K & K Veterinary Supply, Inc. v. Commissioner , 2013 T.C. Memo. 84 ( 2013 )

T.C. Memo. 2013-84UNITED STATES TAX COURT
K & K VETERINARY SUPPLY, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9442-11. Filed March 25, 2013.
John P. Neihouse and Laurence M. McCredy, for petitioner.
Kirk Steven Chaberski, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined deficiencies of $499,267 and
$291,798 in petitioner’s Federal income tax for taxable years ended May 31, 2006,
and May 31, 2007, respectively. The issues for decision are: (1) whether amounts
paid as compensation to officers and certain employees are reasonable within the
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[*2] meaning of section 162(a)(1); (2) whether amounts paid as rental expenses to
a related entity are reasonable within the meaning of section 162(a)(3); and (3)
whether the doctrine of equitable recoupment applies. Unless otherwise indicated,
all section references are to the Internal Revenue Code as in effect for the years in
issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated facts are
incorporated in our findings by this reference. At the time the petition was filed,
petitioner had its principal place of business in Arkansas.
Petitioner was incorporated in 1988 by John K. Lipsmeyer (J. Lipsmeyer) and
Kelly Bright. Petitioner was a wholesale distributor of animal health products for
large animals, swine, sheep, goats, and horses; lawn and garden products; farm
hardware; pet supplies; and products for farm stores and related dealers. Petitioner
sold roughly 17,000 to 19,000 different products and had between 550 and 600
vendors.
J. Lipsmeyer has worked for petitioner since its incorporation. Petitioner
bought Bright’s stock in 2002, leaving J. Lipsmeyer as petitioner’s sole
shareholder at that time, and he remained petitioner’s sole shareholder. J.
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[*3] Lipsmeyer was petitioner’s president, co-chief executive officer, and co-chief
operating officer; his wife, Melissa Lipsmeyer (M. Lipsmeyer) was petitioner’s vice
president, secretary, and assistant chief financial officer; his brother, David
Lipsmeyer (D. Lipsmeyer), was petitioner’s senior vice president of sales, and co-
chief executive officer and co-chief operating officer with J. Lipsmeyer; and his
daughter, Jennifer Stewart (Stewart), was petitioner’s chief financial officer.
J. Lipsmeyer’s duties were interacting with most of petitioner’s vendors,
negotiating terms and programs that vendors offer or that petitioner would like to
have offered; pricing products; making personnel decisions, including hiring all of
the people who work for petitioner and determining salary and bonus amounts;
sales, including traveling approximately 7 out of 20 working days per month to sales
calls and making sales calls to approximately 34 of petitioner’s customers. The
geographic area in which J. Lipsmeyer made sales calls included North Central
Arkansas, Central Arkansas, Western Arkansas, Southern Missouri, and Eastern
Oklahoma. J. Lipsmeyer, together with M. Lipsmeyer, was co-guarantor of
petitioner’s line of credit that amounted to approximately $3.3 million. Before
forming petitioner, J. Lipsmeyer was employed by Bierwirth Veterinary Supply for
16.5 years to perform sales and warehouse work and drive a truck. He had a
commercial driver’s license while at Bierwirth, which he maintained.
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[*4] M. Lipsmeyer began working for petitioner in 1999 and had worked in
accounts payable and accounts receivable. She worked an average of 30 to 35
hours per week but would work more hours during busier times. Before joining
petitioner, she had worked in customer service and inventory control at Durvet Inc.,
an animal health company.
D. Lipsmeyer’s duties were handling approximately 50 of petitioner’s
accounts; traveling approximately three weeks out of each month and between 700
and 900 miles per week; training the approximate 25-27 members of petitioner’s
sales force; and providing input to J. Lipsmeyer about hiring decisions and product
pricing. In addition to his sales responsibilities, D. Lipsmeyer was responsible for
the two trade shows that petitioner hosted each year that included approximately
200 customers and between 100 and 120 vendors. He worked between 60 and 65
hours per week. He was involved in the formation of petitioner and has worked for
petitioner since its incorporation in 1988. He was not an original shareholder due to
financial constraints. Before working for petitioner he had worked for the same
veterinary supply company as J. Lipsmeyer, taking and filling orders.
Stewart’s duties since assuming her role as chief financial officer in 2002
were overseeing accounts payable and accounts receivable; meeting with
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[*5] petitioner’s accountant; meeting with petitioner’s banking institutions; and
serving as co-trustee of petitioner’s section 401(k) plan. She also dealt with human
resources and petitioner’s various insurance plans, such as medical insurance;
handled payroll for approximately 85-87 people; issued bonuses; and worked with
several of petitioner’s warehouses on OSHA compliance. She had 90 college credit
hours in business finance. She had previously worked part time for petitioner
beginning in 1988 for between 2 and 3 years and then worked full time for petitioner
for 19 years.
Petitioner has had an employee handbook in place since 2002 or 2003, and a
copy given to each employee stated that salary would be determined by petitioner’s
president. The handbook did not include a written bonus policy. Bonuses were
based on how well petitioner was doing financially, employee job performance, and
work ethic. Petitioner paid bonuses to some of its employees. Petitioner had a
section 401(k) plan in place for employees. The plan has a mandatory 5% employer
match, and petitioner’s contributions to the plan have been at least 17% since 2002.
Petitioner’s section 401(k) plan contributions were 20.5% and 17.7% in 2006 and
2007, respectively.
During 2005, petitioner entered into an agreement (Lease No. 1) to lease the
property in Arkansas (Business Property) from Lipspaces, LLC (Lipspaces). J.
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[*6] Lipsmeyer and M. Lipsmeyer were the only members of Lipspaces. The term
of Lease No. 1 began on March 1, 2005, and ended on February 29, 2008. At the
time of Lease No. 1, the Business Property consisted of 87,897 square feet of
warehouse space and office space. J. Lipsmeyer executed Lease No. 1 on behalf of
Lipspaces as lessor and on behalf of petitioner as lessee. During 2007, following
expansion of the Business Property warehouse space, petitioner and Lipspaces
entered into a new agreement for the lease of the Business Property (Lease No. 2).
The term of Lease No. 2 began on April 1, 2007, and ended on February 28, 2010.
At the time of Lease No. 2, the Business Property consisted of 159,497 square feet
of warehouse space and office space.
Petitioner was a subchapter C corporation and an accrual basis taxpayer for
purposes of Federal income tax. Petitioner reported gross receipts/sales of
$59,902,028; gross profit of $9,606,817; total income of $10,468,463; and taxable
income of $128,545 on Form 1120, U.S. Corporation Income Tax Return, for 2006
(2006 Form 1120). Petitioner reported gross receipts/sales of $65,954,366; gross
profit of $9,686,513; total income of $10,373,588; and taxable income of $41,948
on Form 1120 for 2007 (2007 Form 1120).
Petitioner paid a dividend to J. Lipsmeyer of $30,000 during each year in
issue. Petitioner paid compensation to J. Lipsmeyer and M. Lipsmeyer as officers.
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[*7] Petitioner paid compensation to D. Lipsmeyer and Stewart as employees. The
portion of the deduction petitioner claimed as wages accrued to J. Lipsmeyer for
2007 is not in issue in this case. Petitioner claimed deductions for officer and
employee compensation on the 2006 Form 1120 and the 2007 Form 1120 as
follows:
2006 2007
Officers:
J. Lipsmeyer $981,728 $746,229
M. Lipsmeyer 215,000 198,000
Employees:
D. Lipsmeyer 922,853 735,029
Stewart 287,528 287,429
Petitioner claimed deductions for the Business Property rent of $564,000 and
$651,000 on the 2006 Form 1120 and 2007 Form 1120, respectively.
On April 21, 2011, respondent sent to petitioner a notice of deficiency
disallowing (1) a portion of the deduction petitioner claimed for officer
compensation related to J. Lipsmeyer and M. Lipsmeyer for 2006 of $363,017; (2)
a portion of the deduction petitioner claimed for officer compensation related to
M. Lipsmeyer for the year 2007 of $62,946; (3) a portion of the deduction
petitioner claimed for salaries and wages related to D. Lipsmeyer and Stewart for
the year 2006 of $835,788; (4) a portion of the deduction petitioner claimed for
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[*8] salaries and wages related to D. Lipsmeyer and Stewart for the year 2007 of
$520,367; (5) a portion of the deduction petitioner claimed for rent of $242,000 for
2006; and (6) a portion of the deduction petitioner claimed for rent of $251,000 for
2007.
OPINION
Generally, the taxpayer has the burden of proving that the Commissioner’s
determination is in error. See Rule 142(a). However, the burden of proof may shift
to the Commissioner under certain circumstances. See sec. 7491(a)(1). Both
parties have presented evidence and introduced expert witness reports. We decide
this case based on the preponderance of evidence. See Blodgett v. Commissioner,
394 F.3d 1030, 1039 (8th Cir. 2005) (where both parties have satisfied their burden
of production, the party supported by the weight of the evidence will prevail
regardless of which party had the burden of persuasion, proof, or preponderance),
aff’g T.C. Memo. 2003-212.
Opinion testimony of an expert is admissible if and because it will assist the
trier of fact to understand evidence that will determine a fact in issue. See Fed. R.
Evid. 702. We evaluate the opinions of experts in light of the demonstrated
qualifications of each expert and all other evidence in the record. See Parker v.
Commissioner, 86 T.C. 547, 561 (1986). While we may accept an expert opinion
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[*9] in its entirety, Buffalo Tool & Die Mfg. Co. v. Commissioner, 74 T.C. 441,
452 (1980), we may be selective in the use of any part of such opinion or reject the
opinion in its entirety, Parker v. Commissioner, 86 T.C. at 561. We decide, as the
trier of fact, the weight afforded a witness’s testimony. See Helvering v. Nat’l
Grocery Co., 304 U.S. 282, 295 (1938); RTS Inv. Corp. v. Commissioner, T.C.
Memo. 1987-98, aff’d, 877 F.2d 647 (8th Cir. 1989).
Reasonable Compensation
Section 162(a)(1) allows as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business, including a reasonable allowance for salaries or other compensation for
personal services actually rendered. A taxpayer is entitled to a deduction for
salaries or other compensation if the payments were reasonable in amount and are in
fact payments purely for services. Sec. 1.162-7(a), Income Tax Regs.
Whether the compensation paid by a corporate taxpayer to a shareholder-
employee was reasonable is a question of fact. Owensby & Kritikos, Inc. v.
Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987), aff’g T.C. Memo. 1985-267;
Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974), aff’g
T.C. Memo. 1973-130. Courts have considered various factors in assessing the
reasonableness of compensation, such as: employee qualifications; the nature,
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[*10] extent, and scope of the employee’s work; the size and complexity of the
business; prevailing general economic conditions; the employee’s compensation as a
percentage of gross and net income; the employee shareholders’ compensation
compared with distributions to shareholders; the employee-shareholders’
compensation compared with that paid to non-shareholder-employees; prevailing
rates of compensation for comparable positions in comparable concerns; and
comparison of compensation paid to a particular shareholder-employee in previous
years where the corporation has a limited number of officers. Charles Schneider &
Co. v. Commissioner, 500 F.2d at 151-152. No single factor is dispositive. See
Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d 176, 178 (10th Cir. 1975), aff’g
61 T.C. 564 (1974). Special scrutiny is given in situations where a corporation is
controlled by the employees to whom the compensation is paid because there is a
lack of arm’s-length bargaining. Charles Schneider & Co. v. Commissioner, 500
F.2d at 152; Heil Beauty Supplies, Inc. v. Commissioner, 199 F.2d 193, 194 (8th
Cir. 1952).
Petitioner contends the compensation petitioner paid to J. Lipsmeyer, M.
Lipsmeyer, D. Lipsmeyer, and Stewart during each of the years in issue was
reasonable. Respondent argues that petitioner failed to show that any
compensation paid to J. Lipsmeyer, M. Lipsmeyer, D. Lipsmeyer, and Stewart in
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[*11] excess of the amounts respondent allowed constitutes reasonable
compensation and, therefore, it is not deductible under section 162(a)(1).
1. Employee Qualifications
An employee’s superior qualifications for his or her position with the business
may justify high compensation. See Charles Schneider & Co. v. Commissioner, 500
F.2d at 152; Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 121 (6th Cir. 1949);
Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1158 (1980).
J. Lipsmeyer and D. Lipsmeyer were highly qualified for their respective
positions. J. Lipsmeyer was one of petitioner’s two initial shareholders and has
worked for petitioner since its incorporation. Although D. Lipsmeyer was not a
shareholder, he, too, was involved in petitioner’s formation and had worked for
petitioner since its incorporation in 1988. J. Lipsmeyer and D. Lipsmeyer also had
prior experience working for a veterinary supply company that is relevant to
petitioner’s business.
Although Stewart had worked part time for petitioner for approximately 3
years and then worked full time for petitioner for 19 years, the record does not
establish the nature of her duties or responsibilities before 2002 when she assumed
the title of chief financial officer. Nonetheless, the duration of her employment
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[*12] with petitioner demonstrates experience with certain aspects of petitioner’s
operations, and her business finance college credit hours are related to her duties as
chief financial officer.
M. Lipsmeyer’s prior experience in customer relations and inventory with an
animal health company was relevant to petitioner’s business. She testified that she
had worked for petitioner since 1999 and that her work focused on accounts payable
and accounts receivable, which demonstrates familiarity with these aspects of
petitioner’s business. However, the evidence does not establish that M.
Lipsmeyer’s experience rises to the level of superior qualification for her positions
as vice president, secretary, and assistant chief financial officer.
2. Nature, Extent and Scope of Employee’s Work
An employee’s position, duties performed, hours worked, and general
importance to the corporation’s success may justify high compensation. See
Charles Schneider & Co. v. Commissioner, 500 F.2d at 152; Home Interiors &
Gifts, Inc. v. Commissioner, 73 T.C. at 1158.
The evidence supports J. Lipsmeyer’s and D. Lipsmeyer’s importance to
petitioner’s success. J. Lipsmeyer interacted with vendors, priced products, made
personnel decisions, and was actively involved in sales, including traveling 7 out of
20 working days per month to make sales calls to 34 of petitioner’s customers.
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[*13] The record supports his testimony that as president, co-chief executive officer,
and co-chief operating officer, the “bottom line stops with me”. D. Lipsmeyer has
worked for petitioner since its incorporation in 1988. He was co-chief executive
officer and co-chief operating officer with J. Lipsmeyer in addition to serving as
petitioner’s senior vice president of sales. He worked 60-65 hours per week and
traveled approximately three weeks each month. He not only trained approximately
25-27 members of petitioner’s sales force but also handled approximately 50 of
petitioner’s different accounts and was also responsible for petitioner’s two trade
shows each year.
As chief financial officer, Stewart performed a range of duties related to
petitioner’s financial matters. She was also involved in administrative matters, such
as petitioner’s various insurance programs and OSHA compliance. Although her
tenure as chief financial officer had been relatively brief, her duties in that role,
taken together with her administrative duties and her years of experience previously
working for petitioner demonstrate her general importance to petitioner’s success.
Although M. Lipsmeyer held the titles of vice president, secretary, and
assistant chief financial officer, she testified that
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[*14] [i]t’s very hard for me to say what exactly I was doing other than
the obvious, which was helping with, you know, like the financial
decisions. * * * Well, just have conversations naturally with my
husband about, you know, what was going on with the business as far
as were there any--you know, where monies were going or anything
that was upcoming as far as needs of the company, just in general
finances.
Her vague description of her own duties taken together with her 30-35 hour average
work week, which at busier times included an unspecified number of additional
hours, are incongruous with her position titles in companies in which family
relationships do not exist.
3. Size and Complexity of the Business
Courts consider the size and complexity of a taxpayer’s business when
deciding the reasonableness of compensation paid to its shareholder-employees.
See Charles Schneider & Co. v. Commissioner, 500 F.2d at 152; RTS Inv. Corp. v.
Commissioner, T.C. Memo. 1987-98. We have considered a company’s sales, net
income, gross receipts, or capital value in determining a company’s size, Miller &
Sons Drywall, Inc. v. Commissioner, T.C. Memo. 2005-114; see Beiner, Inc. v.
Commissioner, T.C. Memo. 2004-219; Wagner Constr., Inc. v. Commissioner,
T.C. Memo. 2001-160, as well as the number of clients, and the number of
employees; growth in these areas; and compliance with government regulations.
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[*15] See Alpha Med., Inc. v. Commissioner, T.C. Memo. 1997-464, rev’d on other
grounds 172 F.3d 942 (6th Cir. 1999).
Petitioner’s reported gross sales/receipts of $59,902,028 and $65,954,366,
respectively, for 2006 and 2007, respectively, and gross profit of approximately
$9,600,000 for each of these years indicate that petitioner is a substantial business.
There is no evidence of petitioner’s capital value.
J. Lipsmeyer’s testimony that petitioner held licenses to transport certain
hazardous materials and to sell certain products indicates compliance with
government regulations. However, the record does not establish that petitioner held
any or all of these licenses during the years in issue. The number of petitioner’s
different products, the number of vendors, and the number of employees
demonstrate a degree of complexity. Although approximately 200 of petitioner’s
customers attended the trade shows, there is no other evidence as to the number of
customers to which petitioner sold any products or the extent to which petitioner’s
customer base expanded. On this record, there is insufficient evidence to conclude
that the size and complexities of petitioner’s business warrant high compensation.
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[*16] 4. General Economic Conditions
General economic conditions may affect a company’s performance and thus
show the extent of the employee’s effect on the company. See Rutter v.
Commissioner, 853 F.2d 1267 (5th Cir. 1988), aff’g T.C. Memo. 1986-407;
Mayson Mfg. Co. v. Commissioner, 178 F.2d at 119-120. Adverse economic
conditions, for example, tend to show that an employee’s skill was important to a
company that grew during the bad years. Alpha Med., Inc. v. Commissioner, 172
F.3d 942. There is insufficient evidence to conclude that general economic
conditions affected petitioner’s performance.
5. Comparison of Salaries Paid With Gross and Net Income
Compensation as a percentage of a taxpayer’s gross and net income has been
considered in deciding whether compensation is reasonable. See RTS Inv. Corp. v.
Commissioner, T.C. Memo. 1987-98. In most cases the comparison of salaries to
net income is more probative. Owensby & Kritikos, Inc. v. Commissioner, 819
F.2d at 1325.
Petitioner reported gross receipts of $59,902,028 and net income before
taxes of $128,454 on the 2006 Form 1120. The aggregate amount petitioner
deducted as compensation for J. Lipsmeyer, M. Lipsmeyer, D. Lipsmeyer, and
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[*17] Stewart in 2006, $2,407,109, is more than 100% of petitioner’s reported net
income before taxes and is 4% of the reported gross receipts.
Petitioner reported gross receipts of $65,954,366 and net income before taxes
of $41,948 on the 2007 Form 1120. The aggregate amount of compensation
petitioner paid and deducted for M. Lipsmeyer, D. Lipsmeyer, and Stewart in 2007,
$1,022,458, is more than 100% of the reported net income before taxes and is 2% of
the reported gross receipts. Petitioner argues that net income is appropriately
calculated as net income before taxes and before deducting employee compensation
and, as a result, the aggregate compensation petitioner paid was 95% of net income
in 2006 and 97% of net income in 2007.
High percentages may be reasonable in certain circumstances. See Pulsar
Components Int’l, Inc. v. Commissioner, T.C. Memo. 1996-129 (officers were
exceptionally qualified by virtue of education, training, experience, and dedication
and had been undercompensated in prior years); Mad Auto Wrecking, Inc. v.
Commissioner, T.C. Memo. 1995-153 (primary reasons for corporation’s growth
and success were shareholders’ training, experience, and dedication); Acme Constr.
Co., Inc. v. Commissioner, T.C. Memo. 1995-6 (chief executive officer’s services
caused corporation’s success); see also Haffner’s Serv. Stations, Inc. v.
Commissioner, T.C. Memo. 2002-38 (evidence that profits are attributable to
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[*18] compensated officers is required), aff’d, 326 F.3d 1 (1st Cir. 2003). Although
J. Lipsmeyer and D. Lipsmeyer had significant experience in petitioner’s operations
and were important to petitioner’s success, the record does not establish that J.
Lipsmeyer or D. Lipsmeyer was exceptionally qualified or that either was the
primary reason for petitioner’s growth. The record supports Stewart’s general
importance to petitioner’s success, but falls short of establishing that she was
exceptionally qualified or the primary reason for petitioner’s growth. The record
falls far short of establishing that M. Lipsmeyer was exceptionally qualified or was
the primary reason for petitioner’s growth.
6. Prevailing Rates of Compensation
A comparison of the compensation under consideration and the prevailing
rates of compensation paid to those in similar positions in comparable companies
within the same industry is a most significant factor. Charles Schneider & Co. v.
Commissioner, 500 F.2d at 154.
The parties rely on expert reports and testimony with respect to this factor.
Petitioner’s expert is Jason M. Thomas. At the time of trial, Thomas was a senior
tax manager with Frost, PLLC; a CPA and an attorney. His reasonable
compensation experience included providing litigation support services in
commercial litigation cases, dissenting shareholder rights and marital dissolution
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[*19] cases; tax compliance services; and financial advisory services. Respondent’s
expert is Martin Wertlieb. At the time of trial, Wertlieb headed his own
compensation consulting firm of Martin Wertlieb Associates and had not only
provided executive compensation counsel to numerous clients in a range of activities
in both the public and private sectors, but had also qualified as an expert witness on
executive compensation before Congress and various courts, including this Court.
Thomas’ report provides guidance of dubious value because he failed to
identify comparable companies, see, e.g., Mad Auto Wrecking, Inc., v.
Commissioner, T.C. Memo. 1995-153; RTS Inv. Corp. v. Commissioner, T.C.
Memo. 1987-98; and we accord it little weight. First, he failed to identify
companies within an industry comparable to petitioner. The companies in his
sample related to the Southeastern United States and were drawn from SIC Division
F category (wholesale dealers of both durable and nondurable goods). Although
Thomas was aware at the time he prepared his report that petitioner dealt with only
nondurable goods, he failed to narrow his search and merely opined that the broad
SIC Division F industry category was the most applicable. His remaining sample
included companies that were headquartered in Northwest Arkansas and failed to
reflect any industry category whatsoever.
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[*20] Second, Thomas failed to establish that the companies in either of his samples
were of a size comparable to petitioner. Although his report purports to be based on
“gross profit percentage”, which he defined to mean “the difference between gross
revenue and the cost of producing a product or providing a service”, he testified that
“[n]ever was a gross profit percentage a criteria in order to select the companies” in
either of his samples. Instead, he selected the companies in both of his samples
based on the amount of compensation paid to four categories of executives and then
assigned the companies to one of three percentiles (25th, 50th, and 75th) based
exclusively on the amount of compensation those companies paid to the executives.
He provided no data as to how many companies were included in either of his two
samples or the identity of any company; no relevant financial data, such as gross
receipts or sales, net income, or capital value, see Wagner Constr., Inc. v.
Commissioner, T.C. Memo. 2001-160; and no financial analysis.
In contrast, Wertlieb identified 12 publicly listed companies engaged in the
nondurable goods wholesale industry related to chemicals and distributing farming
equipment and supplies (Benchmark Companies) based on financial reports and
proxy statements filed with the Securities and Exchange Commission for each of
the years in issue. He presented financial data for each of the Benchmark
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[*21] Companies, including the amount of annual revenues, amount of pretax
profits, pretax profits as a percentage of annual revenues, and amount of
compensation paid to the top two executives and the chief financial officer.
Although all of the Benchmark Companies are publicly traded and their size ranged
from smaller to larger than petitioner based on gross revenues, we do not think his
industry category is overly broad or otherwise defeats our purpose here and, in any
event, his categorization was the most persuasive of the industry categorizations on
this record. See, e.g., RTS Inv. Corp. v. Commissioner, T.C. Memo. 1987-98.
Wertlieb determined the amounts of reasonable compensation based on the
correlation between the Benchmark Companies’ annual sales/revenues and fixed
compensation as demonstrated by application of the linear regression statistical
technique. He determined that fixed compensation at his correlation’s 90th
percentile was reasonable for J. Lipsmeyer and D. Lipsmeyer after also taking into
account their respective duties and responsibilities and their experience. He then
allocated the compensation amount he had determined to J. Lipsmeyer and D.
Lipsmeyer in proportion to the actual base salaries paid to each of them during the
years in issue. Using the same approach, he determined that fixed compensation at
the correlation’s 75th percentile was reasonable for Stewart after also taking into
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[*22] account her duties and responsibilities and her relatively brief tenure as
petitioner’s chief financial officer. He did not determine a correlation percentile for
M. Lipsmeyer’s fixed compensation. Instead, he determined that M. Lipsmeyer’s
reasonable compensation was 73% of Stewart’s compensation at the 75th
percentile, which was the same proportion of M. Lipsmeyer’s actual base
compensation to Stewart’s actual base compensation in each of the years in issue.
Based on his data, methodology, and analysis, Wertlieb determined that the
following amounts represented reasonable compensation to J. Lipsmeyer, M.
Lipsmeyer, D. Lipsmeyer, and Stewart for each of the years in issue:
2006 2007
Officers:
J. Lipsmeyer $732,300 $559,100
M. Lipsmeyer 134,400 133,500
Total 866,700 692,600
Employees:
D. Lipsmeyer 590,500 470,000
Stewart 183,000 192,700
Total 773,500 662,700
On brief, respondent accepted that the amounts of compensation that Wertlieb
found reasonable for J. Lipsmeyer, M. Lipsmeyer, D. Lipsmeyer, and Stewart were
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[*23] reasonable as to each of them and modified the position taken in the notice of
deficiency.
7. Salary Policy of the Taxpayer as to All Employees
Courts have considered the taxpayer’s compensation policy for its other
employees in deciding whether compensation is reasonable. See Wagner Constr.,
Inc. v. Commissioner, T.C. Memo. 2001-160. This factor focuses on whether the
entity pays top dollar to all of its employees, including both shareholders and
nonshareholders. Wagner Constr., Inc. v. Commissioner, T.C. Memo. 2001-160;
Eberl’s Claim Serv., Inc. v. Commissioner, T.C. Memo. 1999-211 (citing Owensby
& Kritikos, Inc. v. Commissioner, 819 F.2d at 1329-1330), aff’d, 249 F.3d 994(10th Cir. 2001). “[E]vidence of a reasonable, longstanding, consistently applied
compensation plan is evidence that the compensation paid in the years in question
was reasonable.” Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1247 (9th Cir.
1983), rev’g T.C. Memo. 1980-282.
Petitioner’s employee handbook, in place since 2002, provides that
petitioner’s president determined all salary matters and J. Lipsmeyer made the
determinations. Petitioner paid bonuses to some of its employees based on how
well petitioner was doing financially, employee job performance, and work ethic but
did not have a written bonus policy. J. Lipsmeyer determined bonus amounts.
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[*24] Evidence of petitioner’s contributions to the employee section 401(k) plan,
standing alone does not establish that petitioner paid top dollar to all of its
employees, including both shareholders and nonshareholders, see, e.g., Eberl’s
Claim Serv., Inc. v. Commissioner, T.C. Memo. 1999-211, or the existence of a
longstanding, consistently applied compensation plan, see, e.g., Elliotts, Inc. v.
Commissioner, 716 F.2d at 1247.
8. Compensation Paid in Previous Years
Petitioner argues that the salary history of J. Lipsmeyer, D. Lipsmeyer, M.
Lipsmeyer, and Stewart from 2003 through the years in issue demonstrates that the
amounts of their compensation were reasonable. However, this factor applies when
a corporation is deducting compensation in one year for services rendered in prior
years. Lucas v. Ox Fibre Brush Co., 281 U.S. 115 (1930). Petitioner has neither
argued nor established that any amount of compensation petitioner deducted in
either of the years in issue for J. Lipsmeyer, M. Lipsmeyer, D. Lipsmeyer, or
Stewart was allocable to services rendered in prior years.
9. Comparison of Salaries With Distributions and Retained Earnings
The absence of dividend payments by a profitable corporation is a factor
that may be considered in addressing the reasonableness of compensation.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1326; Charles Schneider
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[*25] & Co. v. Commissioner, 500 F.2d at 152. Corporations, however, are not
required to pay dividends. Owensby & Kritikos, Inc. v Commissioner, 819 F.2d at
1326. The prime indicator of the return a corporation is earning for its investors is
the return on equity. Id. at 1326-1327. Petitioner paid J. Lipsmeyer a dividend of
$30,000 in each of the years in issue. There is no evidence of return on equity.
10. Debt Guaranty
Courts have also considered whether an employee personally guaranteed the
employer’s debt. See R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 51 (1972); Mad
Auto Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153. J. Lipsmeyer and M.
Lipsmeyer were co-guarantors of petitioner’s $3.3 million line of credit.
We have considered the various factors in assessing the reasonableness of
compensation. Factors of employee qualifications for only J. Lipsmeyer and D.
Lipsmeyer and the nature, scope, and extent of work for only J. Lipsmeyer and D.
Lipsmeyer; salaries compared to distributions and retained earnings; and debt
guaranty favor petitioner. Factors of business size and complexity; salaries paid
with gross income; prevailing rates of compensation; and employee salary policy
favor respondent. Certain other factors are neutral as to only M. Lipsmeyer and
Stewart, and other factors are neutral or do not apply. Giving due weight to each
of the factors, we have found Wertlieb’s report persuasive and we accept his
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[*26] conclusions. Accordingly, we conclude that: (1) reasonable compensation for
the 2006 tax year was $732,300 for J. Lipsmeyer; $134,400 for M. Lipsmeyer;
$590,500 for D. Lipsmeyer; and $183,000 for Stewart; and (2) reasonable
compensation for the 2007 tax year was $133,500 for M. Lipsmeyer; $470,000 for
D. Lipsmeyer; and $192,700 for Stewart. J. Lipsmeyer’s compensation for 2007 is
not in issue in this case.
Reasonable Rent
Section 162(a)(3) allows as a deduction all ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business,
including “rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business, of property.” In
determining whether the payments here in issue were rental payments deductible
under this section, the “basic question is * * * whether they were in fact rent
instead of something else paid under the guise of rent”. Place v. Commissioner,
17 T.C. 199, 203 (1951), aff’d per curiam, 199 F.2d 373 (6th Cir. 1952). In
connection with a lease between related parties, the inquiry “requires a careful
examination of the circumstances surrounding the rental of the property to
determine the intentions of the parties in agreeing upon * * * [the] lease and in
fixing the terms thereof.” Davis v. Commissioner, 26 T.C. 49, 56 (1956). The
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[*27] question whether payments are rental payments within the meaning of the
statute is a question of fact to be resolved on the basis of all the facts and
circumstances. Thomas v. Commissioner, 31 T.C. 1009, 1012 (1959); S. Ford
Tractor Corp. v. Commissioner, 29 T.C. 833, 842 (1958).
Petitioner contends that the rent amounts paid to Lipspaces, a related party,
for each year in issue were reasonable and, therefore, deductible. Respondent
argues that petitioner failed to show that any amount of the rental payments in
excess of the amounts respondent allowed constitutes reasonable rental deductible
under section 162(a)(3).
Both petitioner and respondent rely on expert reports and testimony to
support their positions. Petitioner’s expert was Joshua A. Smith, senior appraiser,
Grubb & Ellis Landauer Valuation Advisory Services, LLC. He is certified by the
State of Arkansas as a general real estate appraiser and has been involved in real
estate valuation. Respondent’s expert was Stephen Cosby, managing director of
CBRE, Inc. Valuation & Advisory Services. He is certified by the State of
Arkansas as a general real estate appraiser and has over 27 years’ experience in real
property valuation.
Both experts prepared a market rent analysis that determined market rent
based on a percentage return of development cost, including the land acquisition
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[*28] cost, for a property of a similar type to the Business Property. Both experts
estimated land acquisition cost using the sales approach. We question the
comparability of Smith’s seven land sales. Unlike the Business Property’s
“industrial” zoning, four of Smith’s properties located in the same area as the
Business Property were zoned “commercial”. There is no evidence as to Smith’s
remaining three land sales that the location was feasible for petitioner’s business
purposes, and none bore the same “industrial” zoning category as the Business
Property. Smith testified that he assumed, but did not know, whether any of the
land sale prices had been adjusted to take into account property characteristic
differences.
Both experts determined the value of a replacement building using the cost
approach and Marshall Valuation Service (MVS) data based on square footage of
the Business Property. We question the accuracy of Smith’s replacement cost and,
as a result, his market rent determination. His replacement cost was based on
incorrect square footage amounts and on incorrect MVS data. Smith testified that
he did not adjust his data and that “[i]n 2006 and 2007, it was a time in the market
where costs were increasing * * * and so that period costs would have been
substantially higher”. Finally, Smith failed to present industrial lease data of any
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[*29] kind and offered only that he relied on unspecified “market data for industrial
projects of this type”. Hence, we accord his opinion little weight.
Cosby estimated land cost based on his review of three land sales, one of
which was the Business Property. Although Cosby’s sample presents only two
sales other than the Business Property, both sales were located within a short
distance of the Business Property and both sales bore the same “industrial” zoning
designation as the Business Property. He testified that he restricted his search to
this area because the Business Property location was “this kind of little light
industrial market that’s all to itself. * * * [T]here was no city sewer available in that
area at the time. And that limited the use of those sites * * * So I wanted to stay
within that market segment”. He estimated building replacement cost after
depreciation based on the stipulated square footage using MVS data in effect as of
May 31, 2007. His report indicates that market conditions as of May 31, 2006,
were very similar to those conditions as of May 31, 2007, and that there was little
difference in rental rates between 2006 and 2007. Although there is no evidence
corroborating the similarity of market conditions, based on additional data included
in Cosby’s report and the relatively short period of time between the tax years in
issue, we are persuaded that Cosby’s MVS data reflects market conditions during
2006 and 2007.
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[*30] Using an 8.5% rate of return, Cosby determined that market rent was $5.05
per square foot per year for the Business Property at 87,897 square feet and was
$4.80 per square foot per year at 159,497 square feet. His report indicates that he
used an 8.5% rate of return because a typical range of return for a development of
the same type as the Business Property was 8%-10% and negotiations between
developer and tenant typically would result in a return in the lower end of this range.
There is no evidence corroborating his explanation. However, Smith used a 9.5%
rate of return, which was within the range Cosby identified as typical. Cosby’s
report also includes industrial lease data to provide a comparison with, and support
for, his market rent determination for the Business Property.
On brief, respondent accepted petitioner’s rent deductions in the amounts
determined reasonable by Cosby and modified the position taken in the notice of
deficiency.
We conclude that Cosby’s report is persuasive, and we accept his
conclusions. Accordingly, we conclude that: (1) for tax year ended May 31, 2006,
petitioner may deduct $443,879.85 Business Property rent ($5.05 x 87,897 ft2); and
(2) for tax year ended May 31, 2007, petitioner may deduct $497,497.48 Business
Property rent (($5.05 ÷ 12 mos. x 87,897 ft2 x 10 mos.) + ($4.80 ÷ 12 mos. x
159,497 ft2 x 2 mos.)).
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[*31] Equitable Recoupment
Petitioner argues that the doctrine of equitable recoupment applies to permit
offset of the alleged excess income tax J. Lipsmeyer and M. Lipsmeyer paid on the
assumption that the disallowed portions of the compensation and rent were
dividends taxable at a lower rate.
As a general rule, the party claiming the benefit of an equitable recoupment
defense must establish that it applies. Menard, Inc. v. Commissioner, 130 T.C. 54(2008); see Estate of Mueller v. Commissioner, 101 T.C. 551, 556 (1993). In
order to establish that equitable recoupment applies, a party must prove the
following elements: (1) the overpayment or deficiency for which recoupment is
sought by way of offset is barred by an expired period of limitation; (2) the time-
barred overpayment or deficiency arose out of the same transaction, item, or
taxable event as the overpayment or deficiency before the Court; (3) the
transaction, item, or taxable event has been inconsistently subjected to two taxes;
and (4) if the transaction, item, or taxable event involves two or more taxpayers,
there is sufficient identity of interest between the taxpayers subject to the two
taxes that the taxpayers should be treated as one. United States v. Dalm, 494 U.S.
596, 604-605 (1990); Menard, Inc. v. Commissioner, 130 T.C. at 62; Estate of
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[*32] Branson v. Commissioner, 113 T.C. 6, 15 (1999), aff’d, 264 F.3d 904 (9th
Cir. 2001); Estate of Orenstein v. Commissioner, T.C. Memo. 2000-150.
Respondent relies on Catalano v. Commissioner, T.C. Memo. 1998-447,
aff’d, 240 F.3d 842 (9th Cir. 2001), as demonstrating that petitioner has not proven
the second or fourth elements of equitable recoupment. We agree with respondent’s
analysis.
In Catalano, an S corporation shareholder leased boats to his corporation,
which claimed rent deductions disallowed by the Commissioner. He then claimed
that he should not have to include the rental payments in his income because doing
so would duplicate his includable S corporation distributable income. In Catalano,
we stated:
The taxable incomes of a shareholder and his S corporation are
computed separately, even though the corporation's taxable income is
passed through to, and the tax thereon imposed upon, the shareholder.
See sec. 1363(a) and (b). This separate computation of taxable
income means that the disallowance of a deduction for a lease
payment by the lessee-corporation has no impact on the
lessor-shareholder's recognition of the lease payment as income.
“There is no necessary correlation between the payor’s right to a
deduction for a payment and the taxability of the payment to the
recipient.” 1 Mertens, Law of Federal Taxation, sec. 5A.11, at 22
(1998 rev.); see also Smith v. Manning, 189 F.2d 345 (3d Cir. 1951);
Sterno Sales Corp. v. United States, 170 Ct. Cl. 506, 345 F.2d 552(1965); Reynard Corp. v. Commissioner, 30 B.T.A. 451 (1934);
Mosby v. Commissioner, T.C. Memo. 1984-90; Zeunen Corp. v.
United States, 227 F. Supp. 952 (E.D. Mich. 1964). This separate
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[*33] treatment of a payment’s deductibility and recognition as income
obtains even where the payor and payee are a corporation and its sole
shareholder, Reynard Corp. v. Commissioner, supra; Mosby v.
Commissioner, supra; a parent corporation and its wholly owned
subsidiary, Zeunen Corp. v. United States, supra; or two wholly owned
subsidiaries of a common parent. Sterno Sales Corp. v. United States,
supra. * * *
In affirming the Tax Court, the Court of Appeals for the Ninth Circuit
rejected the taxpayer’s invocation of equitable recoupment, stating:
We need consider only the second element. The doctrine of
equitable recoupment does not apply because we do not have
inconsistent legal theories. It was not inconsistent for the Tax Court to
deny a corporate-level deduction for the lease payments while requiring
Catalano to include his receipt of those payments in his individual
income. The corporation and Catalano are separate entities. The tax
outcome results from the structure Catalano chose for this transaction.
Catalano v. Commissioner, 240 F.3d at 844.
Respondent also argues that “[i]n Catalano, the court found no identity of
interest between a sole shareholder and his S corporation; a flow-through entity.
T.C. Memo. 1998-447, aff'd, 240 F.3d at 844. Surely then, petitioner, a C
corporation, likewise lacks a sufficient identity of interest with its sole shareholder
and its sole shareholder's family members.” Again we agree with respondent and
conclude that petitioner has not established the fourth prerequisite to equitable
recoupment. If an S corporation and its shareholder do not have identity of
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[*34] interest, a fortiori a C corporation and its shareholder do not have such
identity of interest. It would be anomalous to offset the C corporation’s liability for
corporate income tax by an alleged overpayment of the shareholder’s individual
income tax.
A corporation formed for legitimate business purposes and its shareholders
are separate entities. Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943). A
corporation’s tax identity is rarely ignored unless it is a sham. See Bennett Paper
Corp. v. Commissioner, 699 F.2d 450, 452 (8th Cir. 1983), aff’g 78 T.C. 458(1982); Crouch v. United States, 692 F.2d 97, 99-100 (10th Cir. 1982); Strong v.
Commissioner, 66 T.C. 12, 22-23 (1976), aff’d without published opinion, 553 F.2d
94 (2d Cir. 1977). As we noted in Bass v. Commissioner, 50 T.C. 595, 601 (1968):
Long ago, the Supreme Court held that when a corporation carries on
business activity the fact that the owner retains direction of its affairs
down to the minutest detail makes no difference tax-wise, observing
that “Undoubtedly the great majority of corporations owned by sole
stockholders are ‘dummies’ in the sense that their policies and day-to-
day activities are determined not as decisions of the corporation but by
their owners acting individually”. National Carbide Corp. v.
Commissioner, * * * [336 U.S. 422,] 433 [1949]; see Chelsea
Products, Inc. [v. Commissioner], 16 T.C. 840, 851 (1951), affd. 197
F.2d 620 (C.A. 3, 1952).
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[*35] Petitioner has not cited any precedential or persuasive authority that
contradicts the well-established separation between the corporation and the
Lipsmeyers for tax purposes. We hold that equitable recoupment does not apply to
petitioner’s situation.
In reaching our conclusions, we have considered all arguments made by the
parties and, to the extent not mentioned above, we conclude they are moot,
irrelevant, or without merit.
To reflect differences between the statutory notice allowances and
respondent’s modifications of that notice,
Decision will be entered
under Rule 155.