T.C. Memo. 2007-272
UNITED STATES TAX COURT
VITAMIN VILLAGE, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8745-02. Filed September 12, 2007.
Daniel L. Reeves (officer), for petitioner.
Wesley F. McNamara, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HAINES, Judge: Respondent determined deficiencies in
petitioner’s Federal corporate income tax for the fiscal years
ending (FYE) June 30, 1995 and 1996 (fiscal years at issue), of
$562,967 and $502,786, respectively.1
1
Unless otherwise indicated, all section references are to
(continued...)
- 2 -
After concessions,2 the issues for decision are: (1)
Whether the amounts paid to petitioner’s sole executive and
shareholder during the fiscal years at issue constituted
reasonable compensation under section 162(a)(1); (2) whether
petitioner is entitled to deduct advertising expenses under
section 162(a) of $1,105,276 for FYE June 30, 1996; and (3)
whether petitioner is entitled to depreciate costs incurred in
constructing a houseboat, a floating garage, and a dock under
section 167(a)(1) during the fiscal years at issue.
FINDINGS OF FACT
The parties’ stipulation of facts and the attached exhibits
are incorporated herein by this reference, and the facts
stipulated are so found. At the time the petition was filed,
petitioner maintained its business office in Wilsonville, Oregon.
A. Petitioner’s Business History
Petitioner was incorporated by Daniel L. Reeves in the State
of Oregon in 1979.3 Petitioner, an accrual basis taxpayer with
1
(...continued)
the Internal Revenue Code, as amended, and Rule references are to
the Tax Court Rules of Practice and Procedure. Amounts are
rounded to the nearest dollar.
2
At trial, respondent conceded that petitioner was entitled
to deduct a net operating loss of $320,845 in FYE June 30, 1996,
carried back from its FYE June 30, 1998. On brief, petitioner
conceded it failed to report interest income of $11,516 in FYE
June 30, 1996.
3
Mr. Reeves originally founded petitioner with two other
(continued...)
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an FYE June 30, was in the business of producing, distributing,
and selling skin care products, tanning lotions, diet aids,
sports performance products, nutritional supplements, health food
products, and apparel at both the retail and wholesale levels.
Petitioner also provided indoor tanning salon services and its
own printing, advertising, and marketing services. Petitioner
used the business names of Vitamin Village for the production and
sales of nutritional supplements, health food, skin care
products, and tanning lotions; Club Tan for its tanning salon
services; and Universal Graphics for its advertising, marketing,
and printing activities.
Mr. Reeves was petitioner’s president from 1979 and its
secretary, treasurer, and sole shareholder from 1986 through the
fiscal years at issue, and he controlled all aspects of
petitioner’s corporate operations. From 1979 through the fiscal
years at issue, Mr. Reeves also performed all of petitioner’s
managerial duties. He worked more than 80 hours per week
managing petitioner’s research, development, production, sales,
marketing, and advertising and supervised petitioner’s employees,
including making all hiring and firing decisions.
3
(...continued)
individuals, Jeff O’Brien and R. Gail Reeves. Mr. O’Brien left
petitioner shortly after its incorporation. R. Gail Reeves
terminated her positions as petitioner’s secretary and treasurer,
and all stock she owned in petitioner was redeemed in FYE June
30, 1986.
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B. Spinoff Corporations
To reduce petitioner’s potential liability and to increase
efficiency and growth, Mr. Reeves organized two new corporations
out of petitioner, Club Tan Centers of Oregon, Inc. (CTC), and
Universal Marketing, Inc. (UMI). In December 1994, petitioner
transferred the assets used by Club Tan to CTC, and on June 1,
1995, petitioner transferred the assets used by Universal
Graphics to UMI. All of the stock issued by CTC and UMI was
transferred to Mr. Reeves in a section 355 reorganization
(spinoff) resulting in petitioner, CTC, and UMI becoming brother-
sister corporations.
Mr. Reeves was the president, secretary, treasurer, and sole
shareholder of CTC and UMI. Although his obligations to
petitioner decreased as a result of the spinoffs, as the sole
officer and manager of three corporations, Mr. Reeves had
significantly increased responsibilities.
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C. Petitioner’s Financial Condition
For FYE June 30, 1985 through 1996, petitioner’s gross
receipts, net income, and net margin were as follows:4
FY Gross receipts Net income Net margin (percent)
1985 $471,720 $21,938 4.7
1986 496,367 2,614 0.5
1987 628,333 (26,344) -4.2
1988 749,595 3,363 0.4
1989 1,044,449 (49,205) -4.7
1990 752,702 (5,281) -0.7
1991 661,928 (46,254) -7.0
1992 1,011,083 7,078 0.7
1993 2,074,682 43,360 2.1
1994 1,936,476 49,545 2.6
1995 12,501,980 1,087,759 8.7
1996 5,709,686 398,585 7.0
1997 2,170,205 31,985 1.5
During the fiscal years at issue, petitioner’s sales, costs
of goods sold, gross profits, net income, total taxes, net income
per books, and ratios of gross profit to gross receipts,
expressed as percentages, were as follows:5
4
The stated gross receipts and net income (taxable income)
for FYE June 30, 1985 through 1997, were obtained from
petitioner’s Forms 1120, U.S. Corporation Income Tax Return, for
the respective fiscal years.
5
The amounts listed in this table were reported in
petitioner’s Forms 1120 for the respective fiscal years at issue.
Net income per books was reported on Forms 1120, Schedule M-1.
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FY 1995 FY 1996
Gross receipts $12,501,980 $5,709,686
Cost of goods sold 6,128,126 1,473,083
Gross profits 6,373,854 4,236,603
Net income 1,087,759 398,858
Total tax 300,374 123,769
Net income per books 742,910 268,326
Ratio of gross profits
to gross receipts 51% 74%
Petitioner reported the following shareholder equity during
the years at issue:6
FY 1995 FY 1996
Common stock $2,770 $2,770
Retained earnings 793,574 1,061,900
Equity 796,344 1,064,670
Net income per books 742,910 268,326
Return on equity 93% 25%
6
Petitioner’s common stock value and retained earnings were
reported on its Forms 1120, Schedules L for the fiscal years at
issue.
Because of the spinoffs, the value of petitioner’s common
stock was reduced from $3,000 to $2,770.
Petitioner’s equity was computed by adding petitioner’s end-
of-year common stock value to its end-of-year retained earnings.
Rate of return on equity is computed by dividing petitioner’s net
income per books by its equity for the respective fiscal years at
issue.
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D. Petitioner’s Employee Compensation
The compensation petitioner paid Mr. Reeves each year from
1982 through 1996 was:7
FYE June 30 Compensation
1982 $15,707
1983 16,100
1984 26,000
1985 42,000
1986 47,000 (includes $18,240 bonus)
1987 11,000
1988 -0-
1989 22,444
1990 4,000
1991 -0-
1992 -0-
1993 310,000
1994 182,300
1995 2,278,000 (includes $2 million bonus)
1996 1,012,000 (includes $1 million bonus)
From FY 1982 through FY 1992, Mr. Reeves’s salary remained
low or he was unpaid so that profits could be invested to expand
petitioner’s business. Beginning in FYE June 30, 1993,
petitioner’s business improved, and profits substantially
increased. Petitioner deducted the compensation paid to Mr.
Reeves as officer compensation on its Forms 1120, U.S.
Corporation Income Tax Return, in the fiscal years at issue.
In FYE June 30, 1995, petitioner paid $374,884 in salary and
wages to its employees including $95,000 in bonuses, and in FYE
June 30, 1996, petitioner paid $348,837 in salary and wages to
7
The table does not include amounts UMI or CTC paid to Mr.
Reeves.
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its employees including $125,000 in bonuses. Petitioner deducted
these amounts as salaries and wages paid to its employees on its
Forms 1120 in the fiscal years at issue.
Petitioner did not maintain a compensation policy for its
officers and employees. However, all 12 of petitioner’s
memorandums of consent to corporate action from FYE June 30, 1985
through 1996, indicated Mr. Reeves received less than full and
adequate compensation for his role as petitioner’s president and
that petitioner would give future consideration to increasing Mr.
Reeves’s salary and/or award future discretionary bonuses to
reimburse him for his past and present service.
The bonuses Mr. Reeves and petitioner’s other employees
received were not based upon a formula or previously set forth in
writing. Each bonus was determined and paid at the end of the
fiscal year when petitioner could ascertain its cash availability
and determine what would be a reasonable bonus, taking into
consideration previous underpayments.
E. Advertising Agreement With UMI
In the fiscal year previous to UMI’s formation, petitioner’s
gross skin care and tanning products sales totaled $600,000 with
$124,000 profit. In an effort to increase sales, in June 1995
(in petitioner’s FYE June 30, 1995), petitioner entered into an
agreement with UMI by which, in exchange for $1 million, UMI
agreed to brand, market, and advertise the skin care and tanning
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products petitioner sold in UMI’s FYE May 31, 1996. Pursuant to
a similar agreement petitioner paid $1,105,276 (in petitioner’s
FYE June 30, 1996) for the same services in UMI’s FYE May 31,
1997.
As a result of UMI’s services, within UMI’s first fiscal
year (FYE May 31, 1996), petitioner’s gross receipts exceeded $1
million with $800,000 in gross profits from the sale of the
products UMI branded, marketed, and advertised.8 Furthermore, in
petitioner’s 1997 fiscal year, UMI’s services caused petitioner’s
gross receipts to double, exceeding $2 million and earning over
$1 million in gross profits. Petitioner deducted the amounts
paid to UMI as advertising expenses in the fiscal years at issue.
F. Mr. Reeves’s Home and the Floating Structures
On September 24, 1993, Mr. Reeves purchased 1.2 acres along
the Willamette River in Newberg, Oregon, which included Mr.
Reeves’s family residence and a dilapidated houseboat and a
floating dock on the river behind and down a hill from the
residence. The residence was a two-story house with
approximately 2,200 square feet per floor. The first floor was a
daylight basement used by the previous owner to store
automobiles. The houseboat and the dock were connected to Mr.
8
The record does not indicate CTC’s earnings or the amount
of time Mr. Reeves spent conducting its activities. The record
indicates Mr. Reeves sold CTC in 1997.
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Reeves’s property by a rundown gangway. The houseboat, the dock,
and the gangway were in a poor and dangerous condition.
In petitioner’s FYE June 30, 1995, Mr. Reeves and petitioner
entered into a lease agreement for $1,000 a month to provide
petitioner with access from Mr. Reeves’s residence to the
houseboat and the dock, the use of his utilities, and the use of
his parking lot, boat, and jet skis for advertising and
promotional purposes.9 In the fiscal years at issue, petitioner
also rented the first floor of Mr. Reeves’s residence for $700 a
month to store goods.
In 1995, Mr. Reeves and petitioner removed the dilapidated
houseboat and the dock and hired a contractor to build a new
houseboat, a 100-foot dock, and a floating garage (floating
structures). Construction of the floating structures was
completed in the spring of 1996, and they were placed into
service on May 28, 1996.10 The Oregon State Marine Board listed
petitioner as the owner and Mr. Reeves as the coowner.11
9
The $1,000 a month also allowed access to Mr. Reeves’s
tennis court and an enclosed area where corporate guests could
place their children so they would be safe from falling into the
Willamette River.
10
Petitioner’s Form 4562, Depreciation and Amortization,
reported the property was placed into service on May 28, 1996.
11
Mr. Reeves claimed that only petitioner owned the
floating structures and he was listed as a coowner because the
State required an individual contact.
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The new houseboat was approximately 43 feet long and 28 feet
wide. It had one floor with three rooms including a living area,
a photo studio, and office space, and an open-air deck on top
which included an outdoor cafe. Adjacent to the new house boat
was the floating garage where Mr. Reeves’s boat and jet skis and
petitioner’s tables and chairs were stored. The garage was
covered and securely locked.
Petitioner and Mr. Reeves shared the costs of the floating
structures’ construction. Mr. Reeves paid $80,717 in 1995 and
petitioner paid a total of $185,327: $95,046 in FYE June 30,
1995, and $90,281 in FYE June 30, 1996. Petitioner capitalized
the $185,327 and depreciated the costs over a 39-year period.
Petitioner reported these expenditures on its Forms 4562,
Depreciation and Amortization, as leasehold improvements
involving nonresidential real property and claimed depreciation
deductions of $721 and $2,726 in the fiscal years at issue,
respectively.
Petitioner and UMI used the floating structures for
promotional events, meetings, and advertising photo shoots.
Beginning in 1996, Mr. Reeves used the floating structures for
personal purposes approximately 10 times a year. Neither
petitioner nor Mr. Reeves kept a log of the use of the floating
structures.
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In 2002, Mr. Reeves sold his residence in Newberg, Oregon,
as part of a bankruptcy sale. As part of the sale, petitioner
sold the floating structures to Mr. Reeves’s wife’s company,
Royal Sun Properties, L.L.C., for $100,000 with $55,000 paid as a
downpayment.12
Respondent issued the notice of deficiency on March 8, 2002.
Petitioner timely filed its amended petition on August 19, 2002.
OPINION
I. Reasonable Compensation
Petitioner contends the amounts paid to its sole executive
and shareholder, Mr. Reeves, in the fiscal years at issue
constituted reasonable compensation under section 162(a)(1).
Conversely, respondent contends Mr. Reeves’s compensation for the
fiscal years at issue was unreasonable but, on the basis of
respondent’s expert’s opinion, concedes deductions of $1 million
and $750,000,13 respectively.
12
Royal Sun Properties, L.L.C., still owes petitioner
$45,000.
13
The $750,000 includes reasonable compensation paid to Mr.
Reeves by petitioner and UMI together. Respondent argued on
brief that if the Court accepted $750,000 as reasonable
compensation for FYE June 30, 1996, it would be appropriate to
divide this amount between petitioner and UMI and allow
petitioner to deduct $499,012. Respondent alternatively argued
that it would be appropriate to allow UMI its full claimed
deduction of $509,000 if petitioner were allowed only $250,000 as
reasonable compensation for its FYE June 30, 1996.
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Section 162(a)(1) permits a taxpayer to deduct “a reasonable
allowance for salaries or other compensation for personal
services actually rendered”. A taxpayer is entitled to a
deduction for compensation only if the payments were reasonable
in amount and in fact paid purely for services. Sec. 1.162-7(a),
Income Tax Regs.14 Although framed as a two-prong test, the
inquiry under section 162(a)(1) generally turns on whether the
amounts of the purported compensation payments were reasonable.
Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th Cir.
1983), revg. T.C. Memo. 1980-282. Petitioner has the burden of
proving the payments to Mr. Reeves were reasonable. See Rule
142(a).
Because petitioner’s place of business is in the State of
Oregon, absent stipulation otherwise, an appeal of this case
would go to the Court of Appeals for the Ninth Circuit. See sec.
7482(b)(1)(B). That Court of Appeals uses five factors to
determine the reasonableness of compensation, with no single
factor being determinative. Elliotts, Inc. v. Commissioner,
supra. The factors are: (1) The employee’s role in the company;
(2) comparison with other companies; (3) the character and
condition of the company; (4) potential conflicts of interest;
and (5) internal consistency in compensation. Id. at 1245-1248.
14
Respondent argues only that the amount of compensation
was unreasonable.
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When shareholder-officers who control the corporation set their
own compensation, careful scrutiny is necessary to determine
whether the alleged compensation is in fact a distribution of
profits and a constructive dividend. Home Interiors & Gifts,
Inc. v. Commissioner, 73 T.C. 1142, 1156 (1980).
II. The Elliotts Factors Applied to Petitioner’s Compensation of
Mr. Reeves
A. Role in the Company
The role the employee plays in the company focuses on the
employee’s importance to the success of the business. Pertinent
considerations include the employee’s position, hours worked, and
duties performed. Elliotts, Inc. v. Commissioner, supra at 1245.
From petitioner’s incorporation in 1979, Mr. Reeves’s hard
work and vision were critical and indispensable to petitioner’s
business and the primary reason for its overall success. He
served as petitioner’s president from its incorporation in 1979
and its secretary and treasurer from 1986. Mr. Reeves also
handled all of petitioner’s managerial duties. On a daily basis
he managed petitioner’s research, development, production, sales,
and marketing and advertising (until UMI was spun off on June 1,
1995). Mr. Reeves also supervised petitioner’s employees15 and
was responsible for all hiring and firing.
15
Mr. Reeves testified that petitioner had approximately 25
employees during the fiscal years at issue.
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Although Mr. Reeves did not devote 100 percent of his time
to petitioner’s business during the fiscal years at issue, as the
only executive and manager he was the driving force behind
petitioner’s success.16 Mr. Reeves was a highly motivated
employee who worked over 80 hours per week for petitioner during
the first 6 months of its FY 1995 and a substantial amount of
time during the second half of its FY 1995. Despite managing two
other companies during petitioner’s FY 1996, Mr. Reeves continued
to devote a substantial amount of time to petitioner’s
operations, which led to its further success.
B. External Comparison
This factor compares the employee’s compensation with that
paid by similar companies for similar services. Elliotts, Inc.
v. Commissioner, supra at 1246; see sec. 1.162-7(b)(3), Income
Tax Regs. Courts often use expert witness opinions to evaluate
the reasonableness of compensation. Nonetheless, this Court is
not bound by the opinion of any expert witness and may accept or
reject expert testimony in the exercise of sound judgment.
16
The record indicated the incorporation of UMI and CTC
resulted in Mr. Reeves’s performing fewer services and spending
less time operating petitioner without delineating the number of
hours per week Mr. Reeves spent operating petitioner. However,
the record did indicate that: CTC was a separate corporation for
one-half of petitioner’s FYE June 30, 1995, and UMI was a
separate corporation for 1 month of petitioner’s FYE June 30,
1995; Mr. Reeves spent over 80 hours a week operating petitioner
before CTC and UMI were spun off; and shortly after CTC and UMI
were spun off Mr. Reeves’s overall time spent working increased
significantly.
- 16 -
Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938);
Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),
affg. T.C. Memo. 1974-285. Furthermore, the Court may be
selective in determining what portions of an expert’s opinion, if
any, to accept. Parker v. Commissioner, 86 T.C. 547, 562 (1986).
Only respondent offered expert testimony comparing Mr.
Reeves’s compensation with that paid by similar companies for
similar services. Respondent’s proffered expert, Scott D.
Hakala, was a principal and director of CBIZ Valuation Group,
Inc., an appraisal, financial advisory, and litigation support
firm. Mr. Hakala has a doctorate in economics, has worked as an
economist and financial analyst, and has testified on numerous
occasions as an expert in cases involving compensation disputes.
Mr. Hakala compared Mr. Reeves’s compensation to chief
executive officer (CEO) compensation in five publicly traded
companies (guideline companies).17 He used four methods to make
the comparison: (1) The average compensation paid to the CEOs
from the guideline companies; (2) a regression analysis based
upon the guideline companies’ relationship between CEO
compensation and their respective sales;18 (3) a guideline
17
Mr. Hakala stated in his report and testified at trial
that he used the guideline companies because some or most of
their operations were based in the development and marketing of
nutritional products.
18
The regression equation for 1995 was Y = 315653.0283 +
(continued...)
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company’s compensation-to-sales ratio of 7.1 percent;19 and (4)
the guideline companies’ net margins. The financial information
used in the four methods was obtained from the guideline
companies’ financial statements. The table below reflects Mr.
Hakala’s range of reasonable compensation for Mr. Reeves,
computed by applying the four methods to the guideline companies’
financial information:
18
(...continued)
0.002365149(X). The regression equation for 1996 was Y =
325357.1548 + 0.002408813(X). Y equals CEO compensation and X
equals revenue. Mr. Hakala’s report did not explain how he
configured the variables used in the regression analysis.
19
The sales ratio is CEO compensation divided by company
sales, expressed as a percent. Mr. Hakala’s report stated that
he used the sales ratio from only one of the five guideline
companies, Natural Health Trends Corp (Natural Health), because
it was the highest of the five companies’ ratios. Natural
Health’s sales ratios for its FY 1995 and FY 1996 were 9.4
percent and 7.1 percent, respectively. Without indicating his
reasoning, Mr. Hakala applied Natural Health’s sales ratio of 7.1
percent to petitioner’s sales for both FY 1995 and FY 1996.
However, he should have computed the guideline company’s sales
ratio for FY 1995 by multiplying Natural Health’s sales ratio of
9.4 percent by petitioner’s sales for FY 1995, not the sales
ratio of 7.1 percent. This computation would make the FY 1995
guideline company percent of sales $1,175,186, instead of
$887,641.
Because the Court does not consider petitioner and UMI as a
single company, i.e., combine their income, reasonable
compensation under the “percent of sales” method for petitioner
for FY 1996 is $405,388 instead of $409,323.
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Method FYE 1995 FYE 1996
Guideline cos. CEO compensation $659,849 $755,309
Guideline cos. regression analysis 345,222 339,111
Guideline co. percent of sales 887,641 409,323
Guideline cos. net margins 2,150,000 1,500,000
Average of the methods 1,010,678 750,936
The notice of deficiency allowed petitioner to deduct
$1,044,809 and $367,382 as compensation to Mr. Reeves in the
fiscal years at issue, respectively. Mr. Hakala’s report
concluded the maximum reasonable compensation payable to Mr.
Reeves in the years at issue was $1 million and $750,000,20
respectively.21
On cross-examination, Mr. Hakala conceded he was unable to
consider all the facts and circumstances needed to conduct a
comprehensive analysis because his financial review was limited
to petitioner’s revenue and net income from FY 1985 through FY
1994 and petitioner’s tax returns for the years at issue. He
testified that additional information could have made a material
impact on his conclusions.22
20
See supra note 13.
21
Mr. Hakala’s reasonable compensation determinations for
the years at issue were the rounded averages of figures computed
by applying the four methods to the guideline companies’
financial information. See table supra p. 18.
22
In Mr. Hakala’s report and at trial, he stated that he
reserved the right to amend the report to reflect consideration
of additional information.
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Mr. Hakala admitted that there were six circumstances not
considered in his report that could affect his findings in
petitioner’s favor. First, he stated that an employee who serves
in multiple positions within a company may be compensated at a
higher level to reflect the additional duties and
responsibilities. He recognized that unlike the CEOs of the
guideline companies, Mr. Reeves served in all of petitioner’s
executive and managerial roles. Consequently, his compensation
should reflect the combined salaries of the positions he held.
See Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.23
Second, Mr. Hakala testified that typically an employee of a
company like petitioner that has variable performance years and
who is underpaid during those years is compensated at a higher
amount in profitable years to make up for the lower income
years.24 In addition, when the employee is reimbursed at a later
date, the time value of money is often considered in increasing
compensation. Mr. Hakala’s report did not take into account that
in some of the years before the fiscal years at issue petitioner
either underpaid Mr. Reeves or did not pay him at all.
23
The average combined executive salaries for the five
guideline companies during the fiscal years at issue were
$1,019,418 and $1,124,167, respectively.
24
Mr. Hakala stated that the common way to compensate
employees in businesses with volatile performance is through a
compensation plan that pays a fixed salary, with a bonus during
good years and no bonus during years in which performance is
poor.
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Mr. Reeves testified that one of the reasons petitioner paid
him a large bonus in its FY 1995 was to compensate for the years
he was underpaid. Multiplying the sales ratio of 8.25 percent by
petitioner’s total sales in FY 1985 through FY 1994, the Court
finds that Mr. Reeves was underpaid for 6 years:25
FY Amount underpaid
1987 $40,837
1988 61,842
1989 63,723
1990 58,098
1991 54,609
1992 83,414
The future values of the amounts underpaid as of December
31, 1995, were $81,102, $111,647, $101,436, $87,373, 71,771, and
$94,021, totaling $547,350.26
Third, Mr. Hakala stated that a company experiencing losses
may significantly decrease compensation to its CEO, and using the
company as a guideline can result in understatement of executive
income. Of the five guideline companies, in FY 1995 one
experienced significant losses, and in FY 1996, three experienced
substantial losses.27 The five guideline companies’ financial
25
8.25 percent was computed by averaging the sales ratios
(9.4 percent and 7.1 percent) used to determine reasonable
compensation under the “percent of sales” method.
26
The future values were determined using the applicable
Federal rate compounded semiannually under sec. 1274(d).
27
Mr. Hakala testified that he chose the guideline
companies because they developed and sold nutritional products
and not because they sustained profits or losses.
- 21 -
characteristics during the fiscal years at issue are set out
below:
Ratio of Net
gross Net income/
profits income/ loss as a Return on
Guideline co. to sales loss percentage equity
and year (percent) (million) of sales (percent)
NBTY, Inc.
1995 40 $5.4 3.2 6.6
1996 49 9.5 5.0 10.4
National Health
1995 53 (0.5) -15.7 -17.5
1996 9 (2.9) -66.5 -86.6
Natural
1995 29 2.0 5.4 15.3
1996 28 3.2 6.8 18.18
Nutritional 21
1995 73 0.5 4.1 4.5
1996 61 (4.4) -27.7 -25.9
Reliv’
1995 78 1 3.4 18.5
1996 38 (10) -31.2 -188.1
Average 1995 55 1.68 0.08 5.9
Average 1996 37 (0.92) -22.72 -54.4
Fourth, Mr. Hakala stated a CEO may be entitled to increased
compensation during a year when his or her company earns higher
profits. He opined that petitioner was more profitable than all
five companies in terms of the ratio of net income to sales (net
margin). Petitioner’s net margins for the fiscal years at issue
- 22 -
were 8.7 percent and 7.0 percent, respectively,28 exceeding the
guideline companies’ average net margins of 1.68 and -0.92,
respectively.
Fifth, Mr. Hakala did not evaluate companies like
petitioner, whose operations during FYE June 30, 1995, included
advertising, indoor tanning services, and the sale of tanning
products.
Sixth, Mr. Hakala stated that publicly held companies have
additional costs of up to 5 percent as compared to privately held
companies. As a result, petitioner would have fewer expenses and
more income available to compensate its employees.29
In conclusion, the Court adopts three of the four methods30
Mr. Hakala used to compute reasonable compensation. After taking
into consideration the six circumstances not considered in his
report, the Court finds that the table below sets out the ranges
for reasonable compensation more accurately:
28
In his report, Mr. Hakala indicated that in FYE 1996 the
guideline companies exhibited increased sales, whereas
petitioner’s sales decreased by over 50 percent during the same
period.
29
In Mr. Hakala’s report and trial testimony he stated that
he reserved the right to amend the report to reflect
consideration of additional information.
30
Because the Court could not determine how Mr. Hakala
computed reasonable compensation under the regression analysis,
the Court did not consider the regression analysis method to
determine petitioner’s compensation of Mr. Reeves.
- 23 -
Method FYE 1995 FYE 1996
Guideline cos. CEO compensation $1,019,418 $1,124,167
Guideline cos. percent of sales 1,175,186 405,388
Guideline cos. net margins 2,150,000 1,500,000
Average of the methods 1,448,201 1,009,852
In addition, taking into consideration the $547,350 Mr.
Reeves was underpaid as of December 31, 1995, the reasonable
compensation for petitioner’s FY 1995 is increased to $1,995,551.
C. Character and Condition of the Company
This factor requires the Court to focus on petitioner’s
size as measured by its sales, net income, or capital value; the
complexities of the business; and general economic conditions.
See Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.
Petitioner was a relatively small company that had secured
itself a market niche enabling it to earn high profit margins on
its product sales and services.
Petitioner’s income was modest until 1993 when it began to
experience a substantial increase. Gross sales grew from
$661,928 in FYE June 30, 1991, to $2,074,682 and $1,936,476 in
FYE June 30, 1993 and 1994, respectively, and continued to
increase in the fiscal years at issue to $12,501,980 and
$5,709,686, with net margins of 8.7 and 7 percent, respectively.
Petitioner’s net income was substantially higher than the
guideline companies’ average and each guideline company’s
individually, except for NBTY, Inc.’s FY 1996. Moreover,
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petitioner’s shareholders return on equity increased to 93
percent and 25 percent in the fiscal years at issue,
respectively. These percentages were also substantially higher
than the guideline companies’ average, as discussed below.
Although petitioner’s business may not have been a complex
operation, this Court does not consider it to have been a simple
task for Mr. Reeves to operate petitioner as its sole executive
and manager. Neither petitioner’s sales nor its gross profits
could have been attained but for the personal skills of Mr.
Reeves.
D. Conflict of Interest
This factor examines whether a relationship exists between
the company and the employee which may permit the company to
disguise nondeductible corporate distributions as section
162(a)(1) compensation payments. Close scrutiny may be used when
the paying corporation is controlled by the compensated employee,
as in the instant case. Elliotts, Inc. v. Commissioner, supra at
1246-1247. However, the mere fact that the individual whose
compensation is under scrutiny is the sole shareholder of the
company, even when coupled with an absence of dividend payments,
“does not necessarily lead to the conclusion that the amount of
compensation is unreasonably high.” Id. at 1246.
The Court of Appeals for the Ninth Circuit formulated the
inquiry by evaluating the compensation payments from the
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perspective of a hypothetical independent investor. The prime
indicator is the return on the investor’s equity. Id. at 1247.
If the company’s earnings on equity after payment of the
compensation remain at a level that would satisfy an independent
investor, there is a strong indication that the employee is
providing compensable services and that profits are not being
siphoned out of the company disguised as salary.31 Id. The
Court of Appeals in Elliotts calculated the return on equity
using the yearend shareholders equity. Id. Dividing
petitioner’s net income book value by the yearend shareholders
equity results in the following:
FYE June 30 Percent return on equity
1995 93 percent
1996 25 percent
Petitioner’s return on equity substantially exceeded the
guideline companies’ average return on equity of 5.9 percent and
-54.4 percent during the fiscal years at issue, respectively, and
exceeded each specific company’s return on equity.32 Mr. Reeves
was solely responsible for petitioner’s success and performed the
31
The Court of Appeals for the Ninth Circuit found that a
20-percent average rate of return on equity would satisfy a
hypothetical inactive independent investor and indicated the
corporate employer and its shareholder/employee were not
exploiting their relationship. Elliotts, Inc. v. Commissioner,
716 F.2d 1241, 1247 (9th Cir. 1983), revg. T.C. Memo. 1980-282.
32
See the table showing each guideline company’s return on
equity supra p. 21.
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services which were directly responsible for petitioner’s
profitability.
E. Internal Consistency in Compensation
This factor focuses on whether the compensation was paid
pursuant to a structured, formal, and consistently applied
program. Elliotts, Inc. v. Commissioner, supra at 1247. Bonuses
not paid pursuant to such plans are suspect. Salaries paid to
controlling shareholders are also suspect if, when compared to
salaries paid to nonowner management, they indicate that the
amount of compensation is a function of ownership, not corporate
management responsibility. Id.
Bonuses paid to employees are deductible “when * * * made in
good faith and as additional compensation for 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.” Sec. 1.162-9, Income Tax Regs. No
internal discrepancy exists when a company pays and deducts
compensation for services performed in prior years. Elliotts,
Inc. v. Commissioner, supra at 1248.
Financial stability was the crucial element in petitioner’s
growth strategy. To foster petitioner’s growth, from 1979
through 1992 petitioner either underpaid Mr. Reeves, petitioner’s
sole executive officer and manager, or did not pay him at all.
Petitioner retained Mr. Reeves’s compensation and used it to
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further develop and expand its business. Petitioner stated in
its memoranda of consent to corporate action that it would
reimburse Mr. Reeves for past underpayment and pay bonuses for
the extraordinary services he provided when petitioner became
more profitable.
Petitioner was a very profitable company in the fiscal years
at issue and paid Mr. Reeves and its other employees bonuses.
The bonuses paid were not awarded under a structured, formal, or
consistently applied program but were paid under petitioner’s
plan to award a bonus for present hard work and prior years’ lack
of compensation when it became more profitable.
F. Conclusion
Mr. Reeves, petitioner’s sole executive officer and manager,
was the driving force behind petitioner’s success. His vision
and hard work resulted in petitioner’s realizing sales of
$12,501,980, and $5,709,686, with a shareholders return on equity
of 93 percent and 25 percent in the respective fiscal years at
issue. The averages of the methods used to determine reasonable
compensation were $1,448,201 and $1,009,852 in the respective
fiscal years at issue, and taking into consideration the $547,350
Mr. Reeves was underpaid as of December 31, 1995, the Court finds
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that $2 million and $1,012,000 in the respective fiscal years at
issue are deductible under section 162(a)(1).33
III. Advertising Expenses
Petitioner argues it is entitled to deduct advertising
expenses under section 162(a) of $1,105,276 for its FYE June 30,
1996.
Advertising expenses are a type of ordinary and necessary
expense for which a current deduction is allowed to an active
trade or business. Sec. 162(a); sec. 1.162-1(a), Income Tax
Regs. Advertising expenses are allowed as a deduction under
section 162 if the taxpayer can demonstrate a sufficient
connection between the expenditure and the taxpayer’s business.
See RJR Nabisco Inc. & Consol. Subs. v. Commissioner, T.C. Memo.
1998-252.
Petitioner is an active trade or business that entered into
an exclusive contract with UMI to conduct all of petitioner’s
marketing, advertising, and branding in the fiscal years at
issue. In its FYE June 30, 1996, petitioner paid UMI $1,105,276
and deducted this amount as advertising expenses.
Respondent argues that $831,137 of the advertising expenses
was not for ordinary and necessary advertising expenses because
it was a distribution to Mr. Reeves from UMI and not paid as
33
Conversely, the Court finds $278,000 of the $2,278,000
claimed by petitioner as a deduction for FYE June 30, 1995, to be
nondeductible.
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advertising expenses. As a result, respondent reduced
petitioner’s allowable advertising expenses to $274,139.
UMI received the $1,105,276 during its FYE May 30, 1997.
UMI did not receive a notice of deficiency for this year, and its
FY 1997 is not at issue in this case. Respondent did not produce
UMI’s tax return for the FY 1997, evidence showing Mr. Reeves
received a $831,137 distribution from UMI, or evidence indicating
how UMI used the amounts petitioner paid for advertising.
Respondent’s revenue agent Steve Rans, who conducted the
audit of petitioner’s returns, testified that in determining
ordinary and necessary advertising expenses he did not take into
consideration wages paid by UMI, UMI’s costs of creating and
developing ideas, nor all the activities UMI performed to market,
advertise, and brand petitioner’s suntan lotion products.
Mr. Reeves testified that UMI had a substantial marketing
and advertising plan to create a lifestyle image for petitioner’s
products by: (1) Developing product catalogs; (2) designing
packaging and logos; (3) developing trade show display booths;
(4) attending trade shows; (5) meeting with salespersons to
educate them on petitioner’s products and how to sell them; and
(6) producing radio advertisements and promoting sporting events
to advertise petitioner’s products.
Steve Rans also testified that because of UMI’s marketing
and advertising in the FY 1996 and FY 1997, petitioner’s gross
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receipts from the sale of suntan products grew to $2,999,000,
with $1,800,000 profit.
The Court finds that petitioner showed a sufficient
connection between the $1,105,276 paid in advertising expenses
and its business of producing and selling suntan lotion products.
Therefore, this Court finds petitioner is entitled to deduct the
$1,105,276 in advertising expenses under section 162(a) for FYE
June 30, 1996.
IV. Floating Structures
Petitioner contends that it may depreciate its cost of
building the floating structures because the structures were used
primarily for business purposes.
Respondent does not dispute petitioner’s costs incurred
building the floating structures. Rather, respondent contends
that petitioner failed to establish the floating structures were
used in petitioner’s business during the fiscal years at issue.
Section 167(a)(1) allows as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear, and
obsolescence of property used in a trade or business.34 The
taxpayer bears the burden of proving the Commissioner’s
determinations are incorrect. Rule 142(a). Furthermore, each
deduction must be carefully scrutinized when the taxpayer is a
34
Petitioner did not argue that the floating structures
were property held for the production of income under sec.
167(a)(2) or that the floating structures qualify for
depreciation as entertainment facilities under sec. 274(a)(1).
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closely held corporation. Intl. Artists, Ltd. v. Commissioner,
55 T.C. 94, 108 (1970).
The floating structures were placed in service on May 28,
1996, approximately 1 month before the end of petitioner’s FYE
June 30, 1996. The structures were under construction in 1995.
Thus, they were not used in petitioner’s trade or business during
its FY 1995. See sec. 167(a)(1). Therefore, this Court finds
petitioner is not entitled to a depreciation deduction pursuant
to section 167(a)(1) in FYE June 30, 1995.
Mr. Reeves testified that after the floating structures were
placed into service, they were used primarily by petitioner and
UMI to develop advertising for the purpose of promoting
petitioner’s skin care and suntan lotion products, nutritional
supplements, and health food products. He testified the
advertising work included photo shoots that involved people
around water; i.e., riding jet skis, skiing, or lying out in the
sun next to the river. Petitioner also indicated the property
was used for promotional events.
Neither petitioner nor Mr. Reeves kept logs of petitioner’s
or UMI’s business use of the floating structures from May 28,
1996, through FYE June 30, 1996. The only evidence petitioner
offered to establish that the floating structures were used for a
business purpose was Mr. Reeves’s testimony and several undated
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photographs or photographs used in petitioner’s advertising dated
before the floating structures were completed.
Petitioner did not provide any evidence showing that the
floating structures were used primarily or at all for business
purposes during the last month of FYE June 30, 1996.35 See
Hobson Motor Co. v. Commissioner, T.C. Memo. 1990-297.
Therefore, this Court also finds petitioner is not entitled to a
depreciation deduction pursuant to section 167(a)(1) for FYE June
1996.
The Court, in reaching its holdings, has considered all
arguments made and concludes that any arguments not mentioned
above are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.
35
The lack of adequate documentation also precludes any
deductions for entertainment, amusement, or recreation with
respect to a facility used in connection with such activities.
Sec. 274(d)(2); see Finney v. Commissioner, T.C. Memo. 1980-23.