In a taxpayer friendly decision, H. W. Johnson, Inc., T. C. Memo 2016-95, issued on May 12, 2016, the Tax Court appears to adopt a 10% return on equity standard in its application of the independent investor test used to determine if compensation paid by a corporation to an employee (who is often also a shareholder) is reasonable in amount and deductible under Section 162 of the Code. We have discussed unreasonable compensation cases in prior blog entries, and this is another in a line of unreasonable compensation cases that we are following. For a summary of the issues normally considered in unreasonable compensation cases, see the recent article that I co-authored by clicking HERE.
In, H. W. Johnson, the Tax Court applied the five factor test used by the Ninth Circuit (to which an appeal in the case would normally lie) to find that large amounts of compensation paid to shareholder-employees of a corporation in the concrete contracting business during 2003 and 2004 were deductible.
The taxpayer (the “Corporation”) was a C corporation controlled by Margaret Johnson (who owned 51% of the Corporation) and her two sons, Bruce and Donald Johnson, who each owned 24.5% of the Corporation. Bruce and David began working for the Corporation as teens, and later worked full time, taking on increasing levels of responsibility over the years. The Court found that the Corporation's business grew rapidly after Bruce and David assumed control over daily operations, noting that Margaret continued to own a majority of the Corporation and handled financial and administrative matters. In its analysis, the Court noted that Bruce and Donald together managed all operational aspects of the business, with each supervising over 100 employees, working 10-12 hour days, five and six days a week. They were in charge, and were known in the local industry for their responsive, hands-on management style. The Court also noted the complexity of the concrete business and that the efforts of Bruce and David contributed greatly to its success.
The Court also outlined how Bruce and David made sure that the Corporation had an adequate supply of concrete by forming a new company (D.B.J.) engaging in the concrete supply business. The new company became an important source of concrete for the Corporation that allowed it to grow market share in a difficult supply market. This required time, effort and financial resources that Bruce and David's mother was not willing to make available through the Corporation.
The Court also outlined how the Corporation's compensation plan for Bruce and David included a bonus formula that had been adopted by the Corporation's board of directors in 1991 and amended in 1999, allowing for large bonus pools to be used to pay significant amounts of compensation to Bruce and David. The amounts of compensation paid to Bruce and David in 2003 and 2004 were $23,754,182 and $38,022,612, respectively. The fact that such amounts were paid under a long-standing compensation plan was found important. Additionally, the Corporation's dividend plan, also adopted in 1991 and amended in 1999, called for dividend payments when retained earnings exceeded $2 Million, with dividends being based on a number of financial factors and the advice of the Corporation's accountant. Dividends under the plan in 2003 and 2004 were $50,000 and $100,000, respectively.
In a notice of deficiency, the IRS asserted that the amount of reasonable compensation paid to Bruce and David in each year should be limited to $1,417,522 and $1,711,842. The Court noted that the IRS conceded that $3,214,000 and $6,532,000 of the amounts of compensation paid to Bruce and David in 2003 and 2004 were deductible, leaving smaller amounts being challenged. With the IRS on its heels, the Tax Court ultimately found that the amounts paid to Bruce, David and D. B. J. were deductible and reasonable.
In making its decision in favor of the Corporation with respect to the amounts paid to Bruce and David, the Court applied a five-factor test to determine the reasonableness of compensation. The factors focused on (1) Bruce and David's respective roles in the Corporation, (2) a comparison of compensation paid by similar companies for similar services, (3) the character and condition of the Corporation, (4) potential conflicts of interest, and (5) the internal consistency of compensation arrangements. The Court noted that in analyzing the fourth factor, the Ninth Circuit emphasizes the reasonableness of compensation based on the perspective of a hypothetical independent investor, focusing on whether such investor would receive a reasonable return on equity after the payment of compensation.
In its brief, the IRS conceded that 4 of the 5 factors tended to support or at least were neutral to the question of reasonableness of compensation, but continued to argue that the Corporation failed the independent investor test. This was the issue on which the case turned.
In finding that the compensation paid to each of Bruce and David was deductible, the court noted that, based on expert testimony in the case, the pretax returns on equity for 2003 and 2004 were 10.2% and 9%, respectively. The Court found that such amounts were in line with industry averages and would have satisfied an independent investor. In fact, the Court noted that in applying the independent investor test, courts have typically found that a 10% rate of return 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. Moreover, the Court noted that a 2.9% return on equity had been found reasonable in Multi-Pak, T. C. Memo 2010-139, but that returns of zero or less than zero have been found to be unreasonable, citing Mulcahy, Pauritsch, Salvador & Co., Ltd, v. Commissioner, 680 F. 3d 867 (7th Cir 2012), aff'g T. C. Memo 2011-74.
As for the payments made to D. B. J., the Court found the $500,000 administration fee paid by the Corporation in 2004 was paid for services provided by David and Bruce in their capacities as owners of D.B.J. The Court determined that the Corporation could not perform the function of D.B.J. itself because of the objection by the majority shareholder (David's and Bruce's mother) was important.
C corporations and their advisors need to familiarize themselves with the independent investor test and its applicability to IRS challenges of compensation arrangements for such C corporations, be they closely held or not. We are seeing an uptick in interest by the IRS in compensation issues of all kinds. Being aware of this developing body of law is necessary to avoid problems in this area. H. W. Johnson, Inc. is an example of effective planning regarding compensation issues.