T.C. Memo. 2007-305
UNITED STATES TAX COURT
UNIVERSAL MARKETING, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8744-02. Filed October 9, 2007.
Daniel L. Reeves (officer), for petitioner.
Wesley F. McNamara, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HAINES, Judge: Respondent determined a deficiency in
petitioner’s Federal corporate income tax of $170,674 for the
fiscal year ending (FYE) May 31, 1996.
The issues for decision are: (1) Whether the amounts paid
to petitioner’s sole executive and shareholder constituted
reasonable compensation pursuant to section 162(a)(1); and
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(2) whether petitioner is entitled to deduct $80,000 as an
expenditure for supplies pursuant to section 162(a), or if
required to capitalize the expenses, whether petitioner is
entitled to depreciate the $80,000 expenditure over a 7-year
recovery period under section 168(c).1
FINDINGS OF FACT
At the time the petition was filed, petitioner maintained
its business office in Wilsonville, Oregon.2
A. Background
Petitioner’s predecessor, Vitamin Village, Inc. (VVI), was
incorporated by Daniel L. Reeves (Mr. Reeves) in the State of
Oregon in 1979. VVI, an accrual basis taxpayer with 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.
VVI also provided indoor tanning salon services and its own
printing, advertising, and marketing services. VVI used the
business name of Vitamin Village for the production and sales of
nutritional supplements, health food, skin care products, and
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code), as amended. All Rule
references are to the Tax Court Rules of Practice and Procedure,
unless otherwise indicated. Amounts are rounded to the nearest
dollar.
2
The parties did not file a stipulation of facts.
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tanning lotions; Club Tan for its tanning salon services; and
Universal Graphics for its advertising, marketing, and printing
activities.
B. Incorporation of Petitioner
On June 1, 1995, VVI incorporated petitioner and elected an
FYE May 31. On June 1, 1995, VVI also transferred $487 in cash
along with the printing equipment used by Universal Graphics, an
automobile, and fixtures with a total fair market value of
$53,555 in exchange for all issued shares of petitioner’s stock.
The shares of stock were transferred to Mr. Reeves in a section
355 reorganization resulting in VVI and petitioner becoming
brother-sister corporations.3
Mr. Reeves was petitioner’s president, secretary, treasurer,
sole shareholder, and sole manager.
C. Petitioner’s Services
In June 1995, at the beginning of petitioner’s FYE May 31,
1996, VVI entered into an agreement with petitioner, in which
petitioner agreed to brand, market, and advertise skin care and
tanning products sold by VVI for $1 million. Petitioner’s only
other customer was its sister corporation Club Tan Centers of
Oregon, Inc., of which Mr. Reeves was the sole owner and
3
Additionally, in December 1994 VVI incorporated Club Tan
Centers of Oregon, Inc. (CTC), transferred the assets used by
Club Tan to CTC in exchange for all issued shares of CTC’s
stock, and the shares of stock were transferred to Mr. Reeves in
a sec. 355 reorganization.
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shareholder. Petitioner provided minimal services for CTC in FYE
May 31, 1996.
During FYE May 31, 1996, petitioner provided the following
marketing and advertising services for VVI: Photographed models
and VVI products, sponsored pro and semipro athletes, sponsored
various sporting events,4 negotiated with retail stores and
distributors to sell VVI’s products, including developing and
distributing advertising displays and posters to these stores,
and promoted VVI’s traveling trade shows.
D. Petitioner’s Financial Condition and Employee Compensation
On its Form 1120, U.S. Corporation Income Tax Return, for
FYE May 31, 1996, petitioner reported gross receipts of
$1,055,433, with total income of $1,143,468.5 After petitioner
deducted a $500,000 bonus and a $9,000 salary as executive
compensation to Mr. Reeves, $31,757 as salary and wages to its
employees, $113,369 for a supplies business expense, and $426,963
in various other deductions, petitioner’s taxable income was
$62,379 with a total tax of $21,2096 and a net income book value
4
Sporting events included volleyball and waterskiing
competitions.
5
Total income included gross rents of $67,347 and gross
royalties of $20,688.
6
The total tax due included an estimated tax penalty of
$1,029.
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of $38,886.7 One component of the $113,369 expense for supplies
was evidenced by a check for $80,000 that was made payable to
VVI. The $80,000 check was signed by Mr. Reeves and bore the
notation “asset purchase UG”.8
Petitioner’s rate of return on equity was 42 percent for FYE
May 31, 1996.9 Petitioner did not pay any dividends in FYE May
31, 1996.
Petitioner did not maintain a compensation policy for Mr.
Reeves or its employees. The bonus Mr. Reeves received was 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 available.
7
Respondent disallowed all but $100,000 of the $509,000
deduction petitioner claimed for officer’s compensation paid to
Mr. Reeves.
Net income book value was reported on petitioner’s Form 1120
Schedule M-1. Net income book value was computed by subtracting
from taxable income of $62,379, $21,209 of Federal income tax and
$2,284 comprising Federal and State underpayment penalties,
accrued related party compensation, and a travel and
entertainment expense recorded on the books but not deducted on
the return.
8
Respondent disallowed the $80,000 expense deduction but
allowed petitioner to depreciate the $80,000 over a 39-year
recovery period under the modified accelerated cost recovery
system. The allowed depreciation deduction was $2,051.
9
Rate of return on equity is computed by dividing
petitioner’s net income book value of $38,886 by its equity value
of $92,928.
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Respondent issued the notice of deficiency on March 8, 2002.
Petitioner timely filed its petition on May 13, 2002, and filed
an amended petition on August 19, 2002.
OPINION
I. Reasonable Compensation
Petitioner contends the $509,000 paid to Mr. Reeves
constituted reasonable compensation under section 162(a)(1)
during its FYE May 31, 1996.
Respondent contends petitioner is entitled to deduct only
$100,000 as compensation under section 162(a)(1) with the
remaining $409,000 constituting a nondeductible dividend.
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.10 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.
10
Respondent argues only that the amount of compensation
was unreasonable.
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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). The 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 of the compensation with that of similar
companies, (3) the character and condition of the company, (4)
potential conflicts of interest, and (5) internal consistency in
compensation. Id. at 1245-1248. Where 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). Petitioner bears the
burden of proving the payments to Mr. Reeves were reasonable.11
See Rule 142(a).
11
Petitioner does not argue that sec. 7491(a) operates to
shift the burden of proof to respondent. Even if petitioner had
so argued, the burden of proof would not shift under sec. 7491(a)
because petitioner has not shown it maintained all required
records, nor has it shown it cooperated with the reasonable
requests of respondent for witnesses, documents, or meetings.
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II. The Elliott Factors Applied to Petitioner’s Compensation of
Mr. Reeves
A. Role in the Company
This factor 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.
Mr. Reeves served as petitioner’s president, secretary, and
treasurer and handled all petitioner’s managerial duties.
However, the record does not establish the specific amount of
time Mr. Reeves spent operating petitioner after it was
incorporated. Instead, the record indicates that Mr. Reeves
spent a considerable amount of his time operating petitioner’s
sister corporation, VVI.
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.
Petitioner failed to provide any data comparing the
compensation paid to Mr. Reeves with that paid by similar
companies providing similar services. Only respondent offered
expert testimony. However, respondent’s expert, Scott D. Hakala,
provided a reasonable compensation analysis focusing only on
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companies dealing with the development and sales of nutritional
products and not on companies that provided branding, marketing,
and advertising services.12
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.
Elliotts, Inc. v. Commissioner, supra at 1246.
Petitioner was incorporated in FYE May 31, 1996, with only
$487 in cash, and used equipment, including an automobile, with a
total fair market value of $53,555. Although petitioner
generated total gross receipts of $1,055,433, petitioner’s net
income was only $38,886 in its initial year of operation. All
but $55,433 of its gross receipts were generated from one
customer, its sister corporation VVI. Petitioner had a small
staff and paid wages of $31,757 to its employees. Therefore,
petitioner was a relatively small company whose operations were
not particularly extensive or complex.
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
12
See Vitamin Vill., Inc. v. Commissioner, T.C. Memo. 2007-
272, for an analysis of Mr. Hakala’s report.
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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, 716 F.2d
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.
The Court of Appeals for the Ninth Circuit determined that
the reasonableness of compensation should be evaluated from the
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
questioned compensation remain at a level that would satisfy a
hypothetical 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. Id. The Court of Appeals in Elliotts calculated the
return on equity using the yearend shareholders equity. Id.
This Court follows that approach. See Golsen v. Commissioner, 54
T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971); Lumber City
Corp. v. Commissioner, T.C. Memo. 1996-171.
Petitioner had a 42-percent return on equity after dividing
the net income book value by the yearend shareholders equity. In
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Elliotts, the Court of Appeals found that a 20-percent average
rate of return on equity would satisfy a hypothetical independent
investor. Elliotts, Inc. v. Commissioner, supra at 1247.
However, because petitioner was thinly capitalized with $487 in
cash, and used equipment with a total fair market value of
$53,555, this factor is given little weight.
E. Internal Consistency in Compensation
This factor focuses on whether the compensation in question
was paid pursuant to a structured, formal, and consistently
applied program. Id. Bonuses not paid pursuant to such a
program are suspect. Id. Bonuses paid to employees are
deductible ”when * * * 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.”
Sec. 1.162-9, Income Tax Regs.
Petitioner did not maintain a compensation policy for its
officers and employees, and Mr. Reeves’s bonus of $500,000 was
not awarded under a structured, formal, or consistently applied
program. Rather, the bonus was determined and paid at the end of
the fiscal year when petitioner could ascertain its cash
available.
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F. Conclusion
Petitioner has failed to meet its burden of proving that the
$509,000 payment to Mr. Reeves constituted reasonable
compensation. Therefore, the Court finds that the payment of
$100,000 in petitioner’s FYE May 31, 1996, as allowed by
respondent, is deductible under section 162(a)(1).13
III. Petitioner’s $80,000 Expense Deduction
Under section 162(a), a taxpayer may deduct ordinary and
necessary business expenses incurred or paid during the taxable
year. Generally, a taxpayer carrying materials and supplies on
hand is allowed to deduct expenditures for them only in the
amount that they are actually consumed and used in operation
during the taxable year.14 Sec. 1.162-3, Income Tax Regs.
However, the cost of acquiring property having a useful life
beyond a taxable year is a nondeductible capital expenditure,
except as otherwise provided in chapter 1 of the Code.15
Prudential Overall Supply v. Commissioner, T.C. Memo. 2002-103;
13
Conversely, the Court finds $409,000 of the $509,000
claimed as a deduction for FYE May 31, 1996, to be
nondeductible.
14
Sec. 1.162-3, Income Tax Regs., also allows costs of
incidental materials and supplies to be deducted when purchased
if inventories and records of consumption are not kept and
taxable income is clearly reflected.
15
For instance, sec. 167(a) provides that there shall be
allowed as a depreciation deduction a reasonable allowance for
the exhaustion, wear, and tear of property used in a trade or
business.
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secs. 1.263(a)-1 and 1.263(a)-2(a), Income Tax Regs. The
taxpayer is required to maintain records sufficient to enable the
Commissioner to determine his correct tax liability. See sec.
6001; sec. 1.6001-1(a), Income Tax Regs. The taxpayer has the
burden to prove the Commissioner’s determination was in error.16
Rule 142(a).
At trial, petitioner produced a check payable to VVI for
$80,000, dated October 3 or 5, 1995, bearing the notation “asset
purchase UG”.17 Mr. Reeves testified that the $80,000
expenditure was initially recorded in petitioner’s books as an
“equipment purchase” and was most likely paid to purchase
darkroom equipment, plates, small hand tools, paper, and ink. On
brief, petitioner indicated that the expenditure was most likely
for “miscellaneous equipment that would have gone hand-in-hand
with the printing equipment”.
Although small hand tools, paper, and ink could fit the
description of incidental materials and supplies the costs of
which may be deducted currently under section 162, petitioner
16
Petitioner does not argue that sec. 7491(a) operates to
shift the burden of proof to respondent. Even if petitioner had
so argued, the burden of proof would not shift under sec. 7491(a)
because petitioner has not shown it maintained all required
records, nor has it shown it cooperated with the reasonable
requests of respondent for witnesses, documents, or meetings.
17
UG was the acronym for Universal Graphics. Universal
Graphics was the business name for VVI’s printing, advertising,
and marketing services before petitioner’s sec. 355
reorganization.
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failed to produce evidence allocating any portion of the $80,000
to such incidental items so as to allow them to be deducted. See
sec. 1.162-3, Income Tax Regs.18 Therefore, the Court finds
petitioner is not entitled to deduct any of the $80,000 as an
ordinary and necessary business expense under section 162(a).
In the alternative, petitioner contends the $80,000 was used
to purchase property which is depreciable over a 7-year recovery
period under the modified accelerated cost recovery system
(MACRS). Respondent does not dispute that the property is
depreciable under section 167(a) but contends that the $80,000
was used to purchase property with a 39-year recovery period
under the MACRS.19
Section 167(a) generally allows as a depreciation deduction
a reasonable allowance for the exhaustion, wear, tear, and
obsolescence of property used in a trade or business. MACRS
provides that the depreciation deduction provided by section
167(a) for any tangible property must be determined by using the
applicable depreciation method, the applicable recovery period,
18
“Taxpayers carrying materials and supplies on hand should
include in expenses the charges for materials and supplies only
in the amount that they are actually consumed and used in
operation during the taxable year.” Sec. 1.162-3, Income Tax
Regs. In contrast, the cost of acquiring “equipment * * * and
similar property having a useful life substantially beyond a
taxable year” is a capital expenditure. Sec. 1.263(a)-2(a),
Income Tax Regs.
19
Respondent did not delineate what type of property
petitioner may have purchased with the $80,000.
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and the applicable convention. Sec. 168(a); Hospital Corp. of
Am. v. Commissioner, 109 T.C. 21, 45 (1997). Only the applicable
recovery period is at issue.
Property with 39-year recovery period is nonresidential real
property.20 Sec. 168(c). Nonresidential real property is
defined as “section 1250 property which is not-- (i) residential
rental property, or (ii) property with a class life of less than
27.5 years.” Sec. 168(e)(2)(B). Section 1250 property is any
real property (other than section 1245 property, as defined in
section 1245(a)(3)) which is or has been subject to the
depreciation allowance under section 167. Sec. 1250(c). Real
property, as used in section 1250(c), includes land, improvements
thereto, including a building or its structural components, and
other real property except that which is defined in section
1245(a)(3)(B)-(F). Sec. 1.1250-1(e)(3)(i), Income Tax Regs.
Respondent concedes petitioner used the $80,000 to purchase
an asset and “petitioner’s records included documentation, at
least at one time, indicating that the check was, in fact, paid
to purchase equipment”. Mr. Reeves credibly testified that the
20
MACRS generally classifies eligible personal property and
certain real property as 3-year property, 5-year property, 7-year
property, 10-year property, 15-year property, or 20-year property
and assigns that property to a corresponding recovery period on
the basis of the property’s class life. Sec. 168(c), (e)(1),
(3). MACRS generally classifies real property as residential
rental property or nonresidential real property, assigning
recovery periods of 27.5 years and 39 years, respectively. Sec.
168(c), (e)(2).
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$80,000 expenditure was initially recorded in petitioner’s books
as an equipment purchase and was likely used to purchase
equipment associated with printing.
The record indicates that the property purchased with the
$80,000 did not consist of nonresidential real property, i.e.
section 1250 property which is not residential rental property,
or property with a class life of less than 27.5 years.
Therefore, this Court finds petitioner is not required to
depreciate the $80,000 over a 39-year recovery period pursuant to
section 168(c).
Petitioner did not produce evidence indicating the
equipment had a class life of less than 10 years, which would
allow petitioner to recover the $80,000 over a 5-year period.21
See sec. 168(e)(3)(B); Rev. Proc. 87-56, 1987-2 C.B. 674, as
clarified and modified by Rev. Proc. 88-22, 1988-1 C.B. 785.
Moreover, none of the property petitioner asserted it had
purchased with the $80,000 had a class life of 16 years or more
with an applicable recovery period greater than 10 years. See
sec. 168(c), (e)(1), (3)(D); Rev. Proc. 87-56, supra.
However, petitioner did produce evidence indicating the
$80,000 was used to purchase printing equipment which has a class
life of 11 years. See Rev. Proc. 87-56, 1987-2 C.B. at 679
21
Property with a class life of greater than 4 but less
than 10 years is treated as 5-year property, which has a 5-year
recovery period. Sec. 168(c), (e)(1), (3)(B).
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(asset class 27.0). Therefore, the Court finds that the
equipment petitioner purchased with the $80,000 was 7-year
property with a 7-year recovery period. See sec. 168(c), (e)(1);
Thomson v. Commissioner, T.C. Memo. 1999-371.
The Court, in reaching its holding, 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.