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Fourth Circuit Affirms Tax Court's Holding That CEO's Bonuses Were Excessive
(Parker Tax Publishing June 2023)
The Fourth Circuit affirmed the Tax Court's use of a multifactor approach to determine that a portion of the compensation a closely held corporation paid its CEO in each of two years was excessive and therefore not deductible as reasonable compensation under Code Sec. 162(a). However, the Fourth Circuit vacated a portion of the Tax Court's judgment after finding that the Tax Court erred in finding that the company had reasonable cause for understating its income tax liability for one of the years but did not have reasonable cause for the other after finding that the company reasonably relied in good faith on the same tax advice for both years. Clary Hood, Inc. v. Comm'r, 2023 PTC 146 (4th Cir. 2023).
Background
Clary Hood, Inc. (Hood, Inc.) is a South Carolina C corporation engaged in land excavation and grading. During 2015 and 2016, Clary Hood and his wife, Gail Hood, each owned 50 percent of the company's stock. They were also the only members of its board of directors, and Clary Hood served as the company's CEO.
From 2000 to 2010, the company averaged approximately $21 million in revenue, earning an average of less than $1 million each year in net income before taxes. Seeking to increase revenue, Clary Hood decided in 2011 to pivot the company to commercial and industrial projects. Revenues immediately increased, and by 2015, the company's revenue had grown to $44 million and by 2016, to $69 million. For the years 2000 to 2010, Hood, Inc. paid Mr. Hood an annual salary of roughly $130,000. In some of those years Mr. Hood also received a bonus, with the largest bonus amounting to $320,981. In 2013, Hood, Inc. began to increase Mr. Hood's salary and bonuses, and for 2013, it paid him a salary of $381,707 and a $1 million bonus, and for 2014 it paid him a salary of $181,538 and a $1.5 million bonus.
In 2015, Hood, Inc.'s CFO determined that Mr. Hood had been undercompensated in prior years. After meeting with the company's accountants, Elliott Davis Decosimo, LLC (Elliott Davis), the CFO determined that Mr. Hood had been undercompensated since 2000 and that the total amount that would both remedy that past undercompensation and recognize Mr. Hood's service for the 2015 year was $7.1 million. The CFO thus suggested that Hood, Inc. pay Mr. Hood a $5 million bonus in 2015, with the balance of the undercompensation amount to be paid in "future years." Accordingly, as board members Mr. and Mrs. Hood approved the $5 million bonus, in addition to Mr. Hood's $168,559 salary. The following year, after Hood, Inc. went through the same process as it did for determining the bonus for 2015, Mr. and Mrs. Hood again approved a bonus to Mr. Hood of $5 million for 2016, again in addition to Mr. Hood's salary, which was $196,500. Despite substantial retained earnings and cash, however, Hood, Inc. did not consider paying any dividends to its two shareholders, i.e., Mr. and Mrs. Hood. Indeed, the company had never paid any dividends.
Following an audit, the IRS determined that a substantial portion of Mr. Hood's compensation for 2015 and 2016 was excessive and therefore not deductible under Code Sec. 162(a). It calculated deficiencies for 2015 and 2016 to be roughly $1.6 million for each year. Additionally, the IRS determined that the company was liable for a penalty for each year for substantial understatements of income tax. Hood, Inc. took its case to the Tax Court.
Code Sec. 162(a)(1) allows a deduction as an ordinary and necessary business expense for "a reasonable allowance for salaries or other compensation for personal services actually rendered." Under Reg. Sec. 1.162-7(b)(3), compensation "may not exceed what is reasonable under all the circumstances," taking into account "such amount as would ordinarily be paid for like services by like enterprises under like circumstances." And under Reg. Sec. 1.162-9, any bonuses paid similarly must not exceed what is reasonable for the services rendered in order to be deductible. In cases involving closely held corporations whose controlling shareholders set their own level of compensation, the reasonableness of the compensation paid to the shareholder-employee is subject to close scrutiny. This is because such corporations may more readily choose to pay out larger salaries and bonuses, which are deductible, rather than pay dividends, which are not. Thus, under Reg. Sec. 1.162-7(b)(1), if some portion of an ostensible salary or bonus paid to a shareholder-employee is a disguised dividend, rather than compensation for services rendered, it is not deductible.
In Clary Hood, Inc. v. Comm'r, T.C. Memo. 2022-15, the Tax Court agreed with the IRS that a portion of Mr. Hood's compensation for 2015 and 2016 was excessive and unreasonable. In reaching this conclusion, the Tax Court applied a multifactor approach set forth in an unpublished opinion of the Fourth Circuit, Richlands Med. Ass'n v. Comm'r, 953 F.2d 639 (4th Cir. 1992). Under the multifactor approach, no single factor is decisive; instead, a court considers and weighs the totality of the facts and circumstances. In doing so, a court may find certain factors less relevant or helpful than other factors when considering the facts necessary to reach a conclusion.
While the Tax Court recognized Mr. Hood's extraordinary talents and the need to compensate him in 2015 and 2016 for undercompensation in earlier years, the Tax Court also pointed to several relevant factors that indicated overpayment. First, the Tax Court noted that Hood, Inc. had never declared a dividend even as it began to accumulate significant capital during the period from 2013 to 2016. Second, the Tax Court found that Hood, Inc. had no structured system in place for determining compensation and that Mr. Hood's compensation was set by himself and his wife. Third, the Tax Court placed considerable weight on the comparison of Mr. Hood's compensation with that paid to similarly situated executives in comparable companies.
The Tax Court did not impose a penalty for 2015, finding that the company established a reasonable-cause defense because it reasonably relied on professional tax advice in good faith. But the court found that the company had not established the same defense for 2016, and therefore it sustained the imposition of a penalty for that tax year.
Hood, Inc. appealed to the Fourth Circuit. It argued that because the Fourth Circuit has not formally adopted the multifactor test, the Tax Court erred in applying it here. Hood, Inc. argued that the Fourth Circuit should adopt the singular "independent investor" test applied by the Seventh Circuit in Menard, Inc. v. Comm'r, 560 F.3d 620 (7th Cir. 2009), and Exacto Spring Corp. v. Comm'r, 196 F.3d 833 (7th Cir. 1999). Under the independent investor test, an executive's compensation is treated as reasonable if the corporation's shareholders are receiving a sufficiently high rate of return on their equity investment. Hood, Inc. pointed out that the company generated a 22 percent return on equity for its shareholders in 2015 and a 36 percent return in 2016 after accounting for Mr. Hood's total compensation. Hood, Inc. also contended that the Tax Court did not appropriately credit Mr. Hood's extraordinary performance and recognize that such performance could justify compensation in excess of the norm. In addition, the company argued that the Tax Court overemphasized the comparison of Mr. Hood's compensation with that of similarly situated executives in the industry.
Hood, Inc. also contended that the Tax Court clearly erred in imposing a penalty for the 2016 tax year. It noted that the Tax Court found that Hood, Inc. had reasonably relied in good faith on its tax advisers when paying the 2015 bonus and based on this finding, the company argued that because it relied on the same tax advice for paying the 2016 bonus, the Tax Court should also have found good faith in 2016.
Analysis
The Fourth Circuit affirmed the Tax Court's application of the multifactor approach in to determine the portion of Mr. Hood's compensation that was attributable only to his personal services and its conclusion that not all of his compensation was so attributable. However, the Fourth Circuit vacated the portion of the Tax Court's decision imposing a penalty on Hood, Inc. for the 2016 tax year.
In the view of the Fourth Circuit, Hood, Inc.'s contention that the Tax Court failed to adequately account for Mr. Hood's extraordinary performance and the return on equity generated for the company's shareholders simply raised questions regarding the weight to assign the factors, as the Tax Court considered them among the many factors it addressed in its extensive opinion. The Fourth Circuit also found that, while it might be reasonable to consider the Seventh Circuit's independent investor test along with other factors relevant to the totality of the circumstances, solely using that test to establish a presumption of reasonableness, would be too narrow in light of the demand in Reg. Sec. 1.162-7(b)(3) that the court consider "what is reasonable under all the circumstances." The court noted that under the independent investor test, an executive's compensation could be presumed to be reasonable even if it exceeded the amount that was genuinely compensation for personal services actually rendered and that would ordinarily be paid for like services by like enterprises under like circumstances.
However, the Fourth Circuit agreed with Hood, Inc. that the Tax Court erred in imposing a penalty for 2016. The Fourth Circuit found that when Hood, Inc. determined Mr. Hood's bonus for 2015, the company believed at that time that Mr. Hood would still be undercompensated in 2016 and would therefore require additional backpay compensation in the future. In addition, the court found that Hood Inc. followed the same process to determine the bonus amount in 2016 as it did in 2015. Thus, the Fourth Circuit concluded that the Tax Court's finding regarding the reasonable cause defense for 2015 should also have applied for 2016.
For a discussion of the compensation deduction limitations and the various approaches to determine if compensation is reasonable, see Parker Tax ¶91,103.
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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