Donald Palmer Co Inc v. CIR ( 1996 )

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
No. 95-60381
(Summary Calendar)
DONALD PALMER COMPANY, INCORPORATED
Petitioner - Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE
Respondent - Appellee.
Appeal from the United States Tax Court
(24901-92)
April 1, 1996
Before WIENER, PARKER and DENNIS Circuit Judges.
PER CURIAM:*
In this federal income tax case, Petitioner-Appellant David
*
Pursuant to Local Rule 47.5, the court has determined that
this opinion should not be published and is not precedent except
under the limited circumstances set forth in Local Rule 47.5.4.
Palmer Company, Inc. (Petitioner) appeals a decision by the United
States Tax Court that a portion of the compensation paid to its
president and sole shareholder was unreasonable and thus
nondeductible as an expense of the corporation. Finding no error,
we affirm.
I
FACTS AND PROCEEDINGS
Petitioner is a Louisiana corporation engaged in the business
of buying and selling bags and packaging materials. Incorporated
in 1979 by David Palmer with a capital contribution of $5,000,
Petitioner has consistently grossed several million dollars a year
in sales. PalmerSQwho has worked in the plastic packaging business
for most of his lifeSQis Petitioner's sole stockholder, as well as
its president and only officer. Palmer is also the one responsible
for Petitioner's success: He works approximately seventy hours per
week, takes little time off, personally generates almost all of
Petitioner's sales, and manages its daily operations.
In addition to Palmer, Petitioner employs a secretary, a
bookkeeper, and a cleaning person. Petitioner also employed a
salesperson in 1985 and again in 1987. In each of those years,
however, the individual employed accounted for only an
insignificant portion of the total sales and both were discharged
after a short period of employment.
For the tax year ended June 30, 1990 (1990), Petitioner paid
Palmer compensation of $1,259,979, consisting of $441,446 in salary
2
and a bonus of $818,533. This appeal concerns the determination,
for tax purposes, of the maximum amount of compensation that is
reasonable for Palmer's services in 1990.
The following schedule reflects Petitioner's gross receipts,
gross profit, officer's compensation (Palmer's compensation), and
taxable income for most of its history.
Tax
Year Gross Gross Palmer's Taxable
Ended Receipts Profit Compensation Income
6/30/82 $2,469,535 $639,742 $150,000 $197,207
6/30/83 2,602,522 707,338 300,000 99,092
6/30/84 3,112,563 693,348 300,000 46,854
6/30/85 3,532,714 801,997 300,000 87,697
6/30/86 2,948,626 666,139 275,000 76,552
6/30/87 3,182,588 725,687 435,000 121,080
6/30/88 3,395,436 708,678 350,000 150,279
6/30/89 4,068,042 801,490 390,000 262,126
6/30/90 4,017,352 1,137,182 1,259,979 (339,417)
6/30/91 4,057,664 884,969 617,113 17,384
In addition to the compensation listed above, Petitioner also made
pension plan contributions for the benefit of Palmer during some of
these years.1 Petitioner has never paid dividends on its stock.
In 1988, Petitioner and Palmer entered into a Deferred
Compensation Agreement (Agreement) which provided that Palmer would
receive $16,666 per month for ten years. These payments were to
begin on the later of the date on which Palmer (1) attained the age
1
These pension plan contributions were made during the tax
years ended June 30, 1982 through June 30, 1986 in the following
respective amounts: $23,239; $90,675; $141,750; $114,300; and
$106,184.
3
of sixty-five years or (2) actually retired. Although no deduction
was taken, Petitioner's federal income tax returns reflected the
accrual of this liability, as follows:
Tax Deferred Deferred
Year Compensation Compensation
Ended Expense Liability
6/30/88 $ 208,013 $ 208,013
6/30/89 208,012 416,025
6/30/90 208,012 624,038
6/30/91 208,013 832,050
The Agreement further provided that Petitioner had no duty to set
aside funds for this obligation owed to Palmer, and payments have
never been made to Palmer pursuant to the Agreement.
Following an examination of Petitioner's 1990 income tax
return, the Internal Revenue Service (IRS) disallowed the deduction
for the entire $818,533 bonus paid to Palmer, insisting that his
salary of $441,446 is reasonable compensation for his 1990
services. Petitioner sought relief in Tax Court. After a trial on
this issue, the Tax Court found that, in addition to Palmer's
salary, $220,723 of the bonusSQan amount equal to one-half of
Palmer's salarySQis reasonable compensation and thus deductible.
Petitioner now appeals to us, arguing that the Tax Court erred
in its determination of reasonable compensation, as well as in
disposing of two evidentiary issues related to this determination.
II
4
ANALYSIS
A. STANDARD OF REVIEW
The determination of what is reasonable compensation is a
question of fact that is reviewed under the clearly erroneous
standard.2 A finding is clearly erroneous when "although there is
evidence to support it, the reviewing court is left with the
definite and firm conviction that a mistake has been committed."3
A trial court's admission of evidence is reviewed for abuse of
discretion.4 Challenges to rulings on expert testimony are
reviewed under the manifestly erroneous standard.5
B. REASONABLE COMPENSATION
A taxpayer is permitted to deduct "a reasonable allowance for
salaries or other compensation for personal services actually
rendered."6 The regulations explain that bonuses paid to employees
are deductible "when such payments are made in good faith and as
additional compensation for services actually rendered by the
employees, provided such payments, when added to the stipulated
2
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,
1323 (5th Cir. 1987).
3
United States v. United States Gypsum Co., 333 U.S. 364,
395, 68 S. Ct. 525, 542, 92 L.Ed. 746 (1948).
4
EEOC v. Manville Sales Corp., 27 F.3d 1089, 1092-93 (5th
Cir. 1994), cert. denied, __ U.S. __, 115 S. Ct. 1252, 131 L.Ed.2d
133 (1995).
5
Edmonds v. Illinois Cent. Gulf R.R., 910 F.2d 1284, 1287
(5th Cir. 1990).
6
26 U.S.C. § 162(a)(1).
5
salaries, do not exceed a reasonable compensation for the services
rendered."7
The amount of compensation that is reasonable depends on the
facts and circumstances of each case.8 When making this inquiry,
a court must consider a number of factors, including:
(1) the employees qualifications;
(2) the nature, extent, and scope of the employee's work;
(3) the size and complexities of the business;
(4) a comparison of salaries paid with gross income and net
income;
(5) the prevailing general economic conditions;
(6) comparison of salaries with distributions to
stockholders;
(7) the prevailing rates of compensation for comparable
positions in comparable concerns;
(8) the salary policy of the taxpayer as to all employees;
(9) in the case of small corporations with a limited number
of officers the amount of compensation paid to the
particular employee in previous years.9
No single factor is determinative.10 Rather, the trial court must
consider and weigh the totality of the facts and circumstances in
a particular case when determining reasonable compensation.11
The taxpayer has the burden to show that it is entitled to a
larger compensation deduction than that allowed by the IRS.12
7
Treas. Reg. § 1.162-9.
8
Rutter v. Commissioner, 853 F.2d 1267, 1271 (5th Cir.
1988).
9
Id. at 1271; accord Owensby & Kritikos, Inc., 819 F.2d at
1323.
10
Owensby & Kritikos, Inc., 819 F.2d at 1323.
11
Rutter, 853 F.2d at 1271.
12
Owensby & Kritikos, Inc., 819 F.2d at 1324.
6
Moreover, in a situation in which shareholders of a closely held
corporation set their own level of compensation, the reasonableness
of this compensation is subject to close scrutiny.13
1. Termination of Deferred Compensation Agreement
At trial, Palmer testified that the Agreement had been
terminated in 1990 to make the corporation more attractive to
potential buyers. Thus, Petitioner contends, much of the bonus
paid to Palmer in 1990 was not compensation earned in that year,
but rather was payment for deferred compensation earned in 1988 and
1989 but lost when the Agreement was terminated. Accordingly,
argues Petitioner, the reasonableness of this compensation must be
analyzed with regard to the facts and circumstances of the years in
which it was actually earned. As the only testimony regarding the
purported termination of the Agreement was Palmer's uncontradicted
testimony, Petitioner insists that the Tax Court's finding that the
Agreement had not been terminated in 1990 is clearly erroneous
because a court may not arbitrarily disregard testimony that is
competent, relevant, credible, and uncontradicted.14
The only testimony on this issue was Palmer's. Petitioner
offered no other evidence documenting the alleged termination of
the Agreement in 1990. Moreover, Petitioner concedes that its 1990
federal income tax return did not reflect a termination of the
13
Id.14
See Banks v. Commissioner, 322 F.2d 530, 537 (8th Cir.
1963).
7
Agreement. In fact, Petitioner's subsequent income tax return
(1991) showed an increase in the deferred compensation liability.
Petitioner's sole effort to explain this incongruence is the
contention that the entries on the tax returns were simply made in
error. The Tax Court's opinion, however, makes clear that it did
not find this explanation persuasive. We therefore conclude that
the Tax Court did not arbitrarily disregard Palmer's testimony.
Petitioner also contends that the payment of Palmer's bonus
left it financially unable to meet its obligation under the
Agreement. Thus, argues Petitioner, this payment supports its
position that the Agreement was in fact terminated in 1990. The
terms of the Agreement, however, did not require any funds to be
set aside for this obligation. Thus, we are unconvinced that the
payment of this bonus is probative that the Agreement had been in
fact terminated in 1990. We therefore conclude that the Tax Court
did not clearly err in finding that the Agreement was not
terminated in 1990.
2. Return on Investment of Hypothetical Investor
In its analysis, the Tax Court also noted that an important
factor in determining reasonable compensation is whether a
hypothetical investor would have been willing to pay Palmer the
same amount of compensation that he was paid by Petitioner.15 The
corporation's rate of return on equity is relevant in making this
15
See Elliots, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th
Cir. 1983).
8
assessment.16 As the large bonus paid to Palmer resulted in
negative retained earnings, a taxable loss, and a negative return
on investment for its shareholders for 1990, the Tax Court
concluded that an independent investor would not have been pleased
with his investment if he had to compensate Palmer so handsomely.
Petitioner challenges the Tax Court's analysis by contending
that it had positive "earnings and profits." Petitioner insists
that the liability for accrued deferred compensation is in the
nature of a reserve for future expenses and thus would not reduce
its earnings and profits.17
This argument misses the mark. Earnings and profits is a tax
concept that generally relates to the determination of whether a
distribution from a corporation to its shareholders is properly
treated as a dividend or a return of capital.18 That earnings and
profits may have been positive, however, in no way impugns the Tax
Court's analysis regarding a hypothetical investor's return on
investment.
Petitioner also insists that a hypothetical investor would
have paid Palmer compensation equal to what he actually received
because otherwise Palmer could have quit. As Petitioner's earnings
16
Id.17
See BORIS I. BITTKER & JAMES S. EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS AND SHAREHOLDERS ¶ 8.04, at 8-31 (6th ed. 1994).
18
See 26 U.S.C. §§ 301(c), 316(a); see also Mazzocchi Bus Co.
v. Commissioner, 14 F.3d 923, 927 (3rd Cir. 1994).
9
depend almost exclusively on the services of Palmer and not on
invested capital, a decision by Palmer to quit would have rendered
the corporation virtually worthless.
Although these facts might support a high level of
compensation for Palmer's services, we have made clear that "limits
to reasonable compensation exist even for the most valuable
employees."19 We therefore are unconvinced that the Tax Court's
analysis regarding a hypothetical investor is clearly erroneous.
3. Application of Factors
Finally, Petitioner argues that the Tax Court failed to
consider the following factors: the employee's qualifications; the
nature, extent, and scope of the employee's work; the size and
complexities of the business; and Petitioner's financial condition.
Petitioner maintains that these factorsSQas well as the others,
which it concedes were consideredSQfavor its position that all of
Palmer's compensation is reasonable. Petitioner therefore
maintains that the Tax Court's determination of reasonable
compensation for Palmer is clearly erroneous. We disagree.
The Tax Court specifically recognized Palmer's many
contributions to Petitioner, including that he worked long hours,
generated almost all of the sales, and managed the daily
operations. The Tax Court also considered Palmer's compensation in
prior years, as well as the relationship of such compensation to
19
Owensby & Kritikos, Inc., 819 F.2d at 1325.
10
Petitioner's sales and gross profit. Although some of the relevant
factors might favor Petitioner's position, the fact that the Tax
Court did not conclude that the entire bonus was reasonable
compensation does not mean that these factors were ignored. To the
contrary, these factors appear to have been not only considered,
but also accorded substantial weight in determining that a bonus
equal to fifty percent of Palmer's salary would be reasonable.
Moreover, the amount of compensation determined by the Tax Court to
be reasonable is consistent with the historical relationship
between Palmer's compensation and Petitioner's performance,
reflecting the fact that Petitioner had one of its best years in
1990. Our review of the record convinces us that the Tax Court
properly considered all of the relevant factors and that its
determination of reasonable compensation for Palmer's services is
not clearly erroneous.
C. ADMISSION OF EMPLOYMENT CONTRACTS INTO EVIDENCE
Petitioner also contends that the trial court abused its
discretion by admitting into evidence the employment contracts of
two former salespersons who were employed by Petitioner for short
periods of time. Petitioner explains that these two individuals
performed different functions than Palmer and generated only an
insignificant amount of the total sales. Petitioner maintains
that, as the compensation of these two salespersons has little
bearing on the issue of reasonable compensation for Palmer, the
admission of this evidence was an abuse of discretion. Again we
11
disagree.
One of the factors to be considered in determining reasonable
compensation is "the salary policy of the taxpayer as to all
employees."20 Moreover, comparison of the compensation paid to
shareholder-employees with that paid to nonshareholder-employees is
relevant.21 Thus, even though the employment contracts with these
nonshareholder-salespersons might not be entitled to great weight,
they cannot be said to be irrelevant. We therefore conclude that
the Tax Court did not abuse its discretion by admitting these
employment contracts into evidence. We note gratuitously that the
Tax Court appears to have accorded little if any significance to
these contracts, and Petitioner has failed to show that it was
prejudiced by their admission.
D. EXPERT WITNESS
Petitioner also insists that the Tax Court's decision not to
qualify Harold Mollere as an expert witness is manifest error.22
Petitioner maintains that Mollere is qualified to be an expert in
this case, given his experience as a practicing certified public
20
Rutter v. Commissioner, 853 F.2d 1267, 1271 (5th Cir.
1988).
21
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,
1329 (5th Cir. 1987).
22
Rule 702 of the Federal Rules of Evidence provides that
"[i]f scientific, technical, or other specialized knowledge will
assist the trier of fact to understand the evidence or determine a
fact in issue, a witness qualified as an expert by knowledge,
skill, experience, training, or education, may testify thereto in
the form of an opinion or otherwise."
12
accountant for thirty-eight years, during which time he reviewed
hundreds of federal income tax returns annually for businesses and
corporations, and advised clients on their compensation in
connection with their year-end planning. Petitioner goes further,
suggesting that the Tax Court disqualified Mollere because the IRS
had no expert of its own rather than because of Mollere's
qualifications.
We are unpersuaded. During voir dire, Mollere admitted that
he had not had any specific training in the field of executive
compensation, and that he had never been retained to evaluate a
company's executive compensation policy. In addition, the Tax
Court noted that Mollere's report was unhelpful as it merely
summarized his view of the evidence and did not provide sufficient
information to make an intelligent evaluation of his conclusion
that all of Palmer's compensation is reasonable. Furthermore,
Petitioner has absolutely no support for its speculation that the
Tax Court's ruling was based on the fact that the IRS had no expert
witness of its own. Under these circumstances, we conclude that
the Tax Court did not commit manifest error by deciding not to
qualify Mollere as an expert.
III
CONCLUSION
Based on the foregoing reasons, the judgment of the Tax Court is
AFFIRMED.
13