T.C. Memo. 2016-95
UNITED STATES TAX COURT
H. W. JOHNSON, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3110-07. Filed May 11, 2016.
Gregory A. Robinson, for petitioner.
John W. Duncan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined deficiencies in petitioner’s Federal
income tax for the taxable years ended June 30, 2003 and 2004 (years at issue),1 of
$877,440 and $2,087,678, respectively. The issues for decision are: (1) whether
1
Unless otherwise indicated, references to a year are to the fiscal year
ending in that calendar year.
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[*2] the amounts paid to Bruce A. Johnson and Donald J. Johnson during the years
at issue constituted reasonable compensation deductible under section 162;2 and
(2) whether petitioner is entitled to deduct a $500,000 payment to DBJ
Enterprises, LLC, an entity controlled by Bruce and Donald, as an ordinary and
necessary business expense under section 162 for 2004.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We incorporate by
this reference the stipulation of facts and the accompanying exhibits. Petitioner
maintained its principal office in Arizona at the time the petition was filed.
I. Petitioner’s inception, management, and organization
During the years at issue petitioner operated a concrete contracting business.
At that time petitioner was one of the largest curb, gutter, and sidewalk contractors
in the State of Arizona, with over 200 employees and contract revenues of
$23,754,182 and $38,022,612 in 2003 and 2004, respectively.
Petitioner was incorporated in 1974 by H.W. Johnson and Margaret
Johnson. H.W. and Margaret had operated a predecessor sole proprietorship out
2
All section references are to the Internal Revenue Code of 1986, as in
effect for the years at issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure. All dollar amounts have been rounded to the nearest
dollar.
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[*3] of their home since 1968. H.W. handled petitioner’s operations, and
Margaret handled financial and administrative matters.
Two of H.W. and Margaret’s sons, Bruce and Donald, began working part
time for petitioner as teenagers in the 1970s, and then full time when they
completed their education in 1977 and 1982, respectively. Bruce and Donald
gradually assumed increasing responsibilities and took over petitioner’s daily
operations in 1993. H.W. and Margaret made gifts of shares of petitioner’s stock
to Bruce and Donald; and by 1996, when H.W. retired from petitioner, Bruce and
Donald had each acquired 24.5% of the shares, with Margaret retaining the
remaining 51%. Upon H.W.’s retirement the brothers became co-vice presidents
and members of petitioner’s board of directors, along with Margaret.
II. Petitioner’s growth and financial condition under Bruce and Donald’s
management
Petitioner’s contract revenues grew rapidly after Bruce and Donald assumed
control of petitioner’s daily operations in 1993. In that year petitioner had
contract revenues of approximately $4 million; contract revenues increased to over
$11 million and $13 million in 1994 and 1995, respectively. Petitioner’s contract
revenues remained steady at about $17 million between 1996 and 1999 and
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[*4] climbed steadily every year thereafter including the years at issue, when
revenues increased dramatically between 2003 and 2004.
Petitioner was profitable and experienced significant revenue and asset
growth during 2003 and 2004, with gross profit margins before payment of officer
bonuses of 38.3% and 38.2%, respectively. Petitioner’s assets, liabilities, equity,
revenue, net income before taxes, and net income after taxes during 2002 through
2004 were as follows:
2002 2003 2004
Assets $6,814,399 $8,844,769 $13,424,705
Liabilities 3,228,649 5,058,551 9,536,121
Equity 3,585,750 3,786,218 3,888,584
Contract
revenue 23,239,207 23,754,182 38,022,612
Net income
before taxes 210,967 387,706 348,579
Net income
after taxes 132,545 250,468 202,366
During the years at issue Bruce and Donald personally guaranteed loans
whose proceeds petitioner used to purchase materials and supplies.
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[*5] III. Petitioner’s operations and industry reputation in 2003 and 2004
During the years at issue Margaret served as petitioner’s president and
chairman of the board. She handled the company’s payroll and finances, accounts
receivable and delinquent account collections, employee hiring and terminations,
and various other administrative functions, working around 40 hours a week.
Bruce and Donald together managed all operational aspects of petitioner’s
business. Operations were split into two geographical divisions, eastern and
western, with each brother managing a division’s operations, including contract
bidding and negotiation, project scheduling and management, equipment purchase
and modification, personnel management, and customer relations. Bruce and
Donald each supervised over 100 employees in their respective divisions,
including superintendents and foremen, and worked 10 to 12 hours a day, five to
six days a week. They were at the jobsites daily and regularly operated equipment
while there. The brothers were readily available if problems at a jobsite arose and
were known in the local industry for their responsive and hands-on management
style.
Approximately 95% of petitioner’s business during the years at issue was
for residential subdivision construction. The concrete work Bruce and Donald
supervised required considerable technical skill and coordination, as fresh
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[*6] concrete is highly perishable. Concrete “sets”--and becomes unusable--either
90 minutes after it is mixed and loaded onto a truck or if it reaches 90 degrees.
(Keeping the concrete from reaching 90 degrees in Phoenix’s typical 100-degree-
plus temperatures was a particular challenge in petitioner’s operations.) The
concrete for sidewalks and curbs had to be poured precisely to prevent surface
areas where water could collect; if water stood more than half an inch deep at any
point on a finished curb or sidewalk, the area had to be ripped out and repoured or
ground down to correct the flaw. Additionally, petitioner had to meet the varying
specifications of different contractors, engineers, cities, towns, and counties on
any given job. Petitioner’s equipment was often modified or specially fabricated
to meet the requirements of a given job. Most such work was done in-house--
thereby reducing costs and improving efficiency--with Bruce or Donald often
supplying the idea for a design that was then refined and implemented by
petitioner’s fabrication foreman.
Petitioner had an excellent reputation with developers, inspectors, and other
contractors and was known for its timely performance and quality product. As a
result, petitioner was routinely awarded contracts even where it was not the lowest
bidder, and the company needed little marketing beyond its reputation in the
industry.
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[*7] IV. Cement shortage and formation of Arizona Materials
A reliable supply of concrete was critical to petitioner’s business.
Petitioner, however, did not produce its own concrete, relying instead on local
suppliers. Starting in late 2002 and throughout the years at issue there were
shortages of concrete in petitioner’s market due to a housing boom in Arizona. In
addition, large multinational and national firms were acquiring suppliers of
concrete in Arizona, disrupting petitioner’s theretofore locally based network.
Faced with the possibility of disruptions in petitioner’s supply of concrete, Bruce
and Donald suggested to Margaret that petitioner invest in a concrete supplier so
as to have a reliable supply. Margaret, holding a controlling share in petitioner,
refused to involve the company in such a venture because she judged it too risky.
On March 21, 2003, Bruce and Donald, acting through D.B.J. Enterprises,
LLC (DBJ),3 partnered with other investors, including a former executive of a
local concrete supplier that had been acquired by a large multinational firm, to
form Arizona Materials, LLC (Arizona Materials), to conduct a concrete supply
business. DBJ owned a 52% interest in Arizona Materials. Bruce and Donald,
3
Bruce and Donald had formed DBJ on August 10, 1995, to hold
investments; during the years at issue Bruce and Donald each owned 50% of DBJ
through family trusts.
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[*8] through DBJ, invested substantial sums in, and guaranteed the indebtedness
of, Arizona Materials.
There were also occasional market shortages of cement--an essential
ingredient of concrete--during the years at issue, but Arizona Materials was able to
obtain access to cement over that period because of the relationships its other
investors had with cement suppliers. Though sometimes unable to procure
concrete from its other suppliers, petitioner obtained a substantial amount of
concrete from Arizona Materials during 2004 and was able to procure concrete
even when other contractors could not (and were therefore forced to temporarily
suspend operations). Petitioner received bulk discounts for large concrete
purchases from Arizona Materials, obtaining concrete at a price lower than it paid
other suppliers. DBJ exercised its influence as majority shareholder of Arizona
Materials to ensure that petitioner received a steady supply of concrete, as at that
time Arizona Materials had other customers willing to pay a higher price for the
concrete.
At the end of 2004 petitioner paid DBJ $500,000. Petitioner’s board
meeting minutes state that the payment was for a “guaranteed supply of concrete at
market prices for the year ended June 30, 2004. DBJ Enterprises, L.L.C. has
negotiated with Arizona Materials L.L.C. on behalf of H.W. Johnson, Inc. to
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[*9] provide a continuous supply of concrete.” Petitioner and DBJ had no written
agreement regarding the $500,000 payment.
V. Petitioner’s officer compensation and dividend plans
During the years at issue petitioner’s board held annual meetings in May to
determine officer compensation, director’s fees, and dividends. Petitioner
compensated Bruce and Donald as follows:4
Officer 2003 2004
Bruce $2,013,250 $3,651,177
Donald 2,011,789 3,649,739
Total 4,025,039 7,300,916
Under petitioner’s officer bonus formula, adopted by petitioner’s board in
1991 and amended in 1999, total potential bonuses were calculated in proportion
to the company’s annual contract revenue and added to a “bonus pool”. The bonus
pool was calculated under the 1991 bonus formula as follows: 12% of contract
revenue up to $10 million; 10% of contract revenue between $10 million and $20
million; and 8% of contract revenue in excess of $20 million. The bonus pool was
calculated under the amended 1999 bonus formula as follows: 20% of contract
revenue up to $15 million; 18% of contract revenue between $15 million and $30
4
These amounts include officer salaries, bonuses, and director’s fees.
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[*10] million; and 16% of contract revenue between $30 million and $45 million.
At yearend and upon the advice of petitioner’s accountant, the board of directors
issued bonuses out of the bonus pool based on officer performance and
petitioner’s ability to pay. Any unpaid amounts remained in the bonus pool for
later payment pending board approval. Petitioner’s board awarded bonuses
between 1992 and 2004 as follows:
Amount overpaid or
(underpaid) from
Year Contract revenue Bonus pool Bonuses awarded1 current bonus pool
1992 $2,637,877 Accumulated: n/a M: $20,000
Current: $316,545 B: 50,000
D: 50,000
Total: 120,000 ($196,545)
1993 3,924,803 Accumulated: 196,545
Current: 470,976 -0- (470,976)
1994 11,148,877 Accumulated: 667,521
Current: 1,314,888 -0- (1,314,888)
1995 13,050,253 Accumulated: 1,982,409
Current: 1,505,025 -0- (1,505,025)
1996 17,297,573 Accumulated: 3,487,434 M: 833,000
Current: 1,929,757 B: 833,000
D: 833,000
Total: 2,499,000 569,243
1997 16,430,480 Accumulated: 2,918,191 M: 833,333
Current: 1,843,048 B: 833,333
D: 833,333
Total: 2,499,000 656,951
1998 18,112,935 Accumulated: 2,261,240 M: 650,000
Current: 2,011,294 B: 775,000
D: 775,000
Total: 2,200,000 188,706
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[*11]
1999 17,924,893 Accumulated: 2,072,534 M: 250,000
Current: 3,529,721 B: 875,000
D: 875,000
Total: 2,000,000 (1,529,721)
2000 19,409,457 Accumulated: 3,602,255 M: 250,000
Current: 3,793,702 B: 1,250,000
D: 1,250,000
Total: 2,750,000 (1,043,702)
2001 20,062,213 Accumulated: 4,645,957 M: 250,000
Current: 3,911,198 B: 1,550,000
D: 1,550,000
Total: 3,350,000 (561,198)
2002 23,239,207 Accumulated: 5,207,155 M: 250,000
Current: 4,483,057 B: 1,750,000
D: 1,750,000
Total: 3,750,000 (733,057)
2003 23,754,182 Accumulated: 5,940,212 M: 250,000
Current: 4,575,753 B: 1,750,000
D: 1,750,000
Total: 3,750,000 (825,753)
2004 38,022,612 Accumulated: 6,765,965 M: 500,000
Current: 6,983,618 B: 3,400,000
D: 3,400,000
Total: 7,300,000 316,382
1
M = Margaret; B = Bruce; D = Donald
During the years at issue petitioner also had a dividend plan, adopted in
1991 and amended in 1999. That plan called for dividend payments when the
company’s retained earnings exceeded $2 million. The board determined the
amount of the dividend on the basis of petitioner’s financial position, profitability,
and capitalization, following the advice of petitioner’s accountant. Petitioner paid
modest annual dividends to its shareholders between 1996 and 2004. For most of
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[*12] those years, the dividend amount was $25,000. In 2002 and 2003 the
amount rose to $50,000, and in 2004, it was $100,000.
VI. Petitioner’s 2003 and 2004 returns and the deficiency determinations
On its timely filed Forms 1120, U.S. Corporation Income Tax Return, for
2003 and 2004 petitioner claimed deductions for the salaries, bonuses, and
director’s fees it paid to Margaret, Bruce, and Donald. Petitioner also claimed a
deduction for 2004 for the $500,000 it paid to DBJ, reporting the payment as an
“administration fees” expense.
Respondent issued a notice of deficiency to petitioner determining that
$2,607,517 and $5,616,771 of the amounts petitioner deducted for 2003 and 2004,
respectively, as officer compensation exceeded reasonable compensation and
disallowing in its entirety the $500,000 deduction petitioner claimed for 2004 as
administration fees. Petitioner timely petitioned this Court for redetermination of
the deficiencies.
OPINION
I. Reasonable compensation
Petitioner contends that the $4,025,039 and $7,300,916 it paid to Bruce and
Donald and deducted as compensation for 2003 and 2004, respectively, constitute
reasonable compensation under section 162(a)(1). Respondent disagrees. The
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[*13] notice of deficiency disallowed $2,607,517 and $5,589,0745 of the claimed
deductions for 2003 and 2004, respectively, as exceeding reasonable
compensation, treating the reasonable amounts as limited to $1,417,522 and
$1,711,842, respectively, for each year. Respondent now concedes that
deductions of $3,214,000 and $6,532,000 for compensation are reasonable,
leaving $811,039 and $768,916 in dispute for 2003 and 2004, respectively.
Section 162(a)(1) permits a taxpayer to deduct “a reasonable allowance for
salaries or other compensation for personal services actually rendered” as an
ordinary and necessary business expense. A taxpayer is entitled to a deduction for
compensation payments if the payments are reasonable in amount and in fact paid
purely for services. Sec. 1.162-7(a), Income Tax Regs. Though framed as a two-
pronged test, courts considering the deductibility of compensation under section
162(a)(1) generally focus on whether the amount of purported compensation is
reasonable. Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1244 (9th Cir. 1983),
rev’g T.C. Memo. 1980-282. Petitioner has the burden of proving that the
5
The notice of deficiency also initially disallowed $27,697 of director’s fees
petitioner paid to Margaret and deducted for 2004. Respondent has not addressed
Margaret’s fees on brief (presumably because his own expert concluded that
Margaret was undercompensated in 2004), and we therefore deem respondent to
have conceded this issue.
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[*14] amounts paid to Bruce and Donald in 2003 and 2004 were reasonable.6 See
Rule 142(a).
The Court of Appeals for the Ninth Circuit, to which an appeal in this case
would normally lie, applies five factors to determine the reasonableness of
compensation, with no factor being determinative: (1) the employee’s role in the
6
At the outset of trial petitioner contended that the notice of deficiency had
lost its presumptive correctness in view of the fact that respondent had abandoned
the position in the notice that reasonable compensation for Bruce and Donald was
limited to $1,417,522 and $1,711,842 for 2003 and 2004, respectively, and had
instead taken the position--in line with his expert’s report--that reasonable
compensation for them was a much higher figure for each year; namely,
$3,214,000 and $6,532,000 for 2003 and 2004, respectively.
Petitioner was presumably relying on a line of cases from the Court of
Appeals for the Ninth Circuit, where an appeal in this case would normally lie,
holding that the Commissioner’s adoption of a litigation position that substantially
deviates from the position in the notice of deficiency results in a forfeiture of any
presumption of correctness in the notice and places the burden of proof on the
Commissioner. See Estate of Mitchell v. Commissioner, 250 F.3d 696 (9th Cir.
2001), aff’g in part, vacating in part and remanding T.C. Memo. 1997-461; Estate
of Simplot v. Commissioner, 249 F.3d 1191 (9th Cir. 2001), rev’g and remanding
112 T.C. 130 (1999); Morrissey v. Commissioner, 243 F.3d 1145 (9th Cir. 2001),
rev’g and remanding Estate of Kaufman v. Commissioner, T.C. Memo. 1999-119.
On brief, however, petitioner does not address such an argument or cite any
of the foregoing cases. Instead, petitioner states that it “has met its burden of
proof in establishing that the compensation paid to Don and Bruce Johnson for
2003 and 2004 was reasonable.” We consequently deem petitioner to have
abandoned any argument that the burden of proof rests with respondent. In any
event, we reach our decision on the basis that the preponderance of the evidence
establishes that the disputed amounts that petitioner deducted for the years at issue
constituted reasonable compensation and therefore find it unnecessary to consider
further any impact of the aforementioned cases.
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[*15] company; (2) a comparison of compensation paid by similar companies for
similar services; (3) the character and condition of the company; (4) potential
conflicts of interest; and (5) the internal consistency of compensation
arrangements. Elliotts v. Commissioner, 716 F.2d at 1245-1247. In analyzing the
fourth factor, the Court of Appeals emphasizes evaluating the reasonableness of
compensation payments from the perspective of a hypothetical independent
investor, focusing on whether the investor would receive a reasonable return on
equity after payment of the compensation. Id. at 1247; see also Metro Leasing
Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019 (9th Cir. 2004), aff’g T.C.
Memo. 2001-119.
Both parties introduced expert witness reports and testimony to support the
parties’ positions. Expert witness testimony is appropriate to help the Court
understand an area requiring specialized training, knowledge, or judgment. See
Fed. R. Evid. 702; Snyder v. Commissioner, 93 T.C. 529, 534 (1989).
Nonetheless, the Court is not bound by an expert’s opinion, and we may either
accept or reject expert testimony in the exercise of sound judgment. Helvering v.
Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Parker v. Commissioner, 86 T.C.
547, 561-562 (1986). Furthermore, the Court may be selective in determining
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[*16] what portions of an expert’s opinion, if any, to accept. Parker v.
Commissioner, 86 T.C. at 562.
On brief respondent effectively concedes four of the five Elliotts factors that
tend to support, or are at least neutral with respect to, the reasonableness of the
compensation petitioner paid. As to the employees’ roles and the condition of the
company, respondent concedes the “significant roles” Bruce and Donald played in
petitioner’s “substantial success” during the years at issue. Similarly, respondent
concedes that the level of petitioner’s success was so great that comparisons to the
compensation paid by similar companies were difficult to make and that the
bonuses paid to Bruce and Donald--while unreasonable compensation in
respondent’s view--were nonetheless the result of a consistently applied bonus
formula. Notwithstanding the foregoing, respondent argues that this case hinges
on the fourth Elliotts factor; namely, whether a hypothetical independent investor
would receive an adequate return on equity after accounting for Bruce’s and
Donald’s compensation. Nevertheless, we consider each of the Elliotts factors,
inasmuch as the Court of Appeals for the Ninth Circuit has indicated that no one
factor is dispositive. See Metro Leasing Dev. Corp. v. Commissioner, 376 F.3d at
1019; LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091, 1095 (9th Cir. 2000),
aff’g T.C. Memo. 1998-343; Elliotts, Inc. v. Commissioner, 716 F.2d at 1245.
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[*17] A. Role in the company
This factor focuses on the employee’s importance to the success of the
business. Elliotts, Inc. v. Commissioner, 716 F.2d at 1245. Pertinent
considerations include the employee’s position, duties performed, and hours
worked. Id.
As our findings demonstrate (and respondent concedes), Bruce and Donald
were integral to petitioner’s success during the years at issue. They were
responsible for contract billing, onsite management and personnel supervision,
and equipment modifications to meet specific project requirements. They were
known to local developers as having a hands-on management style that
consistently produced a quality product on schedule. Furthermore, under Bruce
and Donald’s management, petitioner’s annual contract revenues increased
dramatically, from approximately $4 million in 1993 to over $38 million in 2004.
While some of this growth was undoubtedly due to the housing boom in Arizona
at that time, petitioner’s reputation for quality and timely performance under Bruce
and Donald’s management allowed it to secure contracts even when it was not the
lowest bidder.
Bruce and Donald also personally guaranteed indebtedness that petitioner
incurred to purchase materials and supplies, adding to their role in ensuring its
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[*18] successful operations. See Leonard Pipeline Contractors, Ltd. v.
Commissioner, T.C. Memo. 1998-315, aff’d without published opinion, 210 F.3d
384 (9th Cir. 2000); Owensby & Kritikos, Inc. v. Commissioner, T.C. Memo.
1985-267, aff’d, 819 F.2d 1315 (5th Cir. 1987).
This factor weighs in petitioner’s favor.
B. External comparison
This factor compares the employee’s compensation with that paid by similar
companies for similar services. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246;
sec. 1.162-7(b)(3), Income Tax Regs. Respondent concedes that petitioner’s
performance so exceeded that of any of the companies identified by the parties’
experts as comparable that compensation comparisons are not meaningful.
Petitioner’s expert calculated that petitioner’s officers’ compensation as a
percentage of gross revenue was 18.4% and 20.9% for 2003 and 2004,
respectively, whereas the industry average for those years was 2.2%. Petitioner
contends that its performance so exceeded the industry average that the divergence
of its compensation from the average is justified. On this record we lack any
reliable benchmarks from which to assess petitioner’s claim and therefore find it
unpersuasive. In view of this and respondent’s concession, we conclude that this
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[*19] factor is essentially neutral. See Multi-Pak Corp. v. Commissioner, T.C.
Memo. 2010-139.
C. Character and condition of the company
This factor considers the company’s character and condition, focusing on
size as measured by sales, net income, or capital value. Elliotts, Inc. v.
Commissioner, 716 F.2d at 1246. The complexities of the business and general
economic conditions are also relevant. Id.
As reflected in our findings, petitioner experienced remarkable revenue,
profit margins (before officer compensation), and asset growth during the years at
issue. Respondent concedes petitioner’s “substantial success” during the years at
issue. This factor weighs in petitioner’s favor.
D. Conflict of interest
The primary focus of this factor is whether a relationship exists between the
company and the employee which may permit the company to disguise
nondeductible corporate distributions as deductible section 162(a)(1)
compensation payments. Id. A potentially exploitable relationship may exist
where the employee is the company’s sole or controlling shareholder or where a
special family relationship indicates that the terms of a compensation arrangement
are not the result of a free bargain. Id. Because petitioner’s majority shareholder
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[*20] during the years at issue was Margaret--Bruce and Donald’s mother--and
together the three of them owned all petitioner’s stock, this factor warrants
scrutiny.7
The Court of Appeals for the Ninth Circuit approaches this inquiry by
evaluating the compensation payments from the perspective of a hypothetical
independent investor, focusing on the investor’s return on equity. Id. at 1247. If
the company’s earnings on equity after payment of 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. Id.
The parties and their experts agree that petitioner had pretax returns on
equity of 10.2% and 9% for 2003 and 2004, respectively.8 They differ, however,
7
We further note in this regard that petitioner paid dividends totaling only
$50,000 and $100,000 for 2003 and 2004, respectively, notwithstanding gross
profit margins (before officer compensation) for each year exceeding 38%.
8
Although Elliotts computes return on equity on an aftertax basis--by
dividing net income (i.e., income after taxes) by yearend shareholder equity,
Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1247 (9th Cir. 1983), rev’g T.C.
Memo. 1980-282--both parties’ experts generally computed petitioner’s return on
equity using pretax income figures. They did so because, as respondent’s expert
explained, most of the available data from the companies they considered
comparable provides pretax return on equity figures. Neither the parties nor their
experts offer any insight concerning the possible impact of using pretax versus
(continued...)
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[*21] on what an expected return on equity should have been for petitioner.
Respondent’s expert used return on equity figures from four sources that produced
return on equity figures ranging from 13.8% to 18.3%. We find that the data on
which he relied is not as reliable as that used by petitioner’s expert. Respondent’s
expert’s first return on equity figure was derived from seven “guideline
companies”. But these guideline companies are not comparable to petitioner as
they were publicly traded, operated in industries different from petitioner’s, and
had gross sales substantially larger than petitioner’s. His second figure was
derived from company data in an annual statement published by the Risk
Management Association, yet the publication itself states that its data should be
used “only as general guidelines and not as absolute industry norms” because the
data “may not be fully representative of a given industry” for several reasons,
including that it is not randomly selected and may include small sample sizes for
certain industries. His third figure is derived from the Construction Financial
Management Association’s annual financial survey, but many of the companies in
that data sample operated in industries dissimilar from petitioner’s. Finally,
8
(...continued)
aftertax figures, though presumably pretax returns on equity would always be
higher. In these circumstances, we are constrained to evaluate this factor on the
basis of pretax figures.
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[*22] respondent’s expert derived a “market required return on equity” from data
published by Ibbotson Associates. But that data is from companies engaged in the
construction industry generally, not the concrete contracting sector of which
petitioner is a part.
By contrast, petitioner’s expert used return on equity figures derived from
Integra Information (Integra) data. Integra is a data service which compiles
financial information of privately held companies from government and other
sources. Petitioner’s expert used Integra data from 33 companies falling under
SIC code 1771, Construction--Special Trade Contractors--Concrete Work, with
sales ranging from $25 million to $49,999,999. We find the companies that
petitioner’s expert used to be more comparable to petitioner for purposes of a
return on equity analysis than those used by respondent’s expert.9 Petitioner’s
expert calculated an average pretax return on equity from these 33 companies of
10.5% and 10.9% for calendar years 2003 and 2004, respectively. Thus,
9
Respondent faults the Integra company sample because it has not been
shown whether any of these companies actually had independent investors (who
would presumably serve as a check on excessive officer compensation). However,
the same could be said of any privately held company in the various databases that
respondent’s expert used. On balance, we are persuaded that companies which are
closest to petitioner with respect to the nature of the business activity and the size
of annual sales provide the best index of a reasonable return on equity.
Petitioner’s expert’s companies were closer to petitioner in these respects.
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[*23] petitioner’s pretax return on equity fell 0.3 percentage points below the
Integra companies’ average in 2003 and 1.9 percentage points below it in 2004.
The parties disagree over the implications of these figures. Respondent
argues that because petitioner’s return on equity fell below the industry average in
2003 and 2004, Bruce and Donald were unreasonably compensated in those years.
An independent investor would have demanded a return more commensurate with
petitioner’s superior performance, respondent claims. Petitioner contends that its
return on equity was in line with the industry average and therefore would have
satisfied an independent investor.
We agree with petitioner. Respondent cites no authority for the proposition
that the required return on equity for purposes of the independent investor test
must significantly exceed the industry average when the subject company has been
especially successful, and we have found none in the caselaw. Instead, in applying
the independent investor test the courts have typically found that a return on equity
of at least 10% tends to indicate that an independent investor would be satisfied
and thus payment of compensation that leaves that rate of return for the investor is
reasonable. See, e.g., Thousand Oaks Residential Care Home I, Inc. v.
Commissioner, T.C. Memo. 2013-10; Multi-Pak Corp. v. Commissioner, T.C.
Memo. 2010-139. Indeed, compensation payments that resulted in a return on
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[*24] equity of 2.9% have been found reasonable. Multi-Pak Corp. v.
Commissioner, T.C. Memo. 2010-139. It is compensation that results in returns
on equity of zero or less than zero that has been found to be unreasonable. See,
e.g., Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Commissioner, 680 F.3d 867
(7th Cir. 2012), aff’g T.C. Memo. 2011-74; Multi-Pak Corp. v. Commissioner,
T.C. Memo. 2010-139. We consequently find that petitioner’s returns on equity of
10.2% and 9% for 2003 and 2004, respectively, tend to show that the
compensation paid to Donald and Bruce for those years was reasonable. As
petitioner’s expert points out, mere reductions in their collective compensation of
$9,847 and $75,277 in 2003 and 2004, respectively--differences of approximately
1%--would have placed petitioner’s return on equity at exactly the average for
comparable companies in the concrete business. Consequently, this factor favors a
finding that the compensation at issue was reasonable.
E. Internal consistency of compensation
This factor focuses on whether the compensation was paid pursuant to a
structured, formal, and consistently applied program; bonuses not awarded under
such plans are suspect. Elliotts, Inc. v. Commissioner, 716 F.2d at 1247.
Petitioner consistently adhered to the officer bonus formula from its
inception in 1991. Respondent concedes as much although he argues that the
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[*25] formula yielded unreasonable compensation during the years at issue. We
conclude that this factor weighs in petitioner’s favor.10
F. Conclusion
As a whole, the Elliotts factors support the conclusion that the
compensation petitioner paid to Bruce and Donald in 2003 and 2004 was
reasonable. The brothers were absolutely integral to petitioner’s successful
performance, a performance that included remarkable growth in revenues, assets,
and gross profit margins during those years, as respondent concedes. The return
on equity petitioner generated for each year after payment of Bruce’s and Donald’s
compensation was in line with--indeed closely approximated--the return generated
by the companies most comparable to it. We accordingly conclude that an
independent investor would have been satisfied with the return. For these reasons,
we hold that the $4,025,039 and $7,300,916 petitioner paid as officer
compensation in 2003 and 2004, respectively, were reasonable and therefore
deductible under section 162(a)(1).
10
At trial petitioner sought to introduce evidence pertaining to respondent’s
examination of petitioner’s return for 1996 to show that respondent did not
question the bonus formula (and therefore, in petitioner’s view, approved it). We
have excluded that evidence because it is irrelevant. See, e.g., Pekar v.
Commissioner, 113 T.C. 158, 165-166 (1999).
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[*26] II. DBJ payment
We now address whether petitioner is entitled to deduct the $500,000
“administration fees” expense paid to DBJ and reported on its 2004 return as a
business expense.
Generally, a taxpayer may deduct ordinary and necessary expenses paid or
incurred during the taxable year in carrying on a trade or business, including
reasonable compensation for personal services actually rendered. Sec. 162(a)(1).
Ordinary expenses are “normal, usual, or customary” in the taxpayer’s trade or
business. Deputy v. du Pont, 308 U.S. 488, 495 (1940). In order for an expense to
be ordinary there must be evidence that the transaction in question has some
degree of normality in the type of business under scrutiny. Id. at 495-496. Absent
such evidence, there must be a basis for an assumption, in experience or common
knowledge, that payments sought to be deducted are to be placed in the same
category as ordinary expenses. Id. at 496-497. Necessary expenses are expenses
that are “appropriate and helpful” to a taxpayer’s trade or business. Welch v.
Helvering, 290 U.S. 111, 113 (1933). Whether an expense is ordinary and
necessary is a question of fact. Id. at 115.
Tax deductions are a matter of legislative grace, and a taxpayer has the
burden of proving that he is entitled to the deductions claimed. Rule 142(a);
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[*27] INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice
Co. v. Helvering, 292 U.S. 435, 440 (1934).11
Petitioner argues that the $500,000 “administration fees” expense is an
ordinary and necessary business expense because it constitutes a payment it made
to DBJ to compensate it for securing a guaranteed supply of concrete, discounted
for bulk purchases, from Arizona Materials during 2004. Respondent contends on
several grounds that the $500,000 payment was not an ordinary and necessary
business expense, including: (1) that there was no written agreement or evidence
of any oral agreement obligating petitioner to compensate DBJ, and therefore the
$500,000 payment was voluntary; (2) that DBJ performed no compensable
services on behalf of petitioner; and (3) that the $500,000 payment was made not
for services that DBJ provided, but for services Bruce and Donald performed in
their capacities as officers of petitioner.
Respondent’s arguments are unpersuasive. We are satisfied on this record
that Bruce and Donald, acting through DBJ, used DBJ’s controlling position in
Arizona Materials to cause Arizona Materials to supply concrete to petitioner
during times of shortage at favorable prices. Third-party testimony--to the effect
11
Petitioner did not claim, or show entitlement to, any shift in the burden of
proof under sec. 7491(a) with respect to the factual issues relevant to this
deduction.
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[*28] that petitioner was able to obtain concrete in 2004 at times when other
concrete contractors could not--corroborates the brothers’ account. Moreover,
Bruce and Donald, acting in their individual capacities when their more risk-
averse, controlling-shareholder mother would not allow petitioner to do so, made
arrangements to form Arizona Materials to ensure petitioner’s concrete supply in
the face of looming shortages. They brought in other investors with industry
contacts, including existing relationships with cement suppliers, cement being a
critical ingredient of concrete and also exhibiting shortages. The brothers, again
acting in their individual capacities and using DBJ as their vehicle, invested
substantially in and guaranteed the indebtedness of Arizona Materials. Having
assumed the risks associated with Arizona Materials’ formation and operation in
their individual capacities, Bruce and Donald could reasonably expect to be
compensated by petitioner for doing so when it substantially benefited from the
fruits of their efforts.12 Petitioner also benefited from Bruce’s and Donald’s
12
Notwithstanding substantial credible testimony to the effect that there was
a concrete shortage in Arizona in 2004 and that Arizona Materials supplied
concrete to petitioner when other concrete contractors had experienced supply
disruptions, respondent suggests that Arizona Materials did not play a significant
role in supplying petitioner concrete because petitioner purchased only $3.5
million in concrete from Arizona Materials out of a total of $13 million in concrete
purchases during 2004. We disagree. That petitioner may have purchased only a
little over a quarter of its concrete supply from Arizona Materials does not
(continued...)
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[*29] foresight and business acumen in finding a solution to the concrete shortage,
even when petitioner’s controlling shareholder was unwilling to commit
petitioner’s resources to do so.
In view of the foregoing, respondent’s contention that petitioner’s payment
to DBJ was voluntary, given the absence of a written agreement or evidence of an
oral agreement to compensate DBJ, is unavailing. “Closely held corporations, as
is well known, often act informally, ‘their decisions being made in conversations,
and oftentimes recorded not in the minutes, but by action.’” Levenson & Klein,
Inc. v. Commissioner, 67 T.C. 694, 714 (1977) (quoting Reub Isaacs & Co. v.
Commissioner, 1 B.T.A. 45, 48 (1924)). We are satisfied that petitioner’s board,
including majority shareholder Margaret, concluded at the close of 2004 that the
$500,000 payment to DBJ was appropriate to compensate Bruce and Donald for
the substantial benefit they conferred on petitioner in their individual capacities.
In short, the action in making the payment undoubtedly reflected an informal
understanding among petitioner’s shareholders, Margaret, Bruce, and Donald, that
the latter two ought to be compensated for their individual efforts and their
12
(...continued)
diminish the importance of having that concrete available when shortages
occurred.
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[*30] assumption of the risks entailed in averting the consequences of a concrete
shortage for petitioner during 2004.
In the same vein, we do not agree with respondent that DBJ provided no
compensable services to petitioner. As Bruce’s and Donald’s wholly owned
limited liability company, DBJ was merely the entity through which the brothers
implemented their plan to form and finance Arizona Materials. Through DBJ,
then, petitioner received two distinct benefits: (1) Bruce’s and Donald’s
management acumen behind a successful strategy to avert a potentially crippling
concrete shortage,13 and (2) Bruce’s and Donald’s assumption in their individual
capacities of the risks associated with Arizona Material’s formation and operation,
because Bruce and Donald invested their own funds in, and guaranteed the debt of,
Arizona Materials. Because Bruce and Donald each owned 50% of DBJ, the
payment to DBJ compensated them for the foregoing services received by
petitioner.
13
While one would normally expect that Bruce and Donald, as officers of
petitioner responsible for managing its operations, were already obligated to
provide their management acumen without additional compensation, in the
unusual circumstances presented here their management strategy had been rejected
by petitioner because it was opposed by its majority shareholder. As a
consequence, Bruce and Donald effectively provided their management skills to
avert a concrete shortage as outside, third-party consultants.
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[*31] For essentially the same reasons, we reject respondent’s argument, premised
on Stewart v. Commissioner, T.C. Memo. 2002-199, that the $500,000 payment to
DBJ was actually a payment to Bruce and Donald in their capacities as officers of
petitioner. In Stewart, the taxpayer sought to deduct payments made to his wholly
owned corporation on the grounds that they were for the taxpayer’s management
services provided through the corporation to his sole proprietorship. We rejected
that claim, finding that the taxpayer had provided the services in his individual
capacity directly to the sole proprietorship and not as an employee of the
corporation. Stewart is readily distinguishable, because here Bruce and Donald
were clearly acting in their individual, rather than corporate officer, capacities in
forming and financing Arizona Materials. Petitioner’s controlling shareholder had
expressly rejected the brothers’ proposal that it acquire a concrete supplier. The
brothers thereupon put their own funds and creditworthiness into Arizona
Materials as individuals. The $500,000 payment petitioner made in consideration
of the resulting benefits was therefore earned and received by Bruce and Donald
(through DBJ) in their individual capacities.
The $500,000 payment was an ordinary and necessary expense within the
meaning of section 162(a) because it was normal for a concrete contractor to
expend funds in connection with ensuring a reliable supply of concrete in the face
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[*32] of shortages, and the expenditure was helpful to petitioner’s business,
allowing it to meet customer demand when other companies engaged in the same
business were hampered by the shortage. Petitioner is therefore entitled to deduct
it.
III. Conclusion
We conclude, and hold, that the $4,025,039 and $7,300,916 petitioner paid
to Bruce and Donald as compensation in 2003 and 2004, respectively, are
deductible under section 162(a)(1). We further hold that petitioner is entitled to
deduct the $500,000 payment it made to DBJ in 2004 as an ordinary and necessary
business expense under section 162(a).
To reflect the foregoing,
Decision will be entered for
petitioner.