Deficiencies Resulting from Improper Inventory Reporting and Unreasonable Compensation Upheld

(Parker Tax Publishing March 2018)

The First Circuit affirmed a Tax Court decision to uphold deficiencies resulting from a company's improper inventory reporting and unreasonable compensation payments made to employee-shareholders. According to the First Circuit, the Tax Court properly found that the taxpayer's use of the gross profit method massively understated its inventory and that the salaries in question were unreasonable given the employees' lack of special experience or education. Transupport, Inc. v. Comm'r, 2018 PTC 43 (1st Cir. 2018).

Facts

Transupport, Inc. is a wholesaler of engines and engine parts used in military vehicles. Part of its business is to buy parts in bulk from the U.S. government and resell them. Harold Foote founded the company and was its president and CEO. Foote's four sons, who held nonvoting stock, were Transupport's only other full time employees. Elaine Thompson, Transupport's outside accountant, prepared the company's tax returns based on handwritten summaries of the company's financials provided by one of Foote's sons.

Transupport used the gross profit method to calculate its cost of goods sold (COGS). Instead of tracking changes of inventory, it selected a percent profit that it claimed to make on its sales and used that figure to generate its COGS as well as estimates of its beginning and ending inventory. Transupport's COGS varied from year to year, and the company kept no records indicating how it selected its gross profit percentage. For 2006-2008, the years at issue, the gross profit percentage was between 33 and 39 percent. Based on these percentages, Transupport reported COGS of between $6.3 and $7.5 million.

Foote's sons were officers of Transupport but performed overlapping tasks, some of which could have been performed by lower level employees. Each son was paid between $575,000 and $720,000 for the years at issue. Foote made compensation decisions alone without consulting his accountant. Transupport did not pay dividends during the years at issue.

Foote considered selling Transupport in 2007 and hired a consultant to help him. A confidential offering memorandum was prepared that included a financial summary asserting that Transupport's actual gross profit on sales exceeded 75 percent as a conservative estimate. It also estimated that the company's inventory exceeded $100 million at cost with a market value of over $500 million. The summary "recast to market rate of $50,000" each of the salaries of Foote's sons. The document was circulated to potential buyers, one of whom notified the IRS Whistleblower Office of potential tax fraud.

IRS Audit and Tax Court Decision

The IRS audited Transupport in 2009, resulting in a notice of deficiency that adjusted its deductions for compensation paid to Foote's sons by between $1.3 and $1.8 million for the years at issue. The notice also adjusted the company's COGS to reflect a 25 percent cost and 75 percent profit on sales of surplus parts. Fraud and accuracy related penalties were also applied. Transupport petitioned the Tax Court for review, and separate proceedings were held on the fraud claim and the deficiencies. The Tax Court ultimately held that the IRS had not proven fraud, but it upheld the deficiencies for the years at issue, and Transupport appealed to the First Circuit Court.

Taxpayer's Arguments on Appeal

Transupport argued on appeal that in determining whether the sons' compensation was reasonable, the Tax Court failed to consider the return on equity enjoyed by the company's shareholders. According to Transupport, the burden of proof should have shifted to the IRS to prove unreasonable compensation because the notice was based on a valuation of the company that the IRS disavowed at trial. Moreover, Transupport argued that, contrary to the Tax Court's finding that the sons had no special experience or education, the sons actually had gained valuable experience in their years working for the company and were indispensable to its business. On the COGS issue, Transupport asserted that the Tax Court acted inconsistently by adopting the IRS's 75 percent gross profit percentage for purposes of the deficiencies while it had rejected that figure in the fraud trial. The company also asserted that there was a great deal of obsolescence in its inventory that the IRS had failed to take into account. With respect to the accuracy related penalty, Transupport said it acted with reasonable cause and good faith because it relied on its accountant and because it was audited twice in the past and was not required to change its accounting method or compensation system.

First Circuit's Decision

The First Circuit affirmed the Tax Court's decision on the deficiencies and penalties. The First Circuit determined that the Tax Court correctly found the sons' compensation to be unreasonable. The Tax Court found no reliable evidence of actual return on investment because, while the company's profitability and value depended heavily on its COGS, Transupport presented no credible evidence of its COGS. The First Circuit also found that the IRS's method of determining reasonable compensation, which compared the salaries in question to those of comparable companies, was not arbitrary or unreasonable. The First Circuit rejected the argument that the burden should have shifted to the IRS because it found that the IRS never disavowed its valuation but merely attempted to pursue a larger deficiency at trial. Moreover, the notice was supported by evidence and, in the First Circuit's view, may even have underestimated Transupport's understatement of tax. The Tax Court found that Foote's sons lacked basic knowledge of the managerial roles they purportedly held and many of their tasks were menial, and Transupport offered no evidence to rebut those findings.

With respect to the COGS issue, the First Circuit found that there was sufficient evidence to conclude that the notice of deficiency was not arbitrary. The court reasoned that the IRS has broad discretion to determine whether an inventory accounting method should be disallowed as not clearly reflective of income. The Tax Court's finding in the fraud trial that the 75 percent gross profit was improbable was not a determination that the notice was arbitrary. The Tax Court expressed skepticism about the 75 percent figure in the fraud trial, but the First Circuit found that the Tax Court's determinations in its two opinions were internally consistent given the different burdens of proof in the two proceedings and the poor quality of evidence presented by Transupport. The First Circuit found that there was overwhelming evidence that Transupport had significantly underreported its gross profit percentage and that the company's poor recordkeeping made it impossible to render a more accurate figure. The IRS had presented evidence that Transupport's inventory in 2007 was worth $100 million at cost, while the company claimed to have an ending inventory of only $1.8 million that year. The First Circuit also found that the only evidence offered by Transupport was the testimony of its accountant, who conceded that the records were produced by plugging in unverified figures that Transupport provided. Transupport's argument regarding the obsolescence of its inventory was rejected because the company had failed to provide evidence of obsolescence while the IRS had offered evidence showing a large understatement of inventory.

The First Circuit upheld the imposition of an accuracy related penalty on Transupport. It found that the company did not rely on its expert for its compensation decisions and that it knew or should have known that the inventory figures it provided to its accountant were incorrect. The fact that prior audits permitted Transupport's accounting method did not mean that the Tax Court was required to find the method was reasonable, according to the First Circuit. The First Circuit also found that the Tax Court reasonably took into account Foote's sophistication as a taxpayer given the evidence that Foote knew Transupport's inventory was worth more than reported and that his sons were paid an unreasonable rate.

For a discussion of excessive compensation paid to employee-shareholders see Parker Tax ¶44,120.10. For a discussion of inventory accounting, see Parker Tax ¶242,310.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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