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ELLIOTTS, INC. Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentElliotts, Inc. v. CommissionerDocket No. 10576-78.
United States Tax Court T.C. Memo 1980-282; 1980 Tax Ct. Memo LEXIS 302; 40 T.C.M. 802; T.C.M. (RIA) 80282;July 30, 1980, Filed; Reversed and Remanded September 26, 1983 William H. Adams andGlen E. Clark ,Dan A. Lisonbee ,SCOTTMEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT,
Judge: Respondent determined deficiencies in petitioner's income tax for its fiscal years ending February 28, 1975, and February 28, 1976, in the amounts of $58,159.91 and $62,507.38, respectively. Some of the issues raised by the pleadings have been disposed of by the parties, leaving for our decision whether petitioner is entitled to deduct any amount in excess of $65,000 in each of its fiscal years 1975 and 1976 for compensation paid to its sole stockholder, chief executive officer, Mr. Edward G. Elliott.FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Elliotts, Inc. (petitioner), an Idaho corporation1980 Tax Ct. Memo LEXIS 302">*303 formed in 1952, had its principal place of business in Burley, Idaho at the time of the filing of its petition in this case. Petitioner filed corporate Federal income tax returns for its fiscal years ending February 28, 1975, and February 28, 1976.
Petitioner's principal business is selling equipment manufactured by John Deere Company and servicing the equipment it sells as well as other equipment. During the years here in issue petitioner had the following contracts with John Deere Company:
(a) John Deere Agricultural Dealer Agreement.
(b) John Deere Agricultural Security Agreement.
(c) John Deere Consumer Products Agreement.
(d) John Deere Agricultural D.R.V. Leasing Agreement.
(e) John Deere Industrial Construction Equipment Agreement.
(f) John Deere Industrial Utility Equipment Agreement.
(g) John Deere Forestry Equipment Agreement.
Petitioner had two business locations during the years here in issue, one in Burley, Idaho and one in Idaho Falls, Idaho. The business located in Burley, Idaho dealt in both agricultural and industrial equipment, while the business located in Idaho Falls dealt only in industrial equipment. Of the approximately 168 John1980 Tax Ct. Memo LEXIS 302">*304 Deere agricultural dealers in Zone 11, which includes the states of California, Nevada, Arizona, Utah, Oregon, Washington and Idaho, only three, including petitioner, were dealers in both agricultural equipment and industrial equipment. On March 1, 1975, petitioner sold its business located in Idaho Falls, Idaho to the Elliott Industrial Company and thereafter maintained only the business location in Burley, Idaho.
When petitioner was initially incorporated in 1952, Mr. Elliott was not the sole stockholder. However, in 1954 he bought the interest of the other stockholder in petitioner and has since that time been petitioner's sole stockholder. Mr. Elliott has been petitioner's chief executive officer since its incorporation.
For the first year after its incorporation petitioner sold only agricultural equipment in the Burley, Idaho area and had annual gross sales of approximately $500,000. At that time petitioner employed approximately 8 people. In its fiscal year ending February 28, 1975, petitioner was employing approximately 40 people, selling several lines of equipment, both agricultural and industrial, throughout southeast Idaho and had gross annual sales of over $5 million.
1980 Tax Ct. Memo LEXIS 302">*305 Mr. Elliott was born and reared in Boise, Idaho. He graduated from the University of Idaho in 1938 with a degree in Political Science. Shortly after finishing college he was employed by the Water Resource Branch of the Geological Survey and thereafter was a junior officer in a Civilian Conservation Corps camp in Idaho. Later he became a company commander in the Civilian Conservation Corps and remained in this position until he entered the military service during World War II. Following his releases from active duty in World War II, Mr. Elliott worked for approximately 5 years for the Veterans' Administration in Twin Falls, Idaho. When he resigned from the Veterans' Administration he, together with another person, purchased the John Deere dealership in Burley, Idaho and incorporated the business which is now Elliotts, Inc. In addition to being the president and general manager of petitioner since 1952, Mr. Elliott has participated in a number of civic and other activities including being chairman of the Small Business Advisory Committee for the State of Idaho and president of the Burley Chamber of Commerce and the South Idaho Chamber of Commerce.
Until 1959, petitioner dealt1980 Tax Ct. Memo LEXIS 302">*306 solely in agricultural equipment, but in 1959 began to handle industrial equipment manufactured by John Deere Company. During the years here in issue, as well as the years prior thereto, Mr. Elliott had the total final managerial responsibility for the business of petitioner. During these years petitioner had the following employees, in addition to Mr. Elliott, at its location in Burley, Idaho:
1 Office Supervisor
2-3 Agricultural Salesmen
2-3 Office Employees
1 Parts Manager
2 Parts Employees
1 Industrial Salesman
10-12 Agricultural Mechanics
6-7 Industrial Mechanics
Approximately 28 employees
For its fiscal year ending February 28, 1975, petitioner had the following employees, in addition to Mr. Elliott, at its location in Idaho Falls, Idaho:
1 Division Manager
2 Salesmen
2 Office Employees
1 Parts Manager
1 Service Manager
7-9 Mechanics
Approximately 15 employees
For the years in issue and for several years prior thereto Mr. Elliott was paid a base salary of $2,000 a month and in addition received a bonus at the end of each fiscal year. The bonus was based on a predetermined formula which had been in use since the incorporation of petitioner1980 Tax Ct. Memo LEXIS 302">*307 and represented 50 percent of net profits because deductions for income taxes and management bonuses. Mr. Elliott's employment contract was not in writing and the provision for the bonus was not in writing and had no time period or other limitations as to the amount of the bonus. The following schedule shows the amounts which Mr. Elliott has been paid by petitioner as president and general manager of petitioner for its fiscal years ending February 28, 1968, through February 28, 1978:
Fiscal Year Ending Total Compensation February 28 Paid to Mr. Elliott 1968 $ 42,800 1969 19,600 1970 34,035 1971 84,450 1972 68,323 1973 66,401 1974 136,536 1975 181,074 1976 193,663 1977 153,696 1978 83,052 During each of the years here in issue and for many years prior thereto, Mr. Elliott worked for petitioner from approximately 8 a.m. to 6 p.m., 6 days a week. Generally he worked approximately 80 hours a week. Mr. Elliott, as chief executive officer of petitioner, not only performed the functions of general manager but also most of the functions of sales manager and credit manager, and he made all policy decisions with respect to the parts and service department.
1980 Tax Ct. Memo LEXIS 302">*308 For each of its fiscal years ending February 28, 1968 through 1978, petitioner's net profits have been as follows:
Fiscal Year Ending After Tax February 28 Net Profits Profits 1968 $ 25,090 $19,715 1969 5,635 4,206 1970 27,042 19,190 1971 77,569 43,934 1972 59,873 36,713 1973 57,951 37,268 1974 112,536 63,674 1975 157,074 88,969 1976 169,663 98,297 1977 129,696 78,250 1978 59,052 42,860 The annual return realized by petitioner for each of its fiscal years ending February 28, 1968, through February 28, 1978, on its equity based on total pre-tax income and on after tax profits separately for its agricultural operations and industrial operations, with invested capital allocated between the two on the basis of sales, was as follows:
1980 Tax Ct. Memo LEXIS 302">*309Percent of Percent of Percent of Fiscal Year Annual Return Annual Return Annual Return Ending on After Tax on Agricultural on Industrial February 28 Equity Profits Pre-Tax Income Pre-Tax Income 1968 $130,387 15 20.47 Not shown 1969 131,518 3 4.28 Not shown 1970 149,442 13 18.10 Not shown 1971 192,708 23 40.25 Not shown 1972 226,629 16 26.42 Not shown 1973 263,030 14 24.51 19.31 1974 ** 326,441 20 34.47 34.47 1975 415,133 21 120.43 (49.88) 1976 513,429 19 35.61 24.23 1977 590,597 13 13.42 12.66 1978 633,496 7 (6.96) 39.50 For its fiscal year 1975 petitioner's industrial equipment as contrasted with its agricultural equipment operations in Burley, Idaho and Idaho Falls, Idaho incurred losses. The following schedule shows the income, costs and expenses of the industrial equipment operation of petitioner at Burley and Idaho Falls:
Burley Idaho Falls Total Sales $1,049,235.98 $1,191,166.01 Cost of Sales 950,287.86 1,086,563.20 Gross Margin 98,948.12 104,602.81 Other Income 53,945.85 47,328.57 152,893.97 151,931.38 Operating Expenses 230,656.24 161,987.22 Net Loss ($ 77,762.27) ($ 10,055.84) In its fiscal years 1975 and 1976, petitioner paid bonuses to employees other than Mr. Elliott totaling $20,000 and $25,000 respectively. All of the employees of petitioner participated to some extent in these bonuses, the amount being determined by a vote of the board of directors and not by a preset formula as was the case of the bonus to Mr. Elliott. The following schedule shows the salaries1980 Tax Ct. Memo LEXIS 302">*310 paid to petitioner's key employes, other than Mr. Elliott, during its fiscal years 1975 and 1976:
Position Annual Salary Industrial Salesman $36,471 Office Supervisor 20,666 Shop Foreman (Agricultural) 24,702 Parts Manager 13,362 During its fiscal year 1975, petitioner paid a salary of $15,253 to the division manager at Idaho Falls.
Since its incorporation in 1952, petitioner has never paid a dividend to its shareholder, Mr. Elliott.
For its fiscal years ending February 28, 1968 through 1972, petitioner did not account separately for its industrial sales and agricultural sales and related expenses. For this period petitioner's sales, compensation paid to Mr. Elliott, the percentage of compensation paid to Mr. Elliott of total sales, compensation paid to all employees, other than service labor, and the percentage of compensation paid to all employees of total sales were as follows:
1980 Tax Ct. Memo LEXIS 302">*311Fiscal Year Compensation Percent Ending Paid to of February 28 Sales Officer Sales 1968 $1,779,989 $42,800 2.40 1969 1,603,661 19,600 1.22 1970 2,760,991 34,035 1.23 1971 2,797,767 84,450 3.02 1972 3,637,614 68,323 1.88 Total Fiscal Year Compensation Percent Ending Paid to All of February 28 Employees Sales 1968 $ 97,317 5.47 1969 79.443 4.95 1970 114,261 4.14 1971 186,178 6.65 1972 194,914 5.36 Beginning with its fiscal year ending February 28, 1973, and for all years thereafter, petitioner accounted for industrial sales and agricultural sales separately.
For its fiscal years ending February 28, 1973, through February 28, 1978, petitioner's sales of agricultural equipment, the compensation paid to Mr. Elliott allocated to agricultural sales based on the percentage of agricultural sales to total sales, the percentage of compensation so computed paid to Mr. Elliott to agricultural sales, the compensation paid to all employees, other than service labor, allocated to agricultural sales, and the percentage of such total compensation paid to all employees to agricultural sales, were as follows:
1980 Tax Ct. Memo LEXIS 302">*312Fiscal Year Compensation Percent Ending Paid to of February 28 Sales Officer Sales 1973 $2,127,471 $ 34,727 1.63 1974 3,486,313 107,099 3.07 1975 3,042,791 104,286 3.43 1976 3,467,758 150,001 4.33 1977 3,558,513 119,149 3.35 1978 3,052,209 58,518 1.92 Total Fiscal Year Compensation Percent Ending Paid to All of February 28 Employees Sales 1973 $117,889 5.54 1974 244,377 7.01 1975 219,089 7.20 1976 280,269 8.08 1977 262,849 7.39 1978 185,661 6.08 For its fiscal years ending February 28, 1973, through February 28, 1978, petitioner's sales of industrial equipment, the compensation paid to Mr. Elliott allocated to industrial sales based on the percentage of industrial sales to total sales, the percentage of compensation so computed paid to Mr. Elliott to industrial sales, the compensation paid to all employees, other than service labor, allocated to industrial sales, and the percentage of total compensation paid to all employees to industrial sales were as follows:
Fiscal Year Compensation Percent Ending Paid to of February 28 Sales Officer Sales 1973 $1,940,440 $31,674 1.63 1974 958,241 29,437 3.07 1975 2,240,401 76,786 3.43 1976 1,009,378 43,661 4.33 1977 1,031,789 34,547 3.35 1978 1,279,659 24,533 1.92 Total Fiscal Year Compensation Percent Ending Paid to All of February 28 Employees Sales 1973 $107,525 5.54 1974 67,169 7.01 1975 161,315 7.20 1976 81,579 8.08 1977 76,212 7.39 1978 77,839 6.08 1980 Tax Ct. Memo LEXIS 302">*313 Since 1967, John Deere Company has published an annual Dealer Comparative Management Review. From 1967 through 1971, John Deere Company did not separate industrial and agricultural dealers in this review, but after 1971 a separate review was published for agricultural and industrial dealers. Included in these reviews were statistical summaries of the operations of the dealers covered by the report, including profitability, return on equity, compensation paid to all employees, compensation paid to officers, owners and managers, and sales. The agricultural dealers are separated by regions and then further separated based on the sales volume of the dealer. In this review industrial dealers are separated by region and also separated by sales volume. However, the dealers by region are not further separated based on the sales volume of the dealers. These statistics are compiled from reports submitted by the dealers to John Deere Company. Not all dealers are included in the survey, but over one-half of the dealers are included. All dealers are required to submit these reports. The statistics from the "operation analysis" are based on tax-adjusted information which is submitted during1980 Tax Ct. Memo LEXIS 302">*314 the first 3 or 4 months of the following year. The statistics from the "employee analysis" are gathered in November and December and are based on a different sample than the "operation analysis" statistics. The information for the "employee analysis" is obtained by John Deere Company by surveys sent to all John Deere dealers. The response to these surveys is voluntary by the various dealers. Because the information is compiled in November and December, the salary information may or may not reflect bonuses paid to employees. The dealers included in the sample used for the "operation analysis" are dealers who have adopted the John Deere accounting system. Also, an attempt is made to exclude from the sample those dealers which handle both agricultural and industrial equipment. Because petitioner did not adopt the John Deere accounting system until its fiscal year ending February 28, 1975, it would not have been included in the "operation analysis" sample for the calendar years through 1975. Also, because petitioner handled both agricultural and industrial equipment it was probably excluded from the sample for subsequent years.
The classification contained in the "operation analysis" 1980 Tax Ct. Memo LEXIS 302">*315 headed "Salary and Compensation Paid to Officers, Owners and Managers" generally includes the compensation to owners, corporate officers, general managers, sales managers, parts managers, service managers and possibly other management personnel. However, some reporting dealers do not include all of these employees within the classification. John Deere Company imposes no guidelines in this regard.
Based on statistics compiled and published by John Deere Company in its "operation analysis," the following schedule shows the average total sales, average compensation paid to officers, owners and managers, the percentage of compensation paid to such officers of sales, the average total compensation paid to employees, other than service labor, and the percentage of such compensation to sales for John Deere agricultural dealers located in Zone 11 which had total sales of $800,000 or above for the calendar years 1967 through 1973:
1980 Tax Ct. Memo LEXIS 302">*316Average Compensation Paid to Officers, Percent Calendar Average Owners and of Year Sales Managers Sales 1967 $1,155,308 $20,889 1.81 1968 1,318,883 32,134 2.44 1969 1,106,663 27,090 2.45 1970 1,237,612 47,797 3.86 1971 1,499,603 48,524 3.24 1972 1,403,268 43,749 3.12 1973 2,273,230 75,127 3.30 Average Total Compensation Percent Calendar Paid to All of Year Employees Sales 1967 $ 56,818 4.92 1968 79,902 6.06 1969 64,310 5.81 1970 100,245 8.10 1971 107,263 7.15 1972 96,613 6.88 1973 153,312 6.74 The following schedule shows the information compiled by John Deere Company in its "operation analysis" for the years 1974 through 1977 for agricultural dealers located in Zone 11 with sales comparable to petitioner's, for total compensation paid to officers with the percentage of such compensation to sales, and total compensation paid to all employees with the percentage of such compensation to sales:
Average Compensation Paid to Officers, Percent Calendar Average Owners and of Year Sales Managers Sales 1974 $3,073,860 $117,899 3.84 1975 3,817,313 130,067 3.41 1976 4,660,968 138,988 2.98 1977 4,177,737 149,512 3.58
1980 Tax Ct. Memo LEXIS 302">*317Average Total Compensation Percent Calendar Paid to All of Year Employees Sales 1974 $213,377 6.95 1975 241,352 6.32 1976 283,407 6.08 1977 281,780 6.74 The above information was compiled from agricultural dealers with sales in excess of $1,367,000 for 1974, $1,871,000 for 1975, $2,358,600 for 1976, and $2,568,800 for 1977.
The following schedule lists the indicated information compiled by John Deere Company in its "operation analysis" for the years 1972 through 1977 for all North American industrial dealers with sales in excess of or under the amounts shown:
Average Compensation Paid to Sales Officers, Calendar In Excess Of Average Owners and Year Or Under Sales Managers 1972 In excess of $1,500,000 $2,241,806 $ 74,830 1973 Under 1,317,000 944,773 34,343 1974 In excess of 2,196,000 3,594,992 136,717 1975 Under 1,107,000 755,929 37,490 1976 Under 1,377,700 967,430 39,330 1977 Under 1,652,000 1,214,040 42,581 Average Total Percent Compensation Percent Calendar of Paid to All of Year Sales Employees Sales 1972 3.34 $156,606 6.99 1973 3.64 66,154 7.00 1974 3.80 276,496 7.69 1975 4.96 69,182 9.15 1976 4.07 81,551 8.43 1977 3.51 91,771 7.56 1980 Tax Ct. Memo LEXIS 302">*318 The following schedule shows on the basis of the "employee analysis" published by John Deere Company the average salary paid to managerial personnel, the average number of such personnel reported per dealership, the number of dealers reporting in each category, and the average hours worked per week for John Deere agricultural dealers located in Zone 11 which had total sales of $1,367,000 or above for the calendar year 1974, total sales of $1,871,000 or above for 1975, total sales of $2,358,600 or above for 1976, and total sales of $2,568,800 or above for 1977:
No. Per Calendar Dealership Year Position Reporting 1974 Owners/General Manager 1 Sales Manager 1 Parts Manager 1 Service Manager 1 1975 Owners/General Manager 1.7 Sales Manager 1.2 Parts Manager 1.2 Service Manager 1.1 1976 Owners/General Manager 1.47 Sales Manager 1 Parts Manager 1.20 Service Manager 1.07 1977 Owners/General Manager 1.24 Sales Manager 1 Parts Manager 1.13 Service Manager 1.06 No. of Dealers Reporting Average Hours Calendar in Each Average Worked Year Category Salary Per Week 1974 Not shown $22,636 Not available Not Shown 18,813 Not available Not shown 12,814 Not available Not shown 13,892 Not available 1975 48 25,505 46 17 21,578 45 44 14,117 44 48 14,791 44 1976 72 40,122 44 25 27,760 44 53 14,232 44 49 16,044 43 1977 38 41,476 44 22 32,557 45 38 17,301 44 35 18,012 43 1980 Tax Ct. Memo LEXIS 302">*319 The following schedule shows on the basis of the "employee analysis" published by John Deere Company the average salary paid to managerial personnel, the average number of such personnel reported per dealership, the number of dealers reporting in each category, and the average hours worked per week for North American John Deere industrial dealers which had total sales of $1,317,000 or below for the calendar year 1973, total sales of $2,196,000 or above for the calendar year 1974, total sales of $1,107,000 or below for the calendar year 1975, total sales of $1,377,700 or below for the calendar year 1976, and total sales of $1,652,700 or below for the calendar year 1977:
1980 Tax Ct. Memo LEXIS 302">*320No. Per Calendar Dealership Year Position Reporting 1973 Owners/General Manager Not available Sales Manager Not available Parts Manager Not available Service Manager Not available 1974 Owners/General Manager 1 Sales Manager None reported Parts Manager 1 Service Manager 1 1975 Owners/General Manager 1.3 Sales Manager 1.1 Parts Manager 1.0 Service Manager 1.3 1976 Owners/General Manager 1.3 Sales Manager 1 Parts Manager 1 Service Manager 1.2 1977 Owners/General Manager 1.2 Sales Manager 1.1 Parts Manager 1 Service Manager 1.2 No. of Dealers Reporting Average Hours Calendar in Each Average Worked Year Category Salary Per Week 1973 Not shown $16,175 Not available Not shown 16,526 Not available Not shown 9,559 Not available Not shown 10,440 Not available 1974 Not shown 23,384 Not available Not shown None None reported reported Not shown 13,371 Not available Not shown 15,799 Not available 1975 63 19,099 46 9 15,112 43 29 11,433 45 43 11,908 45 1976 89 22,061 44 16 17,334 44 42 12,607 44 54 20,886 45 1977 78 24,940 49 17 20,088 51 35 16,980 45 57 25,441 44 The statistics compiled by John Deere Company as its "operation analysis" show the following average return on equity (based on pre-tax income) for John Deere agricultural dealers located in Zone 11 in the same sales volume classification as petitioner, and for John Deere industrial dealers in the same sales volume classification as petitioner:
Percent of Percent of Calendar Average Return Average Return Year For Agricultural For Industrial 1967 28.61 1968 18.79 1969 13.10 1970 13.32 1971 19.71 1972 19.36 41.31 1973 31.53 29.56 1974 50.51 24.66 1975 48.77 5.20 1976 38.90 13.60 1977 36.10 16.00 1980 Tax Ct. Memo LEXIS 302">*321 The average net profits before taxes for John Deere dealers with sales comparable to petitioner's for the calendar years 1974 and 1975 and petitioner's total net profits before taxes (not segregated between agricultural and industrial operations) for its fiscal years 1975 and 1976 were as follows:
John Deere Dealers Calendar Average Net Profits Year Agri. Indus. Total 1974 $198,159 $192,956 $391,115 1975 258,592 8,076 266,668 Fiscal Year Petitioner's Calendar Ending Total Year Feb. 28 Net Profits 1974 1975 $157,074 1975 1976 169,663 Petitioner on its Federal income tax returns for its fiscal years ending February 28, 1975, and February 28, 1976, deducted $181,073.71 and $193,662.71, respectively, as compensation of officer, representing payments by petitioner to Mr. Elliott in each of these years. Respondent in his notice of deficiency disallowed $116,073.71 and $128,662.91 of the claimed deductions for compensation of officer for petitioner's fiscal years ending February 28, 1975, and February 28, 1976, respectively, with the following explanation:
It is determined that compensation paid to Edward1980 Tax Ct. Memo LEXIS 302">*322 G. Elliott during the taxable years ended 2/28/75 and 2/28/76 is excessive in the amounts of $116,073.71 and $128,662.91, respectively. Such amounts exceed a reasonable allowance for salaries and other compensation for personal services rendered within the ambit of
section 162 of the Internal Revenue Code . Compensation has been allowed in the amount of $65,000.00 for each year.OPINION
Section 162, I.R.C. 1954 ,1980 Tax Ct. Memo LEXIS 302">*323 It is petitioner's position that the entire amounts paid to Mr. Elliott represent reasonable compensation for personal services actually rendered by Mr. Elliott to petitioner. Petitioner contends that because it had a predetermined formula which had been in use since its incorporation for the bonus paid to Mr. Elliott, the amounts paid in the years here in issue, though high, were reasonable. Petitioner argues that its formula of paying Mr. Elliott 50 percent of the net profits of petitioner before deductions for income taxes and management bonuses was a reasonable formula for determining Mr. Elliott's compensation and did not represent a disguised distribution of profits. Petitioner further argues that in some prior years Mr. Elliott's salary had been too low for the services he rendered to petitioner and for this reason the higher salaries in the years here in issue resulted in average reasonable compensation during the 10-year period covering petitioner's fiscal years 1968 through 1978. Petitioner contends that the stipulated evidence of the amounts paid by other John Deere dealers to officers when compared to the average sales of such businesses supports its position that1980 Tax Ct. Memo LEXIS 302">*324 Mr. Elliott's salary was reasonable.
Respondent takes the position that, since Mr. Elliott was the sole shareholder of petitioner, any agreement between Mr. Elliott and petitioner concerning Mr. Elliott's receiving a percentage of petitioner's profits as a bonus was not an arm's-length agreement and therefore should be given no weight in determining the reasonableness of the amounts paid to Mr. Elliott. Respondent further argues that the arrangement between petitioner and Mr. Elliott, considered in light of the fact that petitioner had not paid a dividend to Mr. Elliott, its sole shareholder, during its entire history is strong evidence that a part of the profits of petitioner paid to Mr. Elliott in the guise of compensation was in reality a dividend to Mr. Elliott. Relying on
Charles McCandless Tile Service v. United States, 191 Ct. Cl. 108">191 Ct. Cl. 108It is well settled that whether compensation paid by a taxpayer to an officer or employee is deductible as reasonable compensation for the services rendered is a question of fact to be determined from all the evidence in the case.
Charles Schneider & Co. v. Commissioner, 500 F.2d 148">500 F.2d 148Laure v. Commissioner, 70 T.C. 1087">70 T.C. 1087Some of the factors to be considered in making the determination of whether amounts paid to an officerstockholder represent reasonable compensation for services rendered are set forth in
section 1.162-7(b), Income Tax Regs. 500 F.2d 148"> , as follows:Charles Schneider & Co. v. Commissioner, supra at 152
1980 Tax Ct. Memo LEXIS 302">*327 Such factors include the employee's qualifications; the nature, extent and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the salary policy of the taxpayer as to all employees; and in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.Mayson Mfg. Co. v. Commissioner, 178 F.2d 115">178 F.2d 115 , 178 F.2d 115">119 (6th Cir. 1949).It is also clear that in determining the reasonableness of the amount paid, the criteria is whether the amount paid to the individual whose compensation is questioned is reasonable and not the overall reasonableness of the total wages paid by the taxpayer.
Commissioner v. R. J. Reynolds Tobacco Company, 260 F.2d 9">260 F.2d 9500 F.2d 148"> Charles Schneider & Co. v. Commissioner, supra ; Pacific Grains, Inc. v. Commissioner, 399 F.2d 603">399 F.2d 603Logan Lumber Co. v. Commissioner, 365 F.2d 846">365 F.2d 846500 F.2d 148"> .Charles Schneider & Co. v. Commissioner ,supra at 153Petitioner in its argument relies primarily on the testimony of an expert witness who gave as his opinion that the amount paid by petitioner to Mr. Elliott1980 Tax Ct. Memo LEXIS 302">*329 in each of the years here in issue was reasonable compensation for the services rendered by Mr. Elliott. This witness stated that the bases of his opinion were (1) the amount of officer's compensation as a percentage of sales paid by other John Deere dealers based on the "operation analysis" published by John Deere Company, (2) the fact that the absolute amount of salary paid by petitioner to Mr. Elliott was less than half the average salary paid to the chief executive officer by 500 leading publicly-held companies in the United States as listed in Forbes Magazine, (3) the relatively low salary paid to Mr. Elliott in some prior years, (4) the fact that Mr. Elliott's bonus had been consistently determined for a number of years, and (5) the absolute amount of Mr. Elliott's salary adjusted for inflation. 1980 Tax Ct. Memo LEXIS 302">*330 the amount of reasonable compensation 1980 Tax Ct. Memo LEXIS 302">*331 arriving at his conclusions. For this reason we give little weight to his opinion.
1980 Tax Ct. Memo LEXIS 302">*332 Considering the evidence here as a whole, we conclude that in fact the system used by petitioner to determine Mr. Elliott's salary was partially, and was intended to be partially, a distribution of profits to Mr. Elliott. As pointed out in
70 T.C. 1087"> , an amount which is in fact a distribution of profit and not intended as compensation for personal services actually rendered is not deductible as compensation even though otherwise compensation might be considered reasonable. In the instant case we have no basis for determining the amount of the payment to Mr. Elliott which was in fact, and was intended to be a distribution of profits as distinguished from compensation.However, on the basis of this record we do not consider the entire amounts paid to Mr. Elliott to be reasonable compensation for the services he rendered to petitioner. Under these circumstances, the best method of determining the amounts paid to Mr. Elliott which were distributions of profits is to determine, on the basis of the other evidence in the record, the amount of1980 Tax Ct. Memo LEXIS 302">*333 reasonable compensation for Mr. Elliott in each of the years here in issue. SeeLaure v. Commissioner ,supra at 1097-1098Commissioner v. R.J. Reynolds Tobacco Company , 260 F.2d 9">260 F.2d 9If there is a reasonable basis in the record for isolating that part of the payment which is reasonable compensation for services, we think that a deduction for that part should be allowed. This is true whether the excess is classified as unreasonable compensation or as dividends.* * *
We have reviewed all the facts in this record with special consideration to the statistics stipulated with respect to salaries paid by other John Deere dealers which had sales comparable to petitioner's. We have used the calendar years 1974 and 1975 as being roughly comparable to petitioner's fiscal years ending February 28, 1975, and February 28, 1976. We have also taken into consideration the number of persons to whom the salaries were paid and the profitability of the operations. We do not consider the amount of salaries paid by 500 unidentified leading publicly-held corporations partially relied on by petitioner's expert witness to be in1980 Tax Ct. Memo LEXIS 302">*334 any way indicative of reasonable compensation for Mr. Elliott.
The record shows that petitioner's profit from agricultural sales for its fiscal year ending February 28, 1975, was phenomenally high as cmpared to other John Deere dealers. However, for its fiscal year 1975 petitioner had a substantial loss on its industrial sales whereas other John Deere dealers had a substantial profit on such sales. Also, we have noted that, compared with other years, all John Deere agricultural dealers in the area in which petitioner operated with sales volume comparable to petitioner's had higher profits than in any other year for which we have statistics, indicating that economic conditions substantially contributed to the profitability of sales of agricultural equipment in that year. We have also noted that the average return of John Deere agricultural dealers in 1975 on sales was substantially higher than petitioner's return on agricultural sales, although in this year petitioner's return on industrial sales was higher than the average return of John Deere dealers on industrial sales.
In our view, the breakdown of statistics between industrial and agricultural sales for a comparison of1980 Tax Ct. Memo LEXIS 302">*335 the reasonableness of the salary petitioner paid to Mr. Elliott has less meaning than it would have if the salary paid to Mr. Elliott had not been allocated on the basis of sales in making the comparison. We are aware that no separate bookkeeping system was maintained to show what portion of Mr. Elliott's compensation was for his work for the part of the business dealing in agricultural equipment and what part was for his work for the part dealing in industrial equipment. However, Mr. Elliott's compensation as computed by petitioner was based on profits and not on sales. Therefore, any comparisons based on sales broken down between the two operations has less meaning than it might have under other circumstances.
While Mr. Elliott's management of petitioner in a manner to return a profit indicates that he was a capable executive, there is nothing in this record to show that he had any special expertise. Compare
70 T.C. 1087"> In fact, this record shows that for the two years here in issue petitioner's operation was overall less profitable than the operations of other John Deere dealers.Laurie v. Commissioner ,supra .However, we do consider the salaries paid by other John Deere dealers1980 Tax Ct. Memo LEXIS 302">*336 to their officers and managers with reference to the volume of sales and profitability of the operation and the number of officers of the business to whom the amounts were paid to be indicative of a reasonable salary for Mr. Elliott. We have examined both the "operation analysis" and the "employee analysis," bearing in mind that the "employee analysis" may well reflect salaries of officers before bonuses.
Based on the record as a whole, and considering (1) the nature of the work done by Mr. Elliott, (2) the hours he worked, (3) the lack of difference in his work in the years here in issue and prior years, (4) the fact that in many instances salaries paid by other John Deere dealers were paid to more than one individual, and (5) the level of salaries paid by petitioner to executive employees other than Mr. Elliott, we conclude that reasonable compensation for Mr. Elliott for petitioner's fiscal years ending February 28, 1975, and February 28, 1976, was $120,000 and $125,000, respectively. We therefore sustain respondent's disallowance of petitioner's claimed deduction for compensation paid to Mr. Elliott which is in excess of these amounts.
Decision will be entered under Rule 1980 Tax Ct. Memo LEXIS 302">*337155 .Footnotes
*. After salary to Mr. Elliott and before State and Federal income taxes.↩
*. Invested capital plus retained earnings.
** Information to allocate is not available and therefore this year is based on total return on total equity for each category.↩
*. This figure is taken from the stipulation although mathematically this figure would come out to 7.18.↩
*. This figure is taken from the stipulation although mathematically this figure would come out to 6.94.↩
1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise stated.↩
2.
Section 1.162-7(b)(1) ,(2) and(3), Income Tax Regs. , provide as follows:SEC. 1.162-7 Compensation for personal services.* * *
(b) The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows:
(1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock. An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business.
(2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.
(3) In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.↩
3. As his analysis of the absolute amounts of compensation paid to Mr. Elliott based on adjustments for inflation, the witness relied on the following stipulated fact:
Fiscal Compensation Federal Year Paid to Income Ending Edward Elliott Taxes * Net 1968 $ 42,800 $ 9,844 $ 32,956 1969 19,600 3,136 16,464 1970 34,035 5,446 28,589 1971 84,450 23,646 60,804 1972 68,323 19,130 49,193 1973 66,401 22,576 43,825 1974 136,536 54,614 81,922 1975 181,074 86,915 9,158 ** 1976 193,663 83,275 110,388 1977 153,696 66,089 87,607 1978 83,052 32,390 50,662 Net Fiscal Consumer Compensation Year Price Index Adjusted for Ending (1967=100.0) Inflation 1968 104.2 $31,628 1969 109.8$14,995 1970 116.3 24,582 1971 121.3 50,127 1972$125.3 39,260 1973 133.1 32,926 1974 147.7 55,465 1975 161.2 58,411 1976 170.5 64,744 1977 185.0 47,355 1978 200.0 25,331 * Based on an average rate for all income for Edward Elliott after taking into account deductions from adjusted gross income.
** This figure is taken from the stipulation although mathematically this figure would come out to 94,159. ↩
4. This witness testified as follows:
Q * * * In arriving at your conclusion in this case, did you take into consideration the fact that in some occasions, the profits of Elliotts, Inc. are lower than the profits of other dealers, average?
A The absolute profits?
Q Yes.
A Yes, I did.Again, my opinion. But in my opinion, the level of absolute profits is a relatively meaningless number. And the reason I say that is because comparing Elliotts' profits to another dealer's profits is like comparing General Motors' profits to John Deere's profits. One has much more capital. One obviously ought to have more profits. And absolute profit, that does not take -- and absolute profit number that doesn't take into consideration the level of capitalization doesn't mean a whole lot. And to make it meaningful, you've got to normalize it using something like earnings per share or return on equity. Those numbers are much more meaningful.↩
Document Info
Docket Number： Docket No. 10576-78.
Citation Numbers： 40 T.C.M. 802, 1980 Tax Ct. Memo LEXIS 302, 1980 T.C. Memo. 282
Filed Date： 7/30/1980
Precedential Status： Non-Precedential
Modified Date： 11/20/2020