T.C. Memo. 2001-119
UNITED STATES TAX COURT
METRO LEASING AND DEVELOPMENT CORPORATION, EAST BAY
CHEVROLET COMPANY, A CORPORATION, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 8054-99, 8055-99. Filed May 18, 2001.
William L. Raby, for petitioners.
Kathryn K. Vetter, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: In these consolidated cases, respondent
determined the following deficiencies and penalties in
petitioners’1 1995 and 1996 taxable years:
1
Petitioner, Metro Leasing and Development Corp. is a
successor in interest to petitioner, East Bay Chevrolet Co., a
corporation. Accordingly, there is no need to distinguish
between them for purposes of this opinion, and petitioners will
be collectively referred to as petitioner.
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Deficiencies
Income Accumulated Penalty
Year tax earnings tax sec. 6662(a)
1995 $307,699 $108,714 $61,540
1996 142,559 --- 28,512
The parties have reached agreement with respect to several
issues, and the following issues remain for our consideration:
(1) Whether for its 1995 or 1996 tax year petitioner is entitled
to deduct officer’s compensation in any amount exceeding $76,800,
the amount determined by respondent; (2) whether for its 1995 tax
year petitioner permitted its earnings to accumulate beyond the
reasonable needs of the business so as to be subject to the
accumulated earnings tax; and (3) whether petitioner is liable
for an accuracy-related penalty under section 6662(a)2 for 1995
and/or 1996.
FINDINGS OF FACT
Metro Leasing and Development Corp., petitioner, had its
principal place of business in El Macero, California, at the time
the petitions were filed in these cases. During the years in
issue, George Valente, who was approximately 70 years old, was
director and owned 100 percent of the common stock of petitioner.
Mr. Valente became ill in 1992 and suffered from prostate cancer
during 1995 and 1996. Mr. Valente was somewhat disabled by and
2
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.
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concerned about his condition, so he appointed his wife, Lena
Valente, to be petitioner’s president during the years under
consideration. During 1995 and 1996, Mrs. Valente was 66 and 67
years of age, respectively. Even though he was ill, Mr. Valente
remained active in petitioner’s business by means of a
cooperative effort with Mrs. Valente. Under that arrangement,
Mr. Valente was the decision-maker, and Mrs. Valente executed his
decisions. Mr. Valente determined the amount of compensation to
be paid to officers based on the profitability of the business.
Because of their joint efforts, Mr. and Mrs. Valente’s
compensation was treated as an undivided amount for their
combined efforts. Mrs. Valente became ill during 1996, retiring
at the end of that year, and she died during 1998.
Mr. Valente became involved in the automobile business in
1959 and at one point owned seven automobile dealerships and an
automobile leasing company. Mr. Valente sold the last of his
automobile dealerships, Green Valley Ford, in 1990. In
connection with the last sale, Mr. Valente agreed to provide
business consultation to the new owners and to “run” the profit-
sharing plan. The new owners agreed to provide the Valentes with
a new car each year. In 1991, Mr. Valente received $20,444 of
compensation from Green Valley Ford and for 1992, 1993, 1995, and
1996 he received $1,690, $2,851, $3,289, and $2,049,
respectively. For 1995 and 1996, Mr. Valente received
distributions of $55,307 and $76,076, respectively, from Green
Valley Ford’s profit-sharing plan.
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During the years in issue, petitioner had three employees,
Mr. and Mrs. Valente and Jo Ann Michaels, who was the corporate
secretary and bookkeeper. As bookkeeper, Ms. Michaels deposited
receipts, prepared checks, reconciled bank statements and
maintained the books of account, including the general ledger and
the cash receipts and disbursement journals. Petitioner’s place
of business was in the Valentes’ residence.
Petitioner’s business during 1995 and 1996 included the
ownership of land and buildings leased to Green Valley Ford,
under which the lessee paid the expenses associated with the
property. Petitioner was also engaged in the business of leasing
automobiles and the purchase and sale of real property.
Petitioner had approximately 10 automobile leases during the
years in question, all of which had been entered into prior to
1995. Petitioner’s assets included land and a building in El
Cerrito, and mortgages receivable in excess of $2.5 million,
secured by real property located on Airport Boulevard, South San
Francisco. Petitioner had sold this property, on the installment
basis, on January 19, 1995.
Mr. Valente was qualified to be involved in any aspect of
the automobile business, including petitioner’s activities of
leasing realty to an automobile dealer and leasing automobiles.
Mr. Valente was, in general, successful and experienced in
business operations. For the 12-year period 1985 through 1996,
his highest annual wages exeeded $1 million, and his average
wages for that period exceeded one-half million dollars. After
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1990 and before 1995, however, Mr. Valente’s reported wages did
not exceed $320,000 and were as low as $151,690 and averaged
$209,462. Mr. Valente consulted for and was compensated by Green
Valley Ford. He also consulted with the dealership executives in
connection with petitioner’s business operations. Mr. Valente
spent as much as 15 hours per week consulting. His expertise was
also used in connection with the South San Francisco property,
which also involved an automobile dealership. He consulted with
that dealership’s executives to help ensure their continued
ability to make mortgage payments on petitioner’s self-financed
sale of the property to the new dealer. Mr. Valente also spent a
limited amount of time working on petitioner’s accounts
collectible.
For 1995, petitioner deducted $240,435 as compensation to
officers, which included a yearend bonus of $180,435. For 1996,
petitioner deducted $460,000 as compensation to officers,
including yearend bonuses of $150,000 to Mrs. Valente and
$250,000 to Mr. Valente. For years prior to 1995, the Valentes
reported wages as follows:
Year Amount
1985 $498,647
1986 493,485
1987 1,053,801
1988 1,075,075
1989 941,407
1990 1,072,362
1991 320,000
1992 151,690
1993 152,851
1994 213,305
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For 1995 and 1996, petitioner’s gross receipts consisted of
the following amounts:
Type of income 1995 1996
Interest income $259,652 $240,427
Gross rents 353,376 388,676
Net capital gains 35,884 267,657
Form 4797 gain 246,346 8,141
Late fees 2,931 1,170
Total income 898,189 906,071
Petitioner’s total income before expenses, officer’s
compensation, and ratio of compensation to total income for 1987
through 1996 were as follows:
Compensation as
Total Officer percentage of
Year income compensation total income
1987 $626,991 $425,000 67.8
1988 583,949 310,000 53.1
1989 503,859 260,000 51.6
1990 569,530 260,000 45.7
1991 946,396 360,000 38.0
1992 604,344 150,000 24.8
1993 633,688 150,000 23.7
1994 640,602 210,000 32.8
1995 898,479 240,435 26.7
1996 806,071 460,000 57.1
Petitioner acquired and sold shares of stock as follows:
Company name Date acquired Date sold
Data Med 9/20/88 5/9/95
Mylex Corp. pre-‘95 ---
Cyrix Corp. ‘95 & ‘96 ‘96
Focus Enhancement 5/23/96 12/9/96
IMP, Inc. 12/16/94 5/9/96
Interactive Medical
Tech. 6/30/95 10/21/96
Oryx ‘96 ---
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Respondent determined the amount of petitioner’s allowable
deductions for reasonable compensation by use of statistics
reflecting compensation for corporate officers in the equipment-
leasing and real estate-rental business. Based on those
statistics, respondent determined that petitioner was entitled to
a deduction of $76,800 for each of the years 1995 and 1996 as
reasonable compensation for the Valentes’ services to petitioner.
The following schedule reflects respondent’s comparison
between petitioner’s taxable income; adjusted taxable income
(adjusted to not include net operating loss deductions, special
deductions, and deductions for officer’s compensation); officer’s
compensation; and the percentage of adjusted taxable income
represented by officer compensation:
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Adjusted
Taxable taxable
Year income income Compensation Percentage
1
1987 ($171,253) $285,636 $425,000 100.0
1988 33,406 343,406 310,000 90.3
1
1989 (19,237) 240,763 260,000 100.0
1990 (5,402) 273,871 260,000 94.9
1991 327,543 692,945 360,000 52.0
1992 244,323 394,376 150,000 38.0
1993 26,348 176,348 150,000 85.1
1
1994 (36,327) 173,673 210,000 100.0
1995 17,825 294,587 240,435 81.6
1996 58,755 518,755 460,000 88.7
1
Greater than 100 percent.
The following schedule reflects the dividends received by
the Valentes from petitioner:
Year Amount
1985 -0-
1986 -0-
1987 -0-
1988 $17,600
1989 10,560
1990 11,241
1991 60,000
1992 10,000
1993 10,800
1994 -0-
1995 -0-
1996 -0-
Petitioner owned property in El Cerrito, which had been used
as a parking lot, and Mr. Valente envisioned future development
of the property. Although Mr. Valente envisioned future
development at a cost ranging from $7 million to $10 million, as
of the years in question, no plans had been made for development
nor action commenced to initiate a formal plan to develop the
property. Petitioner, through its bookkeeper and the Valentes,
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provided all relevant information to their accountant and relied
upon his expertise and judgment in the preparation and reporting
of Federal income.
OPINION
I. Reasonable Compensation
The parties disagree about the methodology to be used for
measuring or determining the amount of reasonable compensation.
They also rely on differing facts in applying the standards.
Section 162 provides for deductions for ordinary and necessary
expenses incurred in carrying on a trade or business, including a
reasonable allowance for salaries or compensation for services
performed.
Respondent, emphasizing case law from opinions of the Court
of Appeals for the Ninth Circuit,3 argues that when payments are
made to a corporate employee who is also a principal shareholder,
the compensation must be reasonable in amount and have a purely
compensatory purpose. See O.S.C. & Associates, Inc. v.
Commissioner, 187 F.3d 1116, 1119-1120 (9th Cir. 1999) (and cases
cited therein), affg. T.C. Memo. 1997-300.
Respondent also points out that the Court of Appeals for the
Ninth Circuit traditionally has looked to five factors, none of
which is decisive, to evaluate whether compensation is
reasonable, to wit: (1) The employee’s role in the company; (2)
3
Barring a stipulation to the contrary, any appeal from
this Court’s decision would be to the Court of Appeals for the
Ninth Circuit. See sec. 7482(b).
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an external comparison of the employee’s salary with salaries
paid by similar companies for similar services; (3) the character
and condition of the company; (4) the conflict of interest
between the company and the employee; and (5) the internal
consistency in the company’s treatment of payments to employees.
See, e.g., Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-
1248 (9th Cir. 1983), revg. T.C. Memo. 1980-282.
Petitioner, in a similar fashion, points out that there are
five traditional factors that the courts have used to decide
whether compensation is reasonable, to wit: (1) The type of
services and their extent; (2) the scarcity of qualified
employees; (3) qualifications and prior earning capacity; (4) the
net earnings of the corporate taxpayer; and (5) the peculiar
characteristics of the taxpayer’s business. Petitioner’s
suggested traditional factors are, in essence, the same ones the
Court of Appeals for the Ninth Circuit has utilized.
Each party reviews the facts of these cases under the
traditional factors and concludes that their position is fully
supported--i.e., respondent contends that his determination is
correct, and petitioner contends that its compensation claims are
reasonable. Petitioner, however, contends that the traditional
tests are not adequate in the circumstances of these cases.
Petitioner urges us to use exclusively the “independent investor
test” in the same manner as used by the Court of Appeals for the
Seventh Circuit in Exacto Spring Corp. v. Commissioner, 196 F.3d
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833, 835 (7th Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo.
1998-220.
We begin our reasonable compensation analysis by evaluating
the facts of these cases in the context of the traditional
factors, in the format used by the Court of Appeals for the Ninth
Circuit.
A. The Employee’s Role in the Company
We consider the Valentes as a single unit in the setting of
this case because Mr. Valente was ill, and, although he was able
to make decisions, it was Mrs. Valente who executed his
decisions. Although a large portion of the compensation was paid
to Mrs. Valente, the total compensation was based on the
Valentes’ joint efforts or performance, and we refer to that
performance collectively and in the singular. The Valentes
(initially Mr. Valente and then Mrs. Valente) were taken ill and
became unable to fully function in petitioner’s business.
Petitioner’s sources of income are of a passive or investment
nature, in that income was generally received from established
capital investment rather than from personal services. Prior to
the years under consideration, Mr. Valente sold his active
operating interests in automobile dealerships and a leasing
operation. Thereafter, operating out of the Valentes’ home,
petitioner’s sources of income were mainly from investment type
activity--collection of rent and interest and the purchase and
sale of securities and realty. Except for the ownership of a
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couple of parcels of land and some stock, petitioner’s source of
income was from the remnants of Mr. Valente’s former ownership of
automobile dealerships. Until the beginning of 1995, they owned
realty that was leased to two different Ford dealerships. In the
beginning of 1995, they sold one of the properties to the lessee
and their income therefrom became income from seller-financing
rather than from rental.
Due to their age and physical condition, the Valentes were
essentially semiretired. During 1995 and 1996, Mr. Valente was
recuperating from surgery necessitated by prostrate cancer, so
that his ability to participate in petitioner’s business activity
was more limited than it had been in prior years. For the 4
years immediately prior to 1995 and 1996, the Valentes’ wages or
salary, including amounts received other than from petitioner,
averaged just over $200,000. For 1995 and 1996, the years under
consideration, petitioner compensated the Valentes in the amounts
of $240,435 and $460,000, respectively. We note that for 1995
and 1996, the Valentes were more hindered by health and age than
in prior years and unable to devote their full efforts to the
business.
Mr. Valente’s consultation to automobile dealerships which
either leased from petitioner or for whom petitioner was
mortgagor is thought by petitioner to be critical to the success
of the automobile companies. We are not able to find that Mr.
Valente’s role was critical, especially because the financial
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condition of the dealerships was not made a part of the record.
There is no indication that the dealerships that leased or
purchased from petitioner were in financial difficulty or that
petitioner’s income stream was in jeopardy. Mr. Valente did, in
any event, play a role in obtaining and maintaining the source of
rental and interest income. We must note, however, that Mr.
Valente received each year the use of a new automobile, monetary
compensation, and relatively large profit-sharing distributions
from the Green Valley Ford dealership.
For the years 1995 and 1996, approximately 68 percent and 78
percent, respectively, of petitioner’s income was from interest
and rents derived from sources that were established prior to or
at the beginning of the 1995 year. The majority of the remainder
of petitioner’s income was derived from the sale of property,
both real and personal. Other than the Valentes, petitioner had
only one employee, who was a clerical/bookkeeper. Accordingly,
petitioner’s financial success and the job of ensuring a
continued income stream fell upon the Valentes. Although it was
not shown that the automobile dealerships to whom land had been
sold on installment contract or leased were in financial
difficulty, petitioner has shown that, to some extent, Mr.
Valente’s efforts helped to ensure or maintain the income stream.
Those same efforts also enhanced the capital structure of
petitioner. In these circumstances, it is difficult to decide
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whether the Valentes’ efforts were designed to generate income
and/or to protect Mr. Valente’s capital investment.
B. An External Comparison of the Employee’s Salary With
Salaries Paid by Similar Companies for Similar Services
On this point, respondent contends that Mrs. Valente would
not be entitled to earn the amount petitioner paid her during
1995 and 1996. Conversely, petitioner argues that the
compensation paid to Mr. and/or Mrs. Valente was for their joint
effort. Admittedly, Mrs. Valente acted in the nature of an
amanuensis for Mr. Valente; however, petitioner has shown that
its payments were to the Valentes for their joint efforts. Our
focus here is not on the question of who should report the income
but on the amount deductible as reasonable compensation for the
efforts of the operative officers of petitioner. See, e.g.,
Lewisville Inv. Co. v. Commissioner, 56 T.C. 770 (1971).
Accordingly, we must evaluate whether the Valentes, acting
together as petitioner’s operative officers, earned the amount of
compensation paid by petitioner. Neither party introduced
evidence about compensation paid by similar companies for similar
services.
C. The Character and Condition of the Company
Respondent characterizes petitioner as a small business with
activities that are not complex. As noted, petitioner’s income
during the years in issue was from passive sources (rents,
interest, and dividends), and respondent emphasizes that those
sources did not require much effort by the Valentes. Respondent,
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however, acknowledges that the increases to petitioner’s 1995 and
1996 income were attributable to gain on the sale of real
property and stocks. Those increases, compared to the average of
the prior 3 years, amounted to $25,922 and $171,719 for 1995 and
1996, respectively.4 Considered as a percentage increase over
the 3 years prior to 1995, the increases were 4 percent and 27
percent, respectively.
Petitioner contends that its assets were “interwoven with
the retail automobile business” and that it was Mr. Valente’s
knowledge, expertise, and involvement that made petitioner
financially successful. Petitioner acknowledges that the
Valentes did not devote their full time to petitioner but argues
that petitioner’s success was nevertheless dependent upon the
Valentes.
D. The Conflict of Interest Between the Company and the
Employee
The question posed here is whether the Valentes used their
control of petitioner to pay deductible salary, as opposed to
nondeductible dividends. As contended by respondent,
substantially all of petitioner’s income was paid out in the form
of compensation to the Valentes. In that regard, respondent
references Elliotts, Inc. v. Commissioner, 716 F.2d at 1243, for
the proposition that there is a
4
For computation of these increases see infra note 6.
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general problem [in] * * * distinguishing between
dividends and compensation for services received by a
shareholder-employee of a closely held corporation.
What makes this situation troublesome is that the
shareholder-employee and the corporation are not
dealing with each other at arm’s length. It is likely
to be in the interests of both the corporation and the
shareholder-employee to characterize any payments to
the shareholder-employee as compensation rather than
dividends. For this reason, a taxpayer’s
characterization of such payments may warrant close
scrutiny to ensure that a portion of the purported
compensation payments is not a disguised dividend. See
Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361
(9th Cir. 1974).
In that regard, respondent points out that petitioner paid
out 26.7 percent and 57.1 percent of its gross income as
compensation for 1995 and 1996, respectively. In addition,
petitioner paid out in compensation to the Valentes’ 81.6 percent
and 88.7 percent of its taxable income before considering the
compensation deduction for 1995 and 1996, respectively.
E. The Internal Consistency in the Company’s Treatment of
Payments to Employees
Under this test, a company’s formal compensation program is
considered, and a comparative analysis is made of compensation to
shareholder/employees in relation to compensation of
nonshareholder employees. Petitioner had no such formal program;
instead, Mr. Valente would decide the amount of compensation on a
year-by-year basis. Moreover, the only other employee of
petitioner was a bookkeeper who did not have comparable
qualifications, responsibilities, etc.
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F. Independent Investor
In addition to and in conjunction with the above-considered
traditional tests, the Court of Appeals for the Ninth Circuit has
also used an independent investor test. In Elliotts, Inc. v.
Commissioner, supra at 1245, that test was described as follows:
A relevant inquiry is whether an inactive, independent
investor would be willing to compensate the employee as
he was compensated. The nature and quality of the
services should be considered, as well as the effect of
those services on the return the investor is seeing on
his investment. The corporation’s rate of return on
equity would be relevant to the independent investor in
assessing the reasonableness of compensation in a small
corporation where excessive compensation would
noticeably decrease the rate of return.
The Court of Appeals for the Ninth Circuit has employed the
independent investor test in conjunction with the other above-
discussed tests as another means of measuring the reasonableness
of officer compensation.
Petitioner contends that we should disregard the traditional
tests and focus solely upon the independent investor test, in the
same manner as the Court of Appeals for the Seventh Circuit did
in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.
1999). Petitioner contends that the traditional tests do not fit
petitioner’s situation, and use of the traditional tests “invites
arbitrary decisions”. Before we decide whether it would be
appropriate to focus solely on the independent investor test, we
will first consider it in light of facts of this case.
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Respondent, based on petitioner’s tax returns, contends
that, after subtracting the compensation deducted by petitioner,
the return on petitioner’s equity is as follows:
Pretax After-tax Return on
Year income income Equity1 equity(%)
19952 $17,825 $15,151 $2,013,692 .75
1996 58,755 49,066 2,028,715 2.42
1
The amount of equity reflected consists of the total of
the yearend balances in the capital stock, paid-in surplus, and
retained earning accounts.
2
The $17,825 amount is after a deduction for a net
operating loss carryforward from another year. Without
considering the net operating loss deduction, the return on
equity would be 1.67 percent for 1995.
Petitioner does not dispute the returns on equity computed by
respondent based upon the information reported in petitioner’s
income tax returns. Petitioner contends that we should focus on
the return on equity in the form of appreciation of petitioner’s
assets. Based on petitioner’s calculation of the increases
(appreciation) in the value of realty and securities, its return
on equity for 1995 and 1996 would have been 34.5 percent and 36.5
percent, respectively. Petitioner, on the same basis, contends
that it had a 29-percent average return on equity for the years
1993 through 1996.
Respondent argues that petitioner’s approach to measuring
the return on equity is speculative and overstated and does not
match the amount shown on petitioner’s tax returns. In other
words, respondent contends that the return on equity should be
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measured based on realized income and not on unrealized
appreciation of the business assets. Respondent points out that
petitioner’s percentage return is due to unrealized appreciation
on marketable securities and estimated average appreciation on
the leased Green Valley Ford property. In addition, respondent
notes that petitioner did not factually establish that the real
property had appreciated to the extent claimed. Significantly,
there has been no showing that any portion of the claimed asset
appreciation was due to the Valentes’ efforts rather than general
market conditions.
We cannot accept the inherent premise of petitioner’s
approach; i.e., that an independent investor would be satisfied
with little or no return on petitioner’s current income stream
that was being generated with little effort on the part of
petitioner’s officers. Petitioner’s approach also assumes that
an independent investor would forgo an established stream of
income cash-flow return on equity for the possibility that
unrealized asset appreciation will be available in the future.
To some extent, an independent investor might invest in an entity
for the possibility of asset appreciation. That investor,
however, would not, without some compelling reason, forgo the
income stream from those assets. That is especially true where,
as here, the Valentes’ efforts were, in great part, directed at
the maintenance, as opposed to the creation of the income stream.
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In fact, there is no evidence that the income stream (rental
income and mortgage installment payments) was in jeopardy. While
it is clear that the Valentes played some role in producing the
1995 and 1996 income increases over prior years, the increases
were limited to the acquisition and sale of realty and marketable
securities.
During 1995 and 1996, petitioner’s adjusted taxable income
(pretax and without considering net operating loss deductions
from other years) was $294,587 and $518,755, respectively.
Assuming an independent investor would have been satisfied with a
20-percent return, then as much as $235,670 and $415,004, for
1995 and 1996, respectively, would have been available for
compensation of petitioner’s officers. However, reasonable
compensation cannot be based solely on allowing an amount that
represented what was left after computing what was thought to be
a fair return for an investor. Under any measure of reasonable
compensation, the amount must be for “personal services actually
rendered”. Sec. 162(a)(1); Elliotts, Inc. v. Commissioner, supra
at 1245; Exacto Spring Corp. v. Commissioner, supra at 835.
The facts in these cases reflect that a majority of
petitioner’s income stream would have existed regardless of the
Valentes’ services or efforts during 1995 and 1996. The passive
portion of petitioner’s income was well established and would
continue with a minimum amount of effort. We also note that Mr.
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Valente had been well compensated in prior years, reflecting that
he had already been compensated for petitioner’s financial
success prior to 1995. Significantly, the Valentes were
physically less able to devote their time and efforts to
petitioner’s business during 1995 and 1996, yet petitioner seeks
to justify substantial increases in the Valentes’ compensation
over the average of the prior 3 years. The increases over the
$209,462 average for the 4 prior years was approximately $30,000
in 1995 and $250,000 for 1996. Although, as discussed infra,
there appears to be some justification for compensation in excess
of the amount determined by respondent, the amounts sought by
petitioner are unreasonable and unjustified on this record. The
profit from the acquisition and sale of realty and securities, on
the other hand, was more directly attributable to the Valentes’
efforts.
The compensation paid to the Valentes represented 81.6
percent and 88.7 percent, respectively, of petitioner’s 1995 and
1996 adjusted5 taxable income. That would leave an independent
investor with less than 20 percent and 10 percent of petitioner’s
income for 1995 and 1996, respectively. An independent investor
might or might not be willing to accept a division of “operating”
profits that is not based on the extent to which the efforts,
5
The income was adjusted so as not to include net operating
loss deductions from other years, special deductions, and the
deductions for officers’ salaries.
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talents, or services of the officers were necessary for the
generation of the profit. Those are the same aspects that we
have considered to decide the amount of compensation that is
reasonable. Accordingly, petitioner must show here that the
Valentes were compensated for services and that the compensation
was reasonable; i.e., that the officers in these cases were
responsible for 81.6 percent and 88.7 percent of the profit.
Petitioner has not shown that the Valentes’ efforts in the
collection of petitioner’s established stream of income would
warrant any amount in excess of the annual $76,800 in
compensation that respondent determined was reasonable.
Petitioner, however, has shown that the increases to its income
for 1995 and 1996 due to the sale of assets during the 1995 and
1996 years were attributable to the Valentes’ efforts. Those
efforts produced additional income in the amounts of $25,922 and
$171,719 for 1995 and 1996, respectively.6 Unfortunately the
parties did not provide the Court with appropriate expert
testimony or some methodology by which to decide the quantum of
compensation (bonus) to be attributed to the results obtained by
6
The total income for 1992, 1993, and 1994 was $604,344,
$633,688, and $640,602 for an average total income of $626,211
($1,878,634 ÷ 3). The total income for 1995 and 1996 was
$898,479 and $806,071 for increases of $272,268 and $179,860,
respectively. The $272,268 for 1995, however, includes $246,346
of income from recapture of depreciation, so that the increase in
earned income was actually $25,922 ($272,268 - $246,346). The
1996 income figure contained recapture of $8,141 so that the
adjusted income was $171,719.
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the Valentes’ efforts. Starting with respondent’s $76,800
determination as a base amount attributable to the Valentes’
collection of petitioner’s established income, we have
approximated an additional amount of compensation attributable to
the increase in income generated by the Valentes during 1995 and
1996. We conclude and hold that reasonable compensation for the
Valentes’ services for 1995 and 1996 is $89,750 and $162,650,
respectively. We calculated those amounts by dividing the
increased amount of income earned by the Valentes’ efforts
between the officer/employee and equity holder, which when added
to respondent’s $76,800 determination resulted in an annual
reasonable compensation of $89,750 and $162,650 for 1995 and
1996, respectively.7
Petitioner argues that the independent investor test should
be the sole method of deciding whether the officer compensation
claimed by petitioner was reasonable. Respondent counters that
the independent investor test should be only one of the factors
considered, citing the Court of Appeals for the Ninth Circuit
opinion in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th
Cir. 1983). In addition, respondent contends that the facts of
7
The amount of compensation in excess of the $76,800, the
amount determined by respondent, was calculated by dividing in
half the 1995 and 1996 increases in income over the average of
the 3 prior years, $25,922 and $171,719 and arriving at bonuses
of $12,950 and $85,850.
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these cases are distinguishable from those in Exacto Spring Corp.
v. Commissioner 196 F.3d 333 (7th Cir. 1999).
Respondent points out that the compensated officer of Exacto
Spring Corp. (Exacto), a fine wire and spring manufacturer, was a
technical expert who was integrally involved in development of
the automated machinery that was one of the reasons for Exacto’s
financial success. In addition, the compensated officer in
Exacto was responsible for the solicitation of 60 percent to 70
percent of Exacto’s sales. By contrast, the Valentes’ services
to petitioner were, with the exception of the purchase and sale
of assets during the years under consideration, essentially to
maintain and collect petitioner’s established and passive sources
of revenue. Considering the fact that venue for any appeal of
this case would be the Court of Appeals for the Ninth Circuit,
see Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d
985 (10th Cir. (1971), and the fact that petitioner failed to
meet the independent investor test, we do not find it appropriate
to rely solely on the independent investor test to reach our
findings and/or holding.
II. Whether Petitioner Permitted Its 1995 Earnings To Accumulate
Beyond the Reasonable Needs of the Business--Section 531
Section 531 imposes an additional 39.6-percent tax on
accumulated taxable income. Under section 535, accumulated
taxable income is adjusted taxable income less a dividends paid
deduction and the accumulated earnings credit. For corporations,
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other than holding or investment companies, the credit is
generally an amount equal to the part of earnings and profits
that is retained for the reasonable needs of the business. See
sec. 535(c)(1). The term “reasonable needs of the business”
includes the reasonably anticipated needs of the business. Sec.
537(a)(1). The accumulated earnings tax is imposed on
corporations “formed or availed of for the purpose of avoiding
the income tax * * * by permitting earnings and profits to
accumulate instead of being divided or distributed.” Sec.
532(a).
The controversy here focuses on two questions: (1) Whether
petitioner was a “mere holding or investment company” so as to
not be entitled to accumulate income for reasonable needs beyond
$250,000, and, if not, (2) whether petitioner accumulated income
beyond its reasonable needs. Respondent argues that petitioner
meets the definition of a holding company as set forth in the
statute and the regulations. A corporation is a “holding
company” if it has “practically no activities except holding
property and collecting the income therefrom or investing
therein”. Sec. 1.533-1(c), Income Tax Regs. A corporation is
also considered an investment company if, in addition to holding
properties and collecting income, it actively trades stocks,
securities, real estate, or other investments. See id.
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Petitioner held real property and stocks and received income
from rent, interest, and the sale of stocks and realty. Although
some of the income was from rent, the leases were net leases, and
petitioner was not involved in operating or managing the rental
properties. Petitioner’s situation here is not, in any
distinguishable aspect, different from that in H.C. Cockrell
Warehouse Corp. v. Commissioner, 71 T.C. 1036 (1979), where the
taxpayer’s income was derived from the rental of real property to
operating companies.
Petitioner argues that its circumstances are more similar to
those of the taxpayer in Dahlem Found., Inc. v. Commissioner, 54
T.C. 1566 (1970). In that case, the Court explained that the
word “mere” was designed to draw a distinction between holding or
investment corporations that are strictly passive and those that
engage in some measure of business activity. See id. at 1576.
In H.C. Cockrell Warehouse Corp. v. Commissioner, supra at 1046,
we described the activities that were sufficient to avoid “mere
holding company” status in Dahlem Found., Inc. v. Commissioner,
supra, as follows:
(1) Locating an undeveloped parcel of real estate for a
shopping center; (2) negotiating and paying the
purchase price of such undeveloped land; (3) securing
leases for occupancy of the buildings to be situated in
the shopping center; (4) arranging for a loan for
construction of the shopping center; (5) various
management functions with respect to the center; and
(6) maintaining and repairing various portions of the
center. The taxpayer also actively managed other
properties.
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We do not find petitioner’s activities to approach those
that this Court found sufficient to distinguish between a
corporation that is primarily a “holding company” and one that is
a “mere holding company” in Dahlem Found., Inc. v. Commissioner,
supra. Accordingly, we hold that petitioner is a “mere holding
company” within the meaning of section 533(b) and prima facie had
a purpose of avoiding the income tax on shareholders. In
addition, petitioner has not shown evidence of any purpose for
its accumulation other than testimony about possible expansion
and legal theories about possible needs.8 Accordingly,
8
We note that the burden of proof is on petitioner and has
not been shifted to respondent under sec. 534(c). See also Rule
142(e). Although it is unnecessary for us to consider whether
petitioner had reasonable needs of its business in excess of
$250,000, we must note that under traditional standards
petitioner has not shown that its needs exceeded the $250,000
amount. Petitioner’s needs were based on the speculation that
Mr. Valente’s future inability to provide such consultation to
the auto dealerships could result in defaults on obligations to
petitioner and that there would be a need for capital. The
financial status of the automobile dealerships, however, is not
available in this record, nor is there any indication that such
event was a need, without even considering whether it was
“reasonable”. Petitioner also anticipated the death of the
Valentes and the possibility of stock redemption to pay estate
taxes. To this respondent aptly points out that there would
likely be no estate tax burden when the first of the Valentes
died. Finally, although no formal plans had been made or action
taken, Mr. Valente described a desire to develop a parcel of
property which had been held by petitioner for an extended amount
of time. Although Mr. Valente testified about some of these
(continued...)
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petitioner was availed of for the purpose of evading the income
tax on shareholders and is limited to accumulating, without
imposition of accumulated earnings tax, no more than $250,000.
III. Whether Petitioner Is Liable for Accuracy-Related Penalties
Under Section 6662(a) for 1995 and/or 1996
Section 6662(a) imposes an accuracy-related penalty if any
portion of an underpayment is attributable to negligence or
disregard of rules or regulations or any substantial
understatement of tax. A substantial understatement for a
corporation is an understatement that exceeds the greater of 10
percent of the tax required to be shown on the return or $10,000.
For 1995 and 1996, petitioner’s understatement may exceed the 10-
percent or $10,000 threshold. The penalty will not apply to any
portion of an underpayment for which there was reasonable cause
for the position taken and the taxpayer acted in good faith. See
sec. 6664(c).
Respondent, focusing on the reasonable compensation
question, contends that the Valentes did little or nothing to
earn the $240,435 and $460,000 salaries they were paid. Although
we have concluded that the value of their services was less than
8
(...continued)
matters, no steps had been taken or evidence presented that
corroborated these matters as established or reasonable needs.
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the amounts paid, we have found that the Valentes did play a
meaningful role in the success of petitioner. That is in
contrast to respondent’s contention that the Valentes performed
no services and/or did not play a meaningful role in the
financial success of petitioner.
Petitioner contends that no penalty should apply here
because of its full disclosure to and reliance upon a competent
professional. See sec. 1.6664-4, Income Tax Regs. The
adjustments we have considered in these cases are quite technical
in nature (whether petitioner was a “mere holding company” within
the meaning of section 533 and whether the Valentes’ compensation
was reasonable). Although our holdings are generally unfavorable
to petitioner, we are convinced that petitioner relied on its
accountant and that reliance was reasonable. See United States
v. Boyle, 469 U.S. 241, 251 (1985). Petitioner’s accountant, who
testified at trial, was competent, and he was fully informed of
the factual predicate for deducting the compensation in dispute.
His testimony regarding the compensation reflected that he was
well informed. He relied, however, on factors that the Court
ultimately found insufficient to carry the day. Petitioner, vis-
a-vis the Valentes, had no tax expertise, and it was reasonable
to rely on a fully informed and competent professional in the
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matters under consideration. Accordingly, we hold that
petitioner is not liable for penalties under section 6662.
To reflect the foregoing and the agreement of the parties,
Decisions will be entered
under Rule 155.