T.C. Memo. 2003-15
UNITED STATES TAX COURT
DEVINE BROTHERS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8135-01. Filed January 16, 2003.
Lowell F. Raeder and David R. White, Jr., for petitioner.
Gerald A. Thorpe, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a deficiency of $25,086
in petitioner’s Federal income tax for the fiscal year ended
February 28, 1995. After concessions, the issue for decision is
whether deductions claimed by petitioner for salary and bonuses
paid to one of its officers, who was also a shareholder, exceeded
reasonable compensation. Unless otherwise indicated, all section
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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.
Petitioner is a Pennsylvania corporation with its principal
place of business in Havertown, Pennsylvania. Petitioner has
been operating as a family-run mechanical contractor business,
performing heating, air conditioning, and plumbing services since
1918. The business was started by Michael F. Devine and his
brother James Devine. In the mid-1950s, Michael F. Devine’s son,
Richard E. Devine, Sr. (Richard, Sr.), began working for
petitioner. Petitioner incorporated in 1954.
Richard, Sr. held a bachelor of science degree in
engineering. Richard, Sr. began working for petitioner when he
was about 25 years old. Richard, Sr. continued the business
started by his father and his uncle and by 1961 had acquired
100 percent of petitioner’s outstanding common stock. After
becoming the sole shareholder of petitioner, Richard, Sr. had
responsibility for human resources, finances, sales and
marketing, training and supervising employees, and accounting and
legal matters.
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In the late 1970s, petitioner experienced problems with the
business due to delayed projects and the bankruptcy of a general
contractor. Petitioner released all of its employees and scaled
back operations, and Richard, Sr. became the sole employee of
petitioner. Richard, Sr. changed the direction of the company in
the 1980s. Petitioner began to increase its retained earnings to
increase its bonding capacity in order to compete in the direct
bid market. To meet bonding requirements, petitioner needed to
have 10 percent of its revenue in liquid assets. To accomplish
this result, petitioner underpaid Richard, Sr. in order to keep
liquid assets in the company. Petitioner incrementally increased
its bonding capacity each year.
From April 30, 1986, until April 30, 1989, Richard, Sr.
transferred 220 of his 550 shares of common stock to his son,
Richard E. Devine, Jr. (Richard, Jr.). Discussion began before
December 27, 1993, regarding the sale of Richard, Sr.’s remaining
shares of common stock to Richard, Jr. On January 15, 1996,
Richard, Jr. purchased the remaining shares of petitioner for
$305,000. Richard, Jr. paid the purchase price to Richard, Sr.
with a note payable in monthly installments over 10 years at an
8-percent interest rate.
During the year in issue and continuing until January 1997,
Richard, Sr. was petitioner’s president and chairman of the board
of directors. Likewise, Richard, Jr. was petitioner’s vice
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president and a member of the board of directors. In January
1997, Richard, Jr. became president of petitioner.
For the taxable year ended February 28, 1994, Richard Sr.’s
salary was $51,663 and Richard, Jr.’s salary was $66,897. For
the year in issue, Richard, Sr.’s salary was $260,378 and
Richard, Jr.’s salary was $112,599.
Richard, Sr. determined the compensation that petitioner
paid. Petitioner never paid dividends to any of its shareholders
from its inception to the tax year in issue. Petitioner provided
to Richard, Sr. a retirement plan, health insurance, life
insurance, disability insurance, and use of a vehicle.
Petitioner paid $50,000 into Richard, Sr.’s retirement plan each
year for 5 years from 1989 until 1993.
Petitioner filed a Form 1120, U.S. Corporation Income Tax
Return, for the taxable year ended February 28, 1995. Petitioner
claimed a deduction of $260,378 for compensation of Richard, Sr.
Respondent allowed $195,378 and disallowed the remaining $65,000.
The parties stipulated that “Richard Sr.’s annual salary for the
taxable year ended February 28, 1995 falls in the range of
salaries paid to presidents/chief executive officers of
comparable companies in the same industry during the taxable
year.”
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OPINION
Section 162(a)(1) allows as a deduction “a reasonable
allowance for salaries or other compensation for personal
services actually rendered”. Section 1.162-7(a), Income Tax
Regs., provides a two-part test for deductibility of
compensation: (1) Whether the payment was purely for services
rendered and (2) whether the amount paid was reasonable. See
Estate of Wallace v. Commissioner, 95 T.C. 525, 552 (1990), affd.
965 F.2d 1038 (11th Cir. 1992). 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 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. Estate of Wallace v.
Commissioner, supra at 553; 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. Welch v. Helvering, 290 U.S. 111, 115
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(1933); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,
1324 (5th Cir. 1987), affg. T.C. Memo. 1985-267. Section 7491
does not apply to shift the burden in this case because the
examination of petitioner’s return commenced before July 22,
1998.
Cases traditionally set forth a lengthy list of factors that
are relevant in the determination of reasonableness, including:
(1) The employee’s qualifications; (2) the nature, extent, and
scope of the employee’s work; (3) the size and complexities of
the business; (4) a comparison of salaries paid with gross income
and net income; (5) the prevailing general economic conditions;
(6) comparison of salaries with distributions to stockholders;
(7) the prevailing rates of compensation for comparable positions
in comparable concerns; (8) the salary policy of the taxpayer as
to all employees; and (9) 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. No single factor is determinative. See
id.; Estate of Wallace v. Commissioner, supra at 553; 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.
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Commissioner, supra at 1324; Estate of Wallace v. Commissioner,
supra at 556.
Recent cases in some Courts of Appeals have adopted a
somewhat different view of this analysis, substituting instead an
independent investor test. See, e.g., Exacto Spring Corp. v.
Commissioner, 196 F.3d 833, 838 (7th Cir. 1999), revg. Heitz v.
Commissioner, T.C. Memo. 1998-220. This case is appealable to
the Court of Appeals for the Third Circuit, which has not adopted
the independent investor test but has endorsed the traditional
multifactor test. See B.B. Rider Corp. v. Commissioner, 725 F.2d
945 (3d Cir. 1984), affg. in part and vacating in part on other
grounds T.C. Memo. 1982-98. We have applied the multifactor test
for reasonableness, viewed through the lens of an independent
investor, when a case is not appealable to a circuit that has
addressed this issue. See Haffner’s Serv. Stations, Inc. v.
Commissioner, T.C. Memo. 2002-38.
Whatever analysis is applied, petitioner has made a prima
facie case for reasonableness. Respondent has provided no
evidence to the contrary. Respondent conceded in the stipulation
that Richard, Sr.’s salary was within the range of salaries paid
to similarly situated executives. Respondent allowed all but
$65,000 of Richard, Sr.’s compensation. Respondent gives no
reasoning for his calculation of the “excessive” compensation.
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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, 119 (1930); Estate of Wallace v. Commissioner, supra at
553. 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, supra at 553-554. In the year in issue, Richard,
Sr.’s salary was within the range of those of similarly situated
executives, and witnesses testified that Richard, Sr. had been
paid significantly less than similarly situated executives in
other years. Petitioner has established that Richard, Sr. was
undercompensated in prior years in order to meet specified
bonding requirements, a business necessity. The testimony also
supports an inference, and we conclude, that the bonus paid in
the year in issue was intended to compensate for the established
undercompensation in the earlier years. The entire deduction for
compensation was therefore reasonable.
To reflect the foregoing and the concessions of the parties,
Decision will be entered
under Rule 155.