$11 Million Paid to Officer-Shareholders of Closely Held Contracting Business was Reasonable Compensation.

(Parker Tax Publishing MAY 2016)

The Tax Court held that $11 million in compensation paid over two years by a fast-growing concrete contracting business to two officer-shareholders was deductible as reasonable compensation. The court concluded that a hypothetical independent investor in the closely held business would have been satisfied with the return on equity it would receive after factoring in the officer compensation. H.W. Johnson, Inc. v. Comm'r, T.C. Memo. 2016-95.

Background

H. W. Johnson, Inc. (HWJ), an Arizona based concrete contracting business, was incorporated in 1974 by H.W. Johnson and Margaret Johnson. Two of the Johnsons' sons, Bruce and Donald, took over the company's daily operations in 1993. When their father retired three years later, the brothers became co-vice presidents and members of HWJ's board of directors. Margaret served as HWJ president and chairman of the board, while Bruce and Donald together managed all operational aspects of the business.

HWJ's contract revenues grew rapidly after Bruce and Donald assumed control of daily operations, increasing from approximately $4 million in 1993, to over $11 million in 1994 and $13 million in 1995. HWJ's contract revenues continued to grow over the next decade, reaching $24 million in 2003 and then jumping to $38 million in 2004. Gross profit margins before payment of officer bonuses remained steady at 38.3 percent in 2003 and 38.2 percent in 2004.

Although a reliable supply of concrete was critical to the business, HWJ relied on local suppliers instead of producing its own. Throughout 2003 and 2004, the years at issue, there were shortages of concrete in HWJ's market due to a housing boom in Arizona. Bruce and Donald suggested to Margaret that the business invest in a concrete supplier so as to have a reliable supply, but Margaret, as the controlling shareholder, rejected the proposition because she judged it too risky. In 2003, the brothers, acting through their wholly owned holding company, D.B.J. Enterprises, LLC (DBJ), partnered with other investors to form Arizona Materials, LLC (Arizona Materials), to conduct an independent concrete supply business. The move worked, as HWJ was able to obtain substantial amounts of concrete from Arizona Materials at times when it was unable to get any from other suppliers. Through this channel, the company was able to procure concrete even when other contractors could not. It received bulk discounts for large purchases from Arizona Materials, enabling it to obtain concrete at a price lower than it paid other suppliers.

During 2003 and 2004, HWJ's board held annual meetings to determine officer compensation, director's fees, and dividends. Combined, Bruce and Donald received compensation of $4,025,039 and $7,300,916 for 2003 and 2004, respectively. At the end of 2004 the company paid a $500,000 administrative fee to DBJ for its role in securing a guaranteed supply of concrete. On its Forms 1120 for the years at issue, HWJ deducted these amounts as officer compensation and as a business expense, respectively.

On audit, the IRS determined that only $1,417,522 and $1,711,842 of the compensation paid to the officers for 2003 and 2004, respectively, was reasonable. The IRS disallowed deductions for the payments in excess of those amounts, and disallowed the deduction for the $500,000 administrative fee paid in 2004.

Analysis

Under Reg. Sec. 1.162-7(a), a taxpayer is entitled to a deduction for compensation payments if the payments are reasonable in amount and in fact paid purely for services. Although framed as a two-pronged test, courts considering the deductibility of compensation generally focus on whether the amount of purported compensation is reasonable.

The Ninth Circuit (to which an appeal of the instant case would lie), generally applies five factors, derived from Elliotts v. Comm'r, 716 F.2d 1241 (1983), to determine the reasonableness of compensation:

(1) the employee's role in the 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 (generally evaluated based on a hypothetical independent investor's satisfaction with his or her return on equity); and

(5) the internal consistency of compensation arrangements.

At trial, the IRS conceded that deductions of $3,214,000 and $6,532,000 for compensation were reasonable, leaving $811,039 and $768,916 in dispute for 2003 and 2004, respectively. In addition, the IRS conceded that four of the five Elliotts factors tended to support, or were at least neutral with respect to, the reasonableness of the compensation HWJ paid to Bruce and Donald. As to the employees' roles and the condition of the company (factor 1 and factor 3), the IRS conceded the significant roles Bruce and Donald played in HWJ's substantial success during the years at issue. Similarly, the IRS conceded that the level of HWJ's success was so great that comparisons to the compensation paid by similar companies (factor 2) were difficult to make, and that the bonuses paid to Bruce and Donald - while unreasonable compensation in the IRS's view - were nonetheless the result of a consistently applied bonus formula (factor 5).

The IRS argued that the case hinged on the fourth Elliotts factor - whether a hypothetical independent investor would receive an adequate return on equity after accounting for Bruce's and Donald's compensation. The IRS argued that because HWJ's return on equity fell below the industry average in 2003 and 2004, Bruce and Donald were unreasonably compensated in those years.

The primary focus of this fourth factor, the Tax Court said, was whether a relationship exists between the company and the employee which may permit the company to disguise nondeductible corporate distributions as deductible Code Sec. 162(a)(1) compensation payments. Because HWJ's majority shareholder during the years at issue was Margaret - Bruce and Donald's mother - and together the three of them owned all of HWJ's stock, the court noted this factor warranted scrutiny. The Ninth Circuit, the court said, approaches this inquiry by evaluating the compensation payments from the perspective of a hypothetical independent investor, focusing on the investor's return on equity; 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.

The court found that HWJ had pretax returns on equity of 10.2 percent and 9.0 percent for 2003 and 2004, respectively, and comparable companies had average pretax return on equity of 10.5 percent and 10.9 percent for those years. In applying the independent investor test, the court said, courts have typically found that a return on equity of at least 10 percent tends to indicate that an independent investor would be satisfied, and that compensation payments resulting in a return of as low as 2.9 percent had been found to be reasonable. The court agreed with HWJ that its return on equity was in line with the industry average and therefore would have satisfied an independent investor.

As a whole, the court stated, the Elliotts factors supported the conclusion that the compensation HWJ paid to Bruce and Donald in 2003 and 2004 was reasonable. Accordingly, the court held that the $4,025,039 and $7,300,916 HWJ paid as officer compensation in 2003 and 2004, respectively, were reasonable and therefore deductible under Code Sec. 162(a)(1).

With regard to HWJ's claimed $500,000 deduction for the administrative fees paid to DBJ, the court determined the payment was an ordinary and necessary expense within the meaning of Code Sec. 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 of shortages, and the expenditure was helpful to HWJ's business, allowing it to meet customer demand when other companies engaged in the same business were hampered by the shortage.

The court rejected the IRS's argument that the $500,000 payment to DBJ was actually a payment to Bruce and Donald in their capacities as officers of HWJ. The court noted Margaret, as HWJ's controlling shareholder, had rejected the brothers' proposition to acquire a concrete supplier, and that they had put their own funds and creditworthiness into Arizona Materials as individuals. Accordingly, the court found the payment HWJ made in consideration of the resulting benefits was therefore earned and received by Bruce and Donald (through DBJ) in their individual capacities, and held that HWJ was entitled to the deduction.

For a discussion of deductions for reasonable compensation, see Parker Tax ¶91,101.

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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