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Tax Court Reduces IRS Cuts to Compensation Deduction for CEO
(Parker Tax Publishing March 2022)
While the Tax Court agreed with the IRS that compensation paid to the founder, CEO, and shareholder of a construction-related company was excessive and thus unreasonable for the two years at issue, it found that the deduction should've been higher than the amount allowed by the IRS. Additionally, because the company had sufficient documentation and relied on professional advice for one of the two years, the company was not liable for penalties for that year. Clary Hood, Inc. v. Comm'r, T.C. Memo. 2022-15.
Background
Clary Hood has dedicated his entire career to the construction profession, specializing in the field of land grading and excavation. He first learned the craft as a boy from his father, J.E. Hood, who operated his own land grading business. In 1980, Mr. Hood determined it was time to make his own mark and founded Clary Hood, Inc. (Clary Hood), with his wife. Together they served as the corporation's sole shareholders and members of the board of directors. Mr. Hood held ultimate decisional control over all of the corporation's operations from its founding through 2016. Clary Hood started with two employees and a hodgepodge of used equipment valued at no more than $60,000 before growing into a 150-person company with nearly $70 million in revenue by the end of its 2016 tax year.
From 2000 to 2010, growth was modest and profits irregular, with Clary Hood realizing less than $1 million in net income after taxes most years. Like other construction businesses in the late 2000s, Clary Hood found itself in a particularly troubled financial position during the Great Recession and sustained three years of operating losses for its tax years ending May 31, 2009, to 2011. Unlike many of its competitors who folded during this period, Clary Hood survived on its reputation and the following key decisions in which Mr. Hood played an instrumental, if not exclusive, role: (1) conserving cash outlays by maintaining a low debt profile and not declaring dividends; (2) temporarily reducing employee pay; (3) withholding Mr. Hood's salary, when necessary, to ensure that sufficient funds were available to cover the corporation's payroll needs; and (4) selling $800,000 of equipment to offset losses and supplement its cash reserves. In the summer of 2011, Mr. Hood made a risky decision for which he was handsomely rewarded - he started winding down work on one large retail customer's projects and began diversifying Clary Hood's customer base by transitioning from retail-related work to the commercial and industrial market sectors. Clary Hood's revenue growth and financial performance skyrocketed following this transition.
During the period of May 31, 2000, through 2016 (the review period), Mr. Hood held various titles with Clary Hood but his duties remained relatively constant: (1) oversight of Clary Hood's fleet of equipment (procurement, use, maintenance, and disposition); (2) hiring, training, and supervision of mechanics; (3) supervision and inspection of jobsites; (4) preparation, review, and approval of job estimates and budgets; (5) submission and negotiation of job bids; (6) setting of employee salaries and bonuses; and (7) acquisition of bonding for projects. He rarely took vacations and typically worked 60-70 hours per week (including weekends). While Mr. Hood's leadership and work ethic contributed to Clary Hood's exponential growth, the corporation's success was also dependent on the hard work and dedication of Clary Hood's other executives.
For 2016 and prior years, no written employment agreement existed between Mr. Hood and Clary Hood. Rather, Clary Hood's board of directors, which was comprised solely of Mr. and Mrs. Hood, set the amount of Mr. Hood's annual compensation, including bonuses. Although they generally solicited and accepted the advice of the corporation's accountants, Mr. and Mrs. Hood did not use any type of formula in setting these amounts except during 2015 and 2016. In 2015 and 2016, Mr. Hood received a $5 million bonus each year. Previously, the largest bonus he received was $1.5 million. Clary Hood never declared or paid a cash dividend to its shareholders, i.e., Mr. and Mrs. Hood, at any time during the review period.
IRS Audit and Arguments Before the Tax Court
Upon auditing Clary Hood's 2015 and 2016 tax returns, the IRS allowed $517,964 of the $5,711,105 Clary Hood reported as compensation for Mr. Hood on its 2015 return and $700,792 of the $5,874,585 reported for its 2016 return. The IRS issued a deficiency notice which determined total deficiencies of $1,581,202 and $1,613,308 for Clary Hood's 2015 and 2016 tax years, respectively. The notice also included accuracy-related penalties under Code Sec. 6662 for underpayments due to substantial understatements of income tax of $316,240 and $322,662 for its 2015 and 2016 tax years, respectively. To the IRS, the dramatic increase in Mr. Hood's purported compensation for the 2015 and 2016 tax years did not constitute deductible compensation and was instead a way of draining corporate profits through a disguised dividend. Clary Hood disagreed with the IRS's position and filed a petition with the Tax Court.
Before the Tax Court, Clary Hood argued that, in determining whether the compensation at issue was reasonable, the IRS should follow the independent investor test. With the independent investor test, a court typically asks "whether an inactive, independent investor would be willing to compensate the employee as he was compensated." If so, there may be a strong inference or even presumption under this test that the employee provided reasonable compensable services and that corporate profits are not being siphoned out as dividends disguised as salary. The other approach used by courts in determining whether compensation is reasonable is the multifactor approach, an approach preferred by the Fourth Circuit, the court to which this case is appealable. 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.
Clary Hood's Chief Financial Officer, Mr. Phillips, initially raised the issue of Mr. Hood's historic compensation and met with other executives that agreed with him that Mr. Hood deserved backpay compensation in a $5 million bonus pending follow-up research and analysis. Mr. Phillips worked up a detailed analysis and Clary Hood sought professional advice from two CPAs at the accounting firm Elliott Davis. Both CPAs were experienced and knowledgeable about construction-related compensation issues and were long-time advisers to Clary Hood. After making a few modifications to the analysis, they voiced their approval of the proposed 2015 compensation and bonus. Clary Hood had detailed records surrounding the advice given to them for 2015, but not for 2016.
During the Tax Court trial, Clary Hood offered the expert testimony of Samuel Kursh of BLDS, LLC (BLDS), an economic consulting firm. His expert report (BLDS report) indicated that Mr. Kursh wrote it along with another colleague who was not a witness in the case. Clary Hood also offered the expert testimony of Theodore Sharp, a senior partner at the management consulting firm of Korn Ferry and a specialist in compensation-related issues. Mr. Sharp submitted an expert report also (Korn Ferry report). Mr. Sharp testified that he reviewed and agreed with the report but acknowledged that he had not written it. The reports supported the compensation paid to Mr. Hood.
With respect to the penalties, Clary Hood alleged that its return position for each year at issue was premised on the independent investor test and asserted that two decisions by the Seventh Circuit, Menard, Inc. v. Comm'r, 560 F.3d 620 (7th Cir. 2009), rev'g T.C. Memo. 2004-207, and Exacto Spring Corp. v. Comm'r, 196 F.3d 833 (7th Cir. 1999), provided clear cut substantial authority for Clary Hood's use of this test for the years at issue.
Analysis
The Tax Court held that Clary Hood could not deduct the full amount of the purported compensation paid to Mr. Hood because it failed to adequately establish how the entire amount was both reasonable and paid solely as compensation for his services to Clary Hood during the review period. However, the court was more generous than the IRS and allowed compensation deductions of $3,681,269 for 2015 and $1,362,831 for 2016.
With respect to the expert testimony of Mr. Kursh and the BLDS report, the court found Mr. Kursh's knowledge as to the report's content, supporting data, and calculations materially lacking. Further, the court noted, the BLDS report also lacked necessary supporting calculations and did not include all underlying data, leaving the court unable to verify the veracity of its findings and conclusions. The BLDS report additionally rested on numerous dubious assumptions, the court said. Perhaps most egregious to the court was that the BLDS report crudely compared the performance of Clary Hood, a private regional specialty construction firm, to that of dissimilar public companies such as the multinational conglomerate Caterpillar, Inc., with little attempt at adjusting for the obvious and stark differences between such companies. Finally, the court stated, the BLDS report focused on the independent investor test, which the court did not find to be controlling.
The court also had serious concerns as to the soundness of the assumptions in the Korn Ferry report. For example, the Korn Ferry report relied on compensation survey data for companies with up to $500 million in annual revenue and attempted to offset the disparity with Clary Hood's revenue size by applying a 20 percent "discount" to the data.
The court rejected Clary Hood's position that it should follow the independent investor test in determining whether the purported compensation paid to Mr. Hood in the years at issue was reasonable. The court noted that while other Circuit Courts of Appeals have considered the independent investor test as a part of the multifactor approach, only the Seventh Circuit supports Clary Hood's position, i.e., that it may rely exclusively on the independent investor test in determining reasonable compensation.
With respect to Clary Hood's reliance on professionals in taking deductions for the 2015 and 2016 compensation, the court noted that there was detailed analysis of the 2015 amount but little documentation for the 2016 amount. The court thus held that Clary Hood relied in good faith on the advice of professionals when awarding Mr. Hood the 2015 amount. However, in contrast to the detailed record surrounding advice given to determine the 2015 bonus amount, the court noted that Clary Hood provided almost no evidence with respect to the advice it may have received to determine the 2016 amount. This absence, the court said, was even more critical when considering that (1) in awarding Mr. Hood the 2015 amount, the record did not reflect that Clary Hood still believed Mr. Hood remained entitled to additional backpay compensation for the review period, and (2) in awarding Mr. Hood the 2016 amount, the board minutes did not attempt to address why it felt the 2015 amount had been insufficient in this regard. As a result, the court could not conclude that Clary Hood reasonably relied on professional advice and held that it was liable for the penalty for 2016.
With respect to Clary Hood's argument that it believed it had substantial authority for its position, the court noted that the substantial authority standard is objective, and therefore it was not relevant whether the taxpayer believed substantial authority existed. Moreover, the court observed, the Fourth Circuit is the court to which an appeal of this case would lie and that court applies the multifactor approach and thus it could not accept that Clary Hood's position with respect to the 2016 amount was based on substantial authority.
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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