claims adjusters to
work as needed from time to time. Petitioner contracted with 192
claims adjusters in calendar year 1992, 170 in 1993, and 199 in
1994. Catastrophic claims adjusters travel extensively and are
frequently away from home for long periods of time. Adjusters
could decline calls to work for petitioner if they so chose.
Petitioner contracted with individuals and insurance
companies which were located throughout the United States. Once
petitioner was hired, it was required to have claims adjusters at
the site of the catastrophe immediately after it occurred.
Independent claims adjusting companies typically paid their
claims adjusters 60-65 percent of the fee they received from the
insurance company for each claim adjusted. In contrast,
petitioner paid its claims adjusters 70 percent of the fee it
received for each claim adjusted. This helped petitioner obtain
and keep the services of high-quality claims adjusters.
Petitioner issued to its independent claims adjusters Forms
1099 totaling $15,589,041 for fiscal year 1992 and $6,510,745 for
fiscal year 1993. Petitioner paid 76.2 percent of its gross
receipts to claims adjusters in fiscal year 1992 and 71 percent
in fiscal year 1993.
Petitioner's supervisors coordinated the adjusting
activities at each work site and were liaisons between petitioner
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and the insurance companies. Petitioner's supervisors did not
direct the day-to-day work of its independent claims adjusters or
review a significant number of the claims files handled by
petitioner's independent adjusters.
Petitioner's claims adjusters usually returned the claim
file to the insurance company when they finished adjusting a
claim. They did not send the file to petitioner. The adjuster
completed a billing sheet showing how much petitioner was to
receive for the claim. The claims adjuster gave the billing
sheet to the insurance company and sent a copy to petitioner.
After the insurance companies received a completed claim
file, they issued one check to petitioner and one to the
policyholder. Petitioner usually paid its adjusters 2 weeks
after it received payments from the insurance companies.
3. Eberl's Duties
Eberl has always made all of petitioner's business decisions
and supervised or performed substantially all of its managerial
functions, except accounting. He was solely responsible for
marketing petitioner's services to insurance companies and
negotiating petitioner's contracts with insurance companies and
individual claims adjusters.
From 1990 to 1994, Eberl solicited business from six to
eight insurance companies, and petitioner did work for about
four. Eberl spent a substantial amount of time maintaining
relationships with his insurance company contacts because
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petitioner's successful performance for an insurance company in
one disaster did not guarantee that that company would use its
services in the future.
Eberl traveled extensively to meet with insurance industry
officials. In 1986 and 1987, he traveled by car because he could
not afford to fly. He was away from home for months at a time in
1987 and 1988. In 1992, 1993, and 1994, Eberl was away from home
about 75 percent of the time. Eberl worked long hours, often
from 4:30 a.m. until midnight.
Eberl's work schedule was the most hectic right after a
catastrophe. When a catastrophe occurred, he coordinated
petitioner's work with the insurance companies and petitioner's
claims adjusters. He discussed with the insurance companies the
types and number of anticipated claims, determined which
adjusters to use for which jobs, and, with the help of
petitioner's office staff, contacted adjusters and coordinated
the logistics of getting them to the disaster site.
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4. Petitioner's Employees
Eberl signed an employment agreement with petitioner on July
19, 1988. The agreement provided that petitioner would pay Eberl
a base salary and, if the board of directors approved, a bonus.
The contract did not specify the amount of the base salary.
Eberl's salary and bonus were set at the annual meeting of
petitioner's board of directors near the end of each taxable
year.
Grace Eberl was petitioner's office manager, bookkeeper, and
secretary beginning in 1987. Her employment agreement with
petitioner did not specify how much she would be paid. Her
annual salary was set for the next fiscal year at each annual
meeting of petitioner's board of directors. Petitioner paid no
bonuses to Grace Eberl.
Before fiscal year 1991, Kirk and Grace Eberl were
petitioner's only employees. Beginning in fiscal year 1991,
petitioner employed Grace Eberl's mother, Carol Soucie (Soucie),
as office manager, and some part-time clerical staff. Soucie
began to work full time around 1992. Petitioner did not pay a
bonus to Soucie in fiscal years 1992 and 1993.
5. Compensation Paid by Petitioner
In 1988, petitioner sought the advice of its attorney,
Richard Elrod (Elrod), certified public accountant, Mark Lehrner
(Lehrner), and a financial adviser, George Volland (Volland),
concerning its compensation for Eberl. Elrod, Lehrner, Volland,
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and Eberl met two or three times a year thereafter. Among other
things, at those meetings they discussed Eberl's desire to have
petitioner pay Eberl 20-25 percent of its revenues. Based on
these discussions, Eberl believed that they thought compensation
equal to 20-25 percent of petitioner's gross receipts would be
reasonable.
Petitioner paid salaries and bonuses (excluding pension and
profit-sharing contributions) to its officers and employees as
follows:
Kirk Grace Other
Fiscal year Eberl Eberl Soucie employees
1988 $40,000 -0- -- --
1989 608,000 $122,0001 -- --
1990 300,000 120,000 $6,560 -0-
1991 190,000 120,000 16,530 -0-
1992 4,340,000 120,000 21,980 $861
1993 2,080,000 120,000 26,190 6,394
1
This includes $2,000 paid in November 1989 for fiscal year
1988.
Petitioner has provided health and accident insurance for
Eberl since 1988. Effective May 28, 1990, petitioner started a
pension plan and a profit-sharing plan for its employees.
Petitioner contributed to the plan only if petitioner had
profits. Petitioner contributed a total of $30,000 each year to
its pension and profit-sharing plans for Eberl and for Grace
Eberl. It contributed a total of $5,495 in fiscal year 1992 and
$6,437 in fiscal year 1993 to its pension and profit-sharing
plans for Soucie.
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Petitioner and Eberl entered into a deferred compensation
agreement, effective June 1, 1992, under which petitioner agreed
to establish a reserve of $500,000 for each year of Eberl's
service to petitioner (payable at his death, disability, or
retirement) unless his total annual compensation (including
salary and bonus) exceeded $1 million. Payments under this
agreement were in addition to payments made under his employment
agreement with petitioner. Petitioner made no contributions
under the deferred compensation agreement.
Eberl's compensation, as a percentage of petitioner's total
income (gross receipts less cost of goods sold plus interest
income) and net income (before tax, net operating loss, and
Eberl's compensation) was as follows:
Eberl's Comp. as
Fiscal total Total % of total
year compensation income income
1988 $40,000 $72,943 54.8%
1989 638,000 942,552 67.7
1990 330,000 558,178 59.1
1991 220,000 517,332 42.5
1992 4,370,000 4,862,456 89.9
1993 2,110,000 2,658,025 79.4
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Comp. as % Eberl's salary
1
Fiscal NIBTNOL of NIBTNOL as % of
year & comp. & comp. gross receipts
1988 $36,391 110.0% 14.1%
1989 638,000 100.0 14.7
1990 293,767 112.3 13.7
1991 222,861 98.7 8.7
1992 4,392,439 99.5 21.2
1993 2,151,935 98.0 22.7
1
NIBTNOL is petitioner's net income before tax and net operating
loss.
6. Petitioner's Gross Receipts and Taxable Income
Petitioner's taxable income was as follows:
Fiscal Taxable
year income
1988 ($3,609)
1989 (3,609)
1990 (39,842)
1991 (36,981)
1992 (14,542)
1993 27,393
Petitioner has never paid dividends.
Petitioner's net profits (i.e., profits before tax and net
operating loss) as a percentage of gross receipts were as
follows:
Fiscal Net profits before Net profit as %
year tax and NOL Gross receipts of gross receipts
1988 ($3,609) $282,682 (1.28%)
1989 -0- 4,141,872 0.00
1990 (36,233) 2,190,835 (1.65)
1991 2,861 2,193,708 0.13
1992 22,439 20,438,803 0.11
1993 41,935 9,168,585 0.46
Petitioner's net profits as a percentage of total income and
equity were as follows:
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Net profits
Fiscal as % of
year Total income total income Equity
1988 $72,943 (4.95%) $500
1989 942,552 0.00 500
1990 558,178 6.49 500
1991 517,332 0.55 500
1992 4,862,456 0.46 500
1993 2,658,025 1.58 500
Petitioner's annual and cumulative retained earnings were as
follows:
Fiscal Year Annual Cumulative
1988 ($4,655) ($4,655)
1989 (5,750) (10,405)
1990 (41,276) (51,681)
1991 4,650 (47,031)
1992 16,748 (30,283)
1993 37,098 6,815
7. General Economic Conditions
There was more work for catastrophic claims adjusters during
the years in issue than in prior years because of the large
number of catastrophes in 1992 and 1994. U.S. insured
catastrophic losses (approximate) from 1971 to 1995 were:
Calendar year Amount (billions of $)
1971 <1
1972 <1
1973 1
1974 2
1975 1.5
1976 <1
1977 <1
1978 1.5
1979 3
1980 2
1981 1
1982 2
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1983 3
1984 2
1985 3.5
1986 1
1987 1
1988 1.5
1989 8.5
1990 3
1991 4.5
1992 23
1993 6
1994 17
1995 17.7
Five of the 10 most costly insured U.S. catastrophes, as of
May 2, 1996, occurred in petitioner's tax years at issue, shown
as follows:
Occurred in
petitioner's
Amount fiscal year
Event Date (billions) 1992 or 1993
Hurricane Andrew 8/92 $15.5 x
Northridge (CA) earthquake 1/94 12.5 x
Hurricane Hugo 9/89 4.2
Hurricane Opal 10/95 2.1
Winter storms (20 States) 3/93 1.3 x
Oakland fire 10/91 1.7
Hurricane Iniki 9/92 1.6 x
Texas hail storms 5/95 1.1
Loma Prieta (CA) earthquake 10/89 1.0
California brush fires 11/93 1.0 x
8. Petitioner's Federal Income Tax Returns
Lehrner prepared and signed each of petitioner's returns for
fiscal years 1988 to 1993. Petitioner deducted as compensation
it paid to Eberl $4,340,000 in fiscal year 1992 and $2,080,000 in
fiscal year 1993.
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II. OPINION
A. Positions of the Parties
Respondent determined that it was unreasonable for
petitioner to pay Eberl more than $286,815 for services rendered
in fiscal year 1992 and $234,227 in fiscal year 1993. Respondent
now contends that the amounts petitioner paid in excess of
$500,000 for fiscal year 1992 and $400,000 for fiscal year 1993
were unreasonable compensation, disguised dividends, and not for
services to petitioner. Petitioner contends that the amounts it
paid Eberl in fiscal years 1992 ($4,340,000) and 1993
($2,080,000) were reasonable and were for services Eberl provided
to petitioner.
A taxpayer may deduct payments for compensation if the
amount paid is reasonable in amount and for services actually
rendered. Sec. 162(a)(1). Petitioner bears the burden of
proving the reasonableness of compensation it paid in excess of
what respondent contends was reasonable. Rule 142(a).
B. Controlling Factors
Courts have considered several factors in deciding whether
compensation is reasonable in amount, such as: (1) The
employee's qualifications; (2) the nature and scope of the
employee's work; (3) the size and complexity of the business; (4)
general economic conditions; (5) the employer's financial
condition; (6) a comparison of salaries paid with sales and net
income; (7) distributions to shareholders and retained earnings;
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(8) whether the employee and employer dealt at arm's length, and
if not, whether an independent investor would have approved the
compensation; (9) the employer's compensation policy for all
employees; (10) the prevailing rates of compensation for
comparable positions in comparable companies; (11) compensation
paid in prior years; and (12) whether the employee guaranteed the
employer's debt. Rutter v. Commissioner, 853 F.2d 1267, 1271
(5th Cir. 1988), affg. T.C. Memo. 1986-407; Owensby & Kritikos,
Inc. v. Commissioner, 819 F.2d 1315, 1322-1323 (5th Cir. 1987),
affg. T.C. Memo. 1985-267; Pepsi-Cola Bottling Co. of Salina,
Inc. v. Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), affg.
61 T.C. 564 (1974); Mayson Manufacturing Co. v. Commissioner, 178
F.2d 115, 119 (6th Cir. 1949), revg. and remanding a Memorandum
Opinion of this Court dated Nov. 16, 1948; R.J. Nicoll Co. v.
Commissioner, 59 T.C. 37, 51 (1972). No single factor controls.
Mayson Manufacturing Co. v. Commissioner, supra.
Both parties called experts to testify about whether
compensation paid to Eberl was reasonable. Petitioner's expert
was Albert S. Williams (Williams), and respondent's was James F.
Carey (Carey).
We next apply the factors listed above in deciding whether
compensation petitioner paid to Eberl was reasonable.
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1. Employee's Qualifications
An employee's superior qualifications for his or her
position with the business may justify high compensation. Home
Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1158
(1980). Eberl was highly qualified for his position with
petitioner. This factor favors petitioner.
2. Nature and Scope of Employee's Work
An employee's position, duties performed, hours worked, and
general importance to the success of the company may justify high
compensation. Rutter v. Commissioner, supra; American Foundry v.
Commissioner, 536 F.2d 289, 291-292 (9th Cir. 1976), affg. in
part and revg. in part 59 T.C. 231 (1972); Mayson Manufacturing
Co. v. Commissioner, supra.
Eberl was responsible for the rapid growth in petitioner's
gross receipts. Gerald Underwood, a catastrophe operations
supervisor for State Farm during the years at issue, testified
that State Farm would not have hired petitioner to adjust claims
resulting from Hurricane Andrew if not for Eberl.
Eberl has at times performed or overseen virtually every
task for petitioner except accounting. He made virtually every
important business decision for petitioner before and during the
years at issue.
Respondent contends that it is common for a CEO to work long
hours, suggesting that Eberl's schedule was nothing out of the
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ordinary. We believe respondent understates Eberl's level of
effort.
Michael Lawrence Melvin (Melvin) and K.D. Nunn have been
catastrophic claims adjusters for more than 20 years. They
testified that many people have tried to start a business like
petitioner, but they do not know anyone who has been as
successful as Eberl. Melvin formed an independent catastrophic
claims adjusting company similar to petitioner, but his company
went out of business in 1987 or 1988.
This factor favors petitioner.
3. Size and Complexity of Business
We consider the size and complexity of a taxpayer's business
in deciding whether compensation is reasonable. Rutter v.
Commissioner, supra; Pepsi-Cola Bottling Co. v. Commissioner,
supra; Mayson Manufacturing Co. v. Commissioner, supra. A
company's size is measured by its sales, net income, gross
receipts, or capital value. Elliotts, Inc. v. Commissioner, 716
F.2d 1241, 1246 (9th Cir. 1983), revg. and remanding T.C. Memo.
1980-282; E. Wagner & Son v. Commissioner, 93 F.2d 816, 819 (9th
Cir. 1937).
Respondent contends that petitioner's business was simple
because it sold only one service and performed few functions,
none of which were complex. Respondent points out that: (a)
Petitioner generally contracted with experienced claims adjusters
who needed little or no day-to-day supervision, (b) petitioner
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had few employees because its claims adjusters were independent
contractors, (c) petitioner’s billing and collection process was
simple, and (d) petitioner solicited business from only six to
eight companies from 1990 to 1994. However, respondent concedes
that Eberl’s excellent performance in obtaining and retaining
clients for petitioner offsets the relative simplicity of its
business.
Petitioner had gross receipts of more than $20 million in
fiscal year 1992, and more than $9 million in fiscal year 1993.
It arranged for the services of almost 200 claims adjusters
during the years in issue. Petitioner's business required
expertise in catastrophic claims adjusting, bidding, marketing,
and management. Petitioner was responsible for getting a large
number of claims adjusters located throughout the United States
to disaster sites immediately. This was logistically complex.
It is easy to say that founding and running petitioner was
simple, but we do not think anyone who accomplished what Eberl
did would find that characterization to be fair. This factor
favors petitioner.
4. General Economic Conditions
General economic conditions may affect a company's
performance and thus show the extent of the employee's effect on
the company. Rutter v. Commissioner, supra; Mayson Manufacturing
Co. v. Commissioner, supra.
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Petitioner contends that it grew even though other
independent claims adjusting companies failed. Nonetheless,
petitioner benefited tremendously from the large amount of
catastrophes (5 of the 10 largest in history) during its fiscal
years 1992 and 1993. This factor favors respondent.
5. Petitioner's Financial Condition
The past and present financial condition of a company is
relevant to deciding whether compensation was reasonable. Home
Interiors & Gifts, Inc. v. Commissioner, supra at 1157-1158.
Petitioner contends that the fact that its gross receipts
increased from $282,682 in fiscal year 1988 to $20,438,803 in
fiscal year 1992 and $9,168,585 in fiscal year 1993 shows that
its financial condition was good. We disagree.
Petitioner's financial condition (in contrast to Eberl's)
was poor. Despite having a large increase in gross receipts from
fiscal year 1988 to fiscal years 1992 and 1993, petitioner had a
tiny amount of profits in fiscal years 1992 and 1993, negative
taxable income from fiscal years 1988 to 1992, and taxable income
of only $27,393 in fiscal year 1993. Petitioner's profits in
fiscal years 1992 and 1993 were substantially lower than those of
comparably sized service companies.
In Alpha Med., Inc. v. Commissioner, 172 F.3d 942 (6th Cir.
1999), revg. T.C. Memo. 1997-464, the taxpayer was a medical
management corporation that paid its president and sole
shareholder compensation of $4,439,180. The U.S. Court of
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Appeals for the Sixth Circuit held that the compensation was
reasonable. However, unlike petitioner, the taxpayer in Alpha
Med., Inc. was financially successful; its taxable income
increased by a factor of 18, and its net worth increased by a
factor of 35 in 4 years. In contrast, petitioner had negative
taxable income in all years except fiscal year 1993, negative
accumulated retained earnings in all years except fiscal year
1993, and low profits in fiscal years 1992 and 1993.
This factor favors respondent.
6. Comparison of Salaries Paid With Gross and Net Income
A comparison of compensation to net income can indicate
whether a corporation is disguising dividends as compensation.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1325-1326;
Mayson Manufacturing Co. v. Commissioner, supra.
Eberl's compensation was 99.5 percent of petitioner's net
income1 for fiscal year 1992, and 98 percent of its net income
for fiscal year 1993. Petitioner's pattern of distributing the
vast majority of its net income as compensation to Eberl at the
end of each year suggests that the amount of compensation paid
was unreasonable. Owensby & Kritikos, Inc. v. Commissioner,
supra at 1326.
Petitioner contends that Eberl's compensation was reasonable
because it had agreed to pay Eberl 20 percent of its gross
1
Net income is income before tax, net operating loss, and
compensation.
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receipts under a contingent compensation formula. We disagree.
Petitioner's purported compensation formula was at best vague.
Eberl wanted compensation equal to 20-25 percent of petitioner's
gross receipts,2 and he told petitioner's tax advisers of his
wish. However, this purported formula was not in petitioner's
corporate minutes. While we give little or no weight to the
absence of formal board resolutions in closely held corporations,
Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 713-714
(1977); Reub Isaacs & Co. v. Commissioner, 1 B.T.A. 45, 48
(1924), it is noteworthy here that the purported agreement was
not in writing, despite the fact that petitioner’s employment and
deferred compensation agreements were in writing. Petitioner did
not pay Eberl 20 percent of its gross receipts during any of its
fiscal years from 1988 to 1993. Eberl's compensation increased
from 14.2 percent of petitioner's gross receipts in fiscal year
1988 to 23 percent in fiscal year 1993. Petitioner consistently
paid Eberl almost all of the income left after it paid its claims
adjusters and overhead expenses.
2
Petitioner's reliance on Boca Constr., Inc. v.
Commissioner, T.C. Memo. 1995-5, for the proposition that its
compensation formula was reasonable is misplaced. In Boca, the
taxpayer consistently applied a bonus formula each year. The
bonus could not exceed the lesser of 25 percent of gross receipts
or 67 percent of profits. In contrast to the instant case, the
formula in Boca ensured that the owners' compensation would not
deprive the taxpayer of all of its net profits. Here, Eberl's
compensation caused petitioner to have no taxable income from
fiscal years 1988 to 1992.
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Petitioner contends that it set the amount of Eberl's pay at
the end of the fiscal year because of the contingent compensation
formula. We disagree. We believe Eberl decided the amount of
his compensation late in fiscal years 1992 and 1993 so he could
receive virtually all of petitioner's net profits as
compensation. See Petro-Chem Mktg. Co. v. United States, 221 Ct.
Cl. 211, 602 F.2d 959, 968 (1979) (Court inferred that bonuses
paid to shareholder-employees near the end of the year which
absorbed nearly all of the taxpayer's earnings were at least in
part a distribution of profits); Builders Steel Co. v.
Commissioner, 197 F.2d 263, 264 (8th Cir. 1952); Owensby &
Kritikos, Inc. v. Commissioner, T.C. Memo. 1985-267, affd. 819
F.2d 1315 (5th Cir. 1987); see e.g., Rich Plan, Inc. v.
Commissioner, T.C. Memo. 1978-514. The fact that petitioner made
lump-sum payments to Eberl that were not allocated between salary
and bonus also suggests that the payments to Eberl were in part
disguised dividends. See Nor-Cal Adjusters v. Commissioner, T.C.
Memo. 1971-200, affd. 503 F.2d 359 (9th Cir. 1974) (bonuses paid
to officer-stockholders that were computed based on the
availability of funds were distributions of earnings and thus not
deductible by the taxpayer).
This factor favors respondent.
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7. Comparison of Salary to Distributions to Shareholders
and Retained Earnings
If salaries paid to controlling shareholders are large
compared to salaries paid to nonowner managers who have similar
responsibilities, the salaries suggest that the amount of
compensation is a function of ownership. Elliotts, Inc. v.
Commissioner, 716 F.2d at 1247.
The failure to pay more than a minimal amount of dividends
may suggest that some of the amounts paid as compensation to the
shareholder-employee is a dividend. Edwin's, Inc. v. United
States, 501 F.2d 675, 677 n.5 (7th Cir. 1974); Charles Schneider
& Co. v. Commissioner, 500 F.2d 148, 152-153 (8th Cir. 1974),
affg. T.C. Memo. 1973-130; Owensby & Kritikos, Inc. v.
Commissioner, supra at 1322-1323. However, corporations are not
required to pay dividends; shareholders may be equally content
with the appreciation of their stock if the company retains
earnings. Owensby & Kritikos, Inc. v. Commissioner, supra at
1326-1327; Elliotts, Inc. v. Commissioner, supra; Home Interiors
& Gifts, Inc. v. Commissioner, 73 T.C. at 1161.
Petitioner has never paid dividends. Nonpayment of
dividends in conjunction with paying contingent compensation to
controlling shareholders, such as Eberl, suggests that
unreasonable and excessive compensation is being paid.
Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 528 F.2d
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at 182-183; Perlmutter v. Commissioner, 373 F.2d 45, 48 (10th
Cir. 1967), affg. 44 T.C. 382 (1965).
Petitioner contends that it had no need to retain earnings
and that it was reasonable for it not to do so. We are not
convinced that petitioner had no need to retain earnings to help
it survive if Eberl retired or became disabled or if there was
less work for independent catastrophe claims adjusters. See
Pulsar Components Intl., Inc. v. Commissioner, T.C. Memo. 1996-
129 (Court found that corporation paid reasonable compensation to
two of its officer/shareholders because an independent investor
would have been satisfied with corporation's payment of $65,000
of dividends and additional retention of earnings as cushion for
possible less profitable periods).
The prime indicator of the return a corporation is earning
for its investors is its return on equity. Owensby & Kritikos,
Inc. v. Commissioner, supra at 1324.
Petitioner contends that petitioner's return on equity
should be based on Eberl's $500 investment, that petitioner had a
return on equity for fiscal year 1992 of 3,350 percent and 1,363
percent for fiscal year 1993, and that this return on equity
would satisfy an independent investor. Petitioner also contends
that it did not need to pay dividends because a hypothetical
shareholder would be satisfied with the appreciation in value of
his or her stock due to petitioner's retention of earnings and
the growth in petitioner's annual sales.
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Petitioner cites no case in which the court gave significant
weight to a high return on equity based on a founding
shareholder's small initial investment. Courts have relied on
other financial factors when a shareholder's capital contribution
is small. See, e.g., Alpha Medical, Inc. v. Commissioner, 172
F.3d 942 (6th Cir. 1999), revg. T.C. Memo. 1997-464 (Court
derived return on equity by comparing retained earnings for the
year at issue plus the shareholder's $1,000 capital investment to
retained earnings for the prior year plus the shareholder's
capital investment); Labelgraphics, Inc. v. Commissioner, supra
(annual return on equity may be skewed in years in which the
taxpayer's equity is low); H&A Intl. Jewelry, Ltd. v.
Commissioner, T.C. Memo. 1997-467. We give petitioner's method
for calculating return on equity3 for fiscal year 1993 based on
Eberl's $500 investment little weight in view of petitioner's
small amount of accumulated retained earnings, taxable income,
profits, and lack of dividends. Finally, petitioner did not
retain earnings in fiscal years 1988 to 1990 and had negative
cumulative retained earnings in fiscal years 1988 to 1992; there
is no evidence that the value of petitioner's stock appreciated
during the years in issue; and petitioner offered no reason for
its failure to pay dividends. See Owensby & Kritikos, Inc. v.
3
The parties disagree as to whether we compute return on
equity using current or accumulated retained earnings.
Resolution of this dispute does not affect the outcome of this
case.
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Commissioner, supra at 1326 (in deciding the reasonableness of
compensation, a court may consider the absence of dividends if a
profitable corporation has offered no reasons for its failure to
pay dividends).
This factor favors respondent.
8. Whether Employee and Employer Dealt at Arm's Length
The failure of the employee and employer to deal at arm's
length, such as if the employee is the employer's sole or
controlling shareholder, suggests that the amount of compensation
paid may be unreasonable. Elliotts, Inc. v. Commissioner, 716
F.2d at 1246; Owensby & Kritikos, Inc. v. Commissioner, supra at
1322-1324. We closely scrutinize compensation if the employee
controls the employer to see whether it is something other than
the purchase price of the employee's services. Charles Schneider
& Co. v. Commissioner, 500 F.2d at 152; see also Dielectric
Matls. Co. v. Commissioner, 57 T.C. 587, 591 (1972).
Eberl has been petitioner's sole shareholder and president
at all times since he founded petitioner. He set his own salary
and bonus. Eberl and petitioner did not deal at arm's length.
See Estate of Wallace v. Commissioner, 95 T.C. 525, 555 (1990),
affd. 965 F.2d 1038 (11th Cir. 1992); cf. Mayson Manufacturing
Co. v. Commissioner, 178 F.2d at 121 (bonus plan established by
board of directors for minority shareholders was an arm's-length
transaction).
This factor favors respondent.
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9. Petitioner's Compensation Policy for All Employees
Courts have considered the taxpayer's compensation policy
for its other employees in deciding whether compensation is
reasonable. Mayson Manufacturing Co. v. Commissioner, 178 F.2d
at 119; Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at
1159. This factor focuses on whether the entity pays top dollar
to all of its employees, including both shareholders and
nonshareholders. Owensby & Kritikos, Inc. v. Commissioner, supra
at 1329-1330.
Petitioner offered no evidence that its other employees
(Eberl's wife and mother-in-law) were paid at or near the high
end of the compensation range. Although petitioner's adjusters
were not its employees, we recognize that petitioner paid them 70
percent of the fee it received from the insurance company,
compared to an industry norm of 60-65 percent. However, the
adjusters did not share in the large distribution of profits
petitioner made to Eberl at the end of the fiscal year. Thus,
petitioner's payment policy for its adjusters is not similar to
petitioner's payment policy for Eberl. Cf. Home Interiors &
Gifts, Inc. v. Commissioner, supra (compensation paid to the
taxpayer's shareholder-employees was reasonable in part because
the taxpayer had longstanding practice of paying all of its key
employees on the basis of commissions).
This factor favors respondent.
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10. Prevailing Rates of Compensation for Comparable
Positions in Comparable Companies
In deciding whether pay is reasonable, we compare it to
compensation paid to persons holding comparable positions in
comparable companies. Rutter v. Commissioner, 853 F.2d at 1271;
Mayson Manufacturing Co. v. Commissioner, supra at 119.
Neither respondent's expert, Carey, nor petitioner's expert,
Williams, had data from businesses that are similar to petitioner
or executives whose performance was shown to be similar to
Eberl's. Pulsar Components Intl., Inc. v. Commissioner, supra
(Court not persuaded by expert testimony that did not compare
prevailing rates of compensation for comparable positions in
comparable companies); Mad Auto Wrecking, Inc. v. Commissioner,
T.C. Memo. 1995-153 (same).
Respondent contends that petitioner could have hired someone
to perform all of Eberl's services for $500,000 per year.
Respondent's contention is speculative.
This factor is neutral because neither respondent's nor
petitioner's experts had persuasive comparative pay data.
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11. Compensation Paid in Prior Years
An employer may deduct compensation paid in a year for
services rendered in prior years. Lucas v. Ox Fibre Brush Co.,
281 U.S. 115, 119 (1930); R.J. Nicoll Co. v. Commissioner, 59
T.C. at 50-51. To currently deduct amounts paid as compensation
for past undercompensation, a taxpayer must show: (a) That it
intended to compensate employees for past services from current
payments, and (b) the amount of past undercompensation. Pacific
Grains, Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968),
affg. T.C. Memo. 1967-7; Estate of Wallace v. Commissioner, supra
at 553-554.
Petitioner's records show that Eberl's compensation in
fiscal years 1992 and 1993 was not catchup pay. The minutes for
the annual board meetings authorizing petitioner to pay Eberl's
salary and bonus for fiscal years 1992 and 1993 state that Eberl
was paid "for the current year" and do not indicate that any of
the payment was for prior years. See Pacific Grains, Inc. v.
Commissioner, supra (corporate president was not underpaid in
part because taxpayer's board did not state that some part of the
payments were for his prior services); H&A Intl. Jewelry, Ltd. v.
Commissioner, T.C. Memo. 1997-467 (pay was not catchup pay where
minutes from shareholder meetings showed that the compensation
for the current year was not intended to reward the employee's
efforts for prior years).
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Petitioner paid Eberl less than 20 percent of its gross
receipts in fiscal years 1988 to 1991 and more than 20 percent in
fiscal years 1992 and 1993. Petitioner contends that its
payments to Eberl in fiscal years 1992 and 1993 in excess of 20
percent of its gross receipts were intended to compensate him for
services in petitioner's early years. We disagree. We do not
believe that Eberl was underpaid in prior years. The fact that
Eberl received less than he wanted from fiscal years 1988 to 1991
does not establish that he was underpaid. Cf. Alpha Medical,
Inc. v. Commissioner, supra (the shareholder had been underpaid
for past services because he had received but rejected an offer
paying more than $1 million annually); Comtec Systems, Inc. v.
Commissioner, T.C. Memo. 1995-4 (corporation's president and vice
president were underpaid for past services where both had
accepted low wages (and the vice president received no pay for 6
years) until the corporation was successful).
We conclude that none of the 1992 and 1993 compensation in
issue was catchup pay. This factor favors respondent.
12. Whether Employee Guaranteed Taxpayer's Debt
In deciding whether compensation is reasonable, courts have
considered whether the employee personally guaranteed the
employer's debt. See R.J. Nicoll Co. v. Commissioner, supra at
51. Petitioner had no debt. This factor does not apply here.
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13. Conclusion
Petitioner's increase in gross receipts resulted not only
from the huge volume of catastrophic claims work during the years
in issue, but also from Eberl's long hours, personal contacts,
and his knowledge of the catastrophic claims business. It would
be reasonable for petitioner to compensate him well for that
work. However, the problem from petitioner's stand point is that
Eberl chose to leave petitioner with virtually nothing to show
for his work. Carey testified that it would be reasonable to
expect petitioner to have pretax earnings of about $2 million for
fiscal year 1992 and about $1 million for fiscal year 1993.
Carey acknowledged that if petitioner had retained earnings of $2
million in fiscal year 1992, it would still have had $2,340,0004
to pay Eberl, and that compensation to Eberl of $2,340,000 in
that year might be reasonable. Carey did not change his
conclusion that it would be unreasonable to pay Eberl more than
$500,000 in fiscal year 1992 and $400,000 in fiscal year 1993,
but neither Carey nor respondent gave any convincing reason why
petitioner should have retained more than $2 million in earnings.
This suggests that reasonable compensation to Eberl for fiscal
year 1992 could be as much as $2,340,000, the difference between
the amount paid to Eberl ($4,340,000) and the amount of retained
4
Carey said $2,200,000, not $2,340,000. However, the
record shows that $2,340,000 is the correct amount ($4,340,000 -
$2,000,000 = $2,340,000).
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earnings Carey said it would have been reasonable for petitioner
to have ($2 million). Applying Carey's analysis to fiscal year
1993, reasonable compensation to Eberl could be as much as
$1,080,000 (the difference between the amount petitioner paid
Eberl ($2,080,000) and the amount of retained earnings Carey said
would have been reasonable for petitioner to have ($1 million)).
Other facts present here support a finding that compensation
to Eberl in excess of those amounts would be unreasonable. Eberl
set his own compensation, which was not the result of an arm's-
length agreement; petitioner retained a minimal amount of
earnings and distributed almost all of its profits to Eberl at
the end of the year; and petitioner's other employees and
independent adjusters did not receive yearend bonuses. These
facts suggest that a substantial part of Eberl's compensation was
a disguised dividend and not purely for services. We conclude
that $2,340,000 for fiscal year 1992 and $1,080,000 for fiscal
year 1993 constituted reasonable compensation to Eberl for those
years. See Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. at
568 (the Court must decide the amount of reasonable compensation
where the taxpayer proves the Commissioner's determination to be
wrong).
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C. Whether Petitioner Is Liable for the Penalty Under Section
6662 for Substantial Understatement
Respondent determined that petitioner is liable for the
accuracy-related penalty for substantial understatement for
fiscal years 1992 and 1993 under section 6662.
Taxpayers are liable for a penalty equal to 20 percent of
the part of the underpayment attributable to negligence or
substantial understatement of tax. Sec. 6662(a), (b)(1) and (2).
A substantial understatement of income tax occurs when the amount
of the understatement for a taxable year exceeds the greater of
10 percent of the tax required to be shown on the return or
$10,000 in the case of a corporation. Sec. 6662(d)(1)(A). The
accuracy-related penalty does not apply to any part of an
underpayment if the taxpayer shows that there was reasonable
cause and that the taxpayer acted in good faith. Sec.
6664(c)(1). Reliance on the advice of a professional, such as an
accountant, may constitute reasonable cause if, under all the
facts and circumstances, that reliance is reasonable and the
taxpayer acted in good faith. Sec. 1.6664-4(c), Income Tax Regs.
Respondent contends that petitioner did not have substantial
authority or reasonable cause for deducting the compensation paid
to Eberl because petitioner's tax advisers were not executive
compensation specialists and because they did not advise
petitioner that the amounts it actually paid Eberl were
reasonable compensation. We disagree.
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Based on his discussions with petitioner's advisers, Eberl
reasonably believed that compensation equal to 20-25 percent of
petitioner's gross receipts would be reasonable. Lehrner signed
petitioner's tax returns for the years in issue, which suggests
that Eberl believed Lehrner thought Eberl's compensation was
reasonable. See Bokum v. Commissioner, 94 T.C. 126, 148 (1990)
(accountant's failure to sign the tax return should have put the
taxpayer on notice that he was not backing the advice embodied in
the return). We hold that petitioner's reliance was reasonable
cause for deducting the compensation it paid to Eberl.5
To reflect the foregoing and concessions,
Decision will be entered
under Rule 155.
5
Also, petitioner is not liable for the substantial
understatement penalty for fiscal year 1992 because it adequately
disclosed the facts relating to Eberl's compensation on its 1992
return. Sec. 6662(d)(2)(B)(ii). Rev. Proc. 92-23, 1992-1 C.B.
737, sec. 4(b)(4), 1992-1 C.B. 738, provides that, for purposes
of reducing the understatement of income tax under sec. 6662(d),
additional disclosure of facts relating to an issue involving
reasonable compensation is unnecessary, if the Form 1120,
Schedule E, Compensation of Officers, has been properly
completed. Petitioner included a properly completed Schedule E
concerning Eberl's compensation in its 1992 return.