Brewer Quality Homes, Inc. v. Commissioner

United States Court of Appeals
Fifth Circuit
FILED
UNITED STATES COURT OF APPEALS December 9, 2004
For the Fifth Circuit
Charles R. Fulbruge III
Clerk
No. 03-61040
BREWER QUALITY HOMES, INC.,
Petitioner-Appellant,
VERSUS
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court
( 1:02-CV-110-Ro )
Before DeMOSS, STEWART, and CLEMENT, Circuit Judges.
PER CURIAM:*
Brewer Quality Homes (“BQH”) was issued a statutory notice of
deficiency by the Internal Revenue Service (“IRS” or
“Commissioner”) for BQH’s corporate income tax returns filed for
fiscal years 1995 and 1996. BQH sought a redetermination of the
deficiencies with the United States Tax Court. The Tax Court found
that BQH was not permitted to deduct certain compensation paid to
Jack Brewer (BQH’s founder, principal officer, and 50% shareholder)
because that compensation was not reasonable in amount, determining
that the excess monies paid Brewer by BQH constituted a disguised
*
Pursuant to 5TH CIR. R. 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this opinion should not be published and is not precedent except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 5TH CIR. R. 47.5.4.
dividend. BQH timely filed the instant appeal.
BACKGROUND AND PROCEDURAL HISTORY
BQH was incorporated in 1977 in Bossier City, Louisiana, as a
retail seller of mobile homes. Jack Brewer (“Mr. Brewer”) and his
wife, Mary, each owned fifty percent of BQH’s stock, which is not
publicly traded. Mr. Brewer started BQH as a sole proprietorship
in 1973, using equity from his home in addition to a bank loan.
BQH has alternated its corporate form several times since its
inception, going from an S Corporation in 1987, to a C Corporation
in 1988. BQH returned to an S Corporation in 1989 through 1993,
when it again reverted to a C Corporation.
During the early 1970s, the 1980s, and the early 1990s, BQH
survived several economic downturns that ultimately caused many
mobile home dealers in BQH’s region of the country to go out of
business. BQH was able to take advantage of the financial distress
experienced by his competitors and purchased many mobile homes from
them at favorable prices. Over the years, BQH was involved in the
retail sales of approximately twenty different brands of mobile
homes, and in 1995 and 1996, the years at issue here, BQH’s
principal product was the Fleetwood Homes line. During the market
year from 1995-1996, BQH was ranked thirty-sixth nationally among
the 1,300 Fleetwood Homes retailers. The following market year,
1996-1997, BQH was ranked first among Fleetwood Homes dealers in
the state of Louisiana and thirteenth nationally. In addition to
the actual sales of mobile homes, BQH began, in the early 1990s,
2
offering its customers financing and insurance, both of which were
underwritten by BQH. BQH, therefore, began realizing profits from
interest on the loans it made and from commissions for the
insurance policies it issued its customers.
While Mr. Brewer was BQH’s only employee in its first year, by
the early 1990s, BQH employed approximately sixteen individuals.
By 1996, BQH had twenty-two employees, seven of whom were in sales.
In 1993, while still an S Corporation, BQH distributed $116,100 to
its only two shareholders (Mr. and Mrs. Brewer). In 1994, BQH,
then a C Corporation, distributed $320,949 to the Brewers. Up to
the end of the 1996 fiscal year, the 1993 and 1994 distributions
were the only ones made by BQH. While BQH did not have an official
or written salary policy or bonus plan, it operated under a general
policy of paying compensation equal to or higher than comparable
companies in its market.1
In 1995 and 1996, BQH paid its employees, other than Mr.
Brewer, annual salaries ranging from $18,000 to $75,407. In 1995,
BQH paid Mr. Brewer an annual salary of $62,186 in addition to
$700,000 paid on December 31, 1995, as a bonus. Similarly, in
1996, BQH paid Mr. Brewer an annual salary of $63,559 and, on
December 31, 1996, paid Mr. Brewer $800,000 as a bonus. Mr.
Brewer’s compensation in 1995 represented 82% of BQH’s taxable
income for that year, while Mr. Brewer’s 1996 compensation
1
BQH also offered its non-shareholder employees with paid
health insurance, sick leave, and vacation leave.
3
accounted for 85% of BQH’s total taxable income for 1996.2 In sum,
BQH paid and deducted total compensation to Mr. Brewer of $762,186
in 1995 and $863,559 in 1996.
The IRS commenced an audit of BQH for fiscal years 1995 and
1996 and, in February 1999, issued BQH a statutory notice of
deficiency in February 1999. The sole issue raised in the notice
was whether the compensation paid by BQH to Mr. Brewer during the
two years in question were fully deductible by BQH. The notice
also contained the IRS’s proposed adjustments to BQH’s corporate
income tax returns. Although the IRS eventually made concessions
by allowing BQH to deduct compensation paid to Mr. Brewer in the
amounts of $604,117 for 1995 and $485,966 for 1996, BQH
nevertheless filed a petition in United States Tax Court, seeking
a redetermination of the deficiencies alleged by the IRS.
The case was tried over the course of three days in June 2000.
A total of four witnesses testified at trial, including Mr. Brewer,
Jack Sledge (Mr. Brewer’s accountant, who was called as an expert
witness), Mae Lon Ding (an expert called by BQH), and Dr. Scott
Hakala (the IRS’s expert witness). Not surprisingly, Sledge and
Ding produced expert reports concluding that Mr. Brewer’s
compensation was reasonable, while Hakala testified that the
amounts paid to Mr. Brewer were excessive. On July 10, 2003, the
2
The taxable income figure used in this example is the amount
of taxable income before the deduction of Mr. Brewer’s claimed
compensation.
4
Tax Court issued a memorandum opinion in which it determined that
BQH could deduct not more than $610,000 as reasonable compensation
for Mr. Brewer for 1995, and not more than $630,000 as reasonable
compensation for 1996. The Tax Court thereafter entered its
decision in accordance with its memorandum opinion and BQH filed
this subsequent appeal.
DISCUSSION
I. Whether the notice of appeal mailed on November 25, 2003, and
filed on December 1, 2003, was timely.
A panel of this Court directed the parties to brief the issue
of whether the notice of appeal was timely. Both parties complied
with this directive and now agree that such notice was filed within
all applicable deadlines. Nevertheless, a brief summary of why the
appeal was timely follows.
Under FED. R. APP. P. 13(a)(1), a notice of appeal from a tax
court is timely if it is filed within ninety days of the decision.
If the notice of appeal is sent by mail, it is considered filed on
the postmark date. FED. R. APP. P. 13(b).3 Here, the Tax Court
entered its decision on August 27, 2003. BQH filed its notice of
appeal by mailing the required notice to the Tax Court Clerk of
Court, properly addressed, in an envelope suitable for mailing, via
3
While the date of the mailing will be normally controlled by
the postmark date, this rule is subject to exceptions found in §
7502 of the Internal Revenue Code. 26 U.S.C. § 7502. Based on a
review of § 7502, however, none of the exceptions have any
applicability in this case.
5
certified mail, return receipt requested, on November 25, 2003 –
exactly ninety days from the date the Tax Court entered its
decision. While the photocopy of the envelope in which the notice
of appeal was mailed apparently did not show a legible postmark,
BQH later provided a photocopy of the certified mail receipt
showing a postmark of November 25, 2003. In light of the
photocopied receipt, it is agreed between the parties that the
notice of appeal was timely filed.
II. Whether the Tax Court clearly erred in finding that the
amounts paid as compensation to BQH’s founder and president
were unreasonable and therefore not entirely deductible under
the Internal Revenue Code.
The Tax Court’s determination of whether compensation paid by
a corporation is reasonable is a question of fact that will not be
reversed unless it is clearly erroneous. Rutter v. Cmm’r, 853 F.2d
1267, 1271-72 (5th Cir. 1988). A finding is “clearly erroneous”
when although there is evidence to support it, the reviewing court
on the entire evidence is left with the definite and firm
conviction that a mistake has been committed. Id. at 1272(quotations and citation omitted). The definition and application
of the appropriate factors the Tax Court considers in making its
determination is reviewed de novo. Id.Section 162(a)(1) of the Internal Revenue Code permits a
corporation to deduct “a reasonable allowance for salaries or other
compensation for personal services actually rendered.” 26 U.S.C. §
162(a)(1). It follows, therefore, that “the test for deductibility
6
in the case of compensation payments is whether they are reasonable
and are in fact payments purely for services.” Treas. Reg. § 1.162-
7(a).4 A deduction for compensation that is, in fact, reasonable
is an amount “as would ordinarily be paid for like services by like
enterprises under like circumstances.” Id. § 1.162-7(b)(3). Here,
there is no dispute that Mr. Brewer actually performed services for
BQH. In fact, there was evidence presented to the Tax Court that
Mr. Brewer has exercised complete control over BQH since it was
founded and has fulfilled many roles within the corporation. The
focus of our inquiry, therefore, is on the reasonableness of the
compensation paid to Mr. Brewer by BQH.
The Tax Court’s reasonableness inquiry is governed by the
nine-factor test set forth in Owensby & Kritikos, Inc. v. Cmm’r,
819 F.2d 1315 (5th Cir. 1987). These 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 gross
income and 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; [and] the
salary policy of the taxpayer as to all employees.
Id. at 1323 (alteration in original).
No single factor is decisive of the question; rather the trial
court must consider and weigh the totality of the facts and
4
The two-part deductibility test is designed generally for
corporations “having few shareholders, practically all of whom draw
salaries.” Treas. Reg. § 1.162-7(b)(1). The close-corporation
structure contemplated by the Treasury Regulations applies to BQH’s
corporate form in the instant case.
7
circumstances in determining reasonable compensation. Id. Also,
the Commissioner’s determination of reasonableness carries a
presumption of correctness, placing the burden on the taxpayer to
establish that he is entitled to a deduction larger than that
allowed by the Commissioner. Id. at 1324.
BQH contends that while the Tax Court properly identified the
nine-factor test adopted by this Court, it nevertheless failed to
provide even a minimal analysis and application of those factors.
BQH specifically argues that although the Tax Court considered ten
“indicia” of reasonable compensation, with five in favor of BQH and
five in favor of the IRS, those “indicia” can only be roughly
related to the nine factors the Tax Court was obligated to
consider. The IRS responds that the Tax Court carefully considered
all the factors discussed in Owensby & Kritikos, and points to the
record as providing the necessary support for each of the Tax
Court’s findings.
As a preliminary matter, it should be noted that while BQH
repeatedly argues throughout its brief that the Tax Court’s
analysis is only “roughly related” to the nine-factor test, it
provides no specific reasons to support this contention. In fact,
BQH only raises arguments as to two of the factors in the nine-
factor inquiry: (1) dividend practices and return on equity; and
(2) the prevailing rates of compensation for comparable positions
8
in comparable concerns.5 Even in the absence of any specific
critique on behalf of BQH, this opinion nevertheless addresses the
analysis and application of the relevant factors employed by the
Tax Court to determine whether its decision was clearly erroneous.
1. Mr. Brewer’s Qualifications
As mentioned previously, it is undisputed between the parties
that Mr. Brewer was qualified for the different positions he held
at BQH. The Tax Court observed this fact as well and determined
that this factor weighed in favor of a relatively high compensation
for Mr. Brewer.
2. Nature, Extent, and Scope of Mr. Brewer’s Work
The Tax Court found that Mr. Brewer worked long hours and that
his hard work was the driving force behind BQH’s success, noting
Mr. Brewer’s ability to fulfill numerous roles, including serving
as BQH’s president, chief financial officer, chief executive
officer, general manager, sales manager, loan officer, credit
manager, purchasing officer, personnel manager, advertising
manager, insurance agent, and real estate manager. The Tax Court
also determined that through Mr. Brewer’s “enthusiasm, hard work,
and dedication, he built [BQH] into a successful enterprise.” As
such, the Tax Court concluded that this factor weighed in favor of
5
BQH appears to want this panel to determine that the Tax
Court did not apply the appropriate factors so that we will conduct
a de novo review of the case, instead of the clearly erroneous
standard that would be applicable if it were concluded that the Tax
Court properly considered all relevant factors.
9
a high compensation for Mr. Brewer. Tempering this finding,
however, this Court has observed that “[n]onetheless, limits to
reasonable compensation exist even for the most valuable
employees.” Rutter, 853 F.2d at 1272.
3. Size and Complexity of BQH
The Tax Court recognized the growth BQH made over the years,
especially noting the substantial success it enjoyed beginning in
the early 1990s. The Tax Court cited BQH’s rise in the national
rankings among Fleetwood Homes retailers as evidence of this fact.
The Tax Court also noted the different aspects of BQH’s operations,
specifically observing BQH’s foray into the financing and insurance
aspects of mobile home sales. In sum, the Tax Court made a
determination that this factor favored a higher compensation for
Mr. Brewer.
4. Comparison of Mr. Brewer’s Salary with Gross & Net Income
The Tax Court found that the claimed compensation BQH paid to
Mr. Brewer in 1995 and 1996 constituted 8.5% and 8.7%,
respectively, of BQH’s gross sales and 82% and 85%, respectively,
of BQH’s taxable income. The Tax Court employed financial ratios
in its various computations from the Robert Morris Associates
(“RMA”) report, a resource for the mobile home industry, which
provides data on, among other things, executive compensation as a
percentage of sales for companies comparable to BQH. The Tax Court
determined that the RMA study of comparable companies revealed a
median value of compensation as a percentage of gross sales as 2.3%
10
for 1995 and 1.8% for 1996. Nevertheless, the Tax Court did not
rely on the median value in reaching its decision, relying instead
on the values accorded to the 90th percentile of officer
compensation payments, a reflection of the Tax Court’s earlier
finding regarding BQH’s financial successes during the years in
question. The Tax Court even accepted BQH’s expert witness’s
suggestion that the percentage of gross sales for 1995 and 1996
were 6.0% and 6.3%, respectively. Nonetheless, the Tax Court
determined that Mr. Brewer’s compensation percentages were
substantially higher than the figures urged by BQH’s expert, thus
leading the Tax Court to conclude that reasonable compensation
would have been significantly less than BQH’s actual payments to
Mr. Brewer.
After making this determination, the Tax Court multiplied
BQH’s sales by the corresponding RMA ratio for each year in
question to arrive at the appropriate compensation amounts for the
services Mr. Brewer performed for BQH: $520,000 in 1995 and
$600,000 in 1996. The Tax Court thereafter added $5000 to the 1995
amount to account for Mr. Brewer’s guaranty of a bank loan to BQH
that year, and added 5% of Mr. Brewer’s newly-calculated
compensation to make up for the absence of retirement benefits.
The total amount of reasonable compensation for Mr. Brewer as
determined by the Tax Court was ultimately $610,0006 for 1995 and
6
The IRS’s expert witness offered a formula and a
corresponding dollar figure that attempted to redetermine Mr.
11
$630,000 for 1996.
5. Prevailing General Economic Conditions
The Tax Court noted in its findings of fact that BQH had
survived several economic downturns, evidencing BQH’s resilience.
The Tax Court specifically recognized Mr. Brewer’s efforts in
ensuring BQH’s ability to survive those conditions, and as such
found this factor favored a relatively high compensation.
6. Comparison of Salaries with Distributions to Stockholders
In 1993, BQH distributed $116,100 to its only two shareholders
(Mr. and Mrs. Brewer). In 1994, BQH distributed $320,949 to the
Brewers. Up to the end of the 1996 fiscal year, the 1993 and 1994
distributions were the only ones made by BQH. The Tax Court was
troubled by the fact that the profitability of BQH was considerably
higher in 1995 and 1996 than previous years, yet BQH did not make
any distributions whatsoever. By paying compensation to Mr. Brewer
in the amounts BQH did in 1995 and 1996, the Tax Court concluded
that this factor weighed heavily in favor of a low compensation for
Mr. Brewer.
7. Compensation for Comparable Positions in Comparable
Concerns
The Tax Court determined that Mr. Brewer received compensation
Brewer’s reasonable compensation. The IRS relied upon this formula
and the Tax Court accepted the recommendation offered by the
expert. It turned out, however, that based on mathematical errors
committed by the expert, the actual compensation figure for 1995
was higher than initially represented. Therefore, the upward
correction was made on favor of BQH, raising the amount deductible
from $550,00 to $610,000.
12
higher than those executives in comparable companies. BQH argues
that the Tax Court failed to consider that Oakwood Homes, a BQH
competitor, would have paid Mr. Brewer over $800,000 per year in
both 1995 and 1996. In support of its argument, BQH cites a
recruiting advertisement issued by Oakwood Homes in which it asks,
“Have you ever wondered what it would be like to work with a
company whose top sales personnel earn more than $100,000 a year,
and whose top sales managers earn more than $800,000?” BQH also
cites a letter written by Thom Cross, a vice-president of Oakwood
Homes, in which Mr. Cross apparently states that Oakwood Homes was
paying people in BQH’s region the salaries quoted above and that
Oakwood Homes would be interested in hiring Mr. Brewer and give him
a compensation package that would allow him to make up to $800,000
per year.
In response, the IRS’s expert witness testified that the
advertisement reflected salaries for what a mobile home
manufacturer or retailer with annual sales of $100 million or more
would pay its most senior and successful sales executives. BQH, by
contrast, had sales during all relevant time periods of between $9
and $10 million. Also, the IRS points to the fact that Mr. Cross
was not called by BQH to testify as to Oakwood Homes’ desire to
hire Mr. Brewer for the amounts stated. Moreover, the IRS suggests
that by not calling Mr. Cross to testify, it is impossible to
determine to what extent the advertisement’s vague language
concerning salary ranges represents “recruiting hyperbole” and to
13
what extent it represents actual compensation.
The Tax Court relied instead upon the RMA data, which
systematically draws from numerous companies across the industry
and permits objective comparisons between executive compensation
and company performance. It is also noteworthy that both parties
relied almost exclusively upon the RMA ratios, but, on appeal, BQH
shifted its focus to address only its argument regarding the
Oakwood Homes advertisement. In sum, the speculative nature of the
Oakwood Homes advertisement cannot replace the RMA formulaic
approach both parties initially adopted and upon which the Tax
Court ultimately relied.
8. Salary Policy of BQH as to All Employees
As discussed previously, BQH did not maintain an official
salary policy for any of its employees, including Mr. Brewer. The
Tax Court expressed concern that because Mr. Brewer essentially
controlled BQH, he was able to set his own compensation. While the
IRS concedes that BQH paid its employees salaries equal to or
greater than those paid by its competitors,7 it argues the wide
disparity between the salary paid Mr. Brewer and the next highest-
paid employee supports a low compensation amount.
Substantial bonuses declared at the end of the year when the
earnings of a business are known usually indicate the existence of
disguised dividends. Owensby & Kritikos, 819 F.2d at 1329 (citation
7
BQH’s highest-paid employees earned salaries in the $70,000
range.
14
omitted). Moreover, this Court has previously determined that,
especially in the context of closely held corporations, “it is in
the tax interest of all parties to characterize the amounts
distributed to shareholders/officers as compensation rather than
dividends.” Rutter, 853 F.2d at 1270. Because the “[d]istribution
of profits through compensation payments to shareholder/officers
avoids the double tax on corporate profits which are distributed to
shareholders as dividends,” the concern arises where corporations
distribute their profits through the payment of unreasonably large
salaries and bonuses to those controlling shareholder/officers. Id.
at 1271. Therefore, it is necessary to “carefully scrutinize the
payments to ensure that they are not disguised dividends.” Owensby
& Kritikos, 819 F.2d at 1324.
In Owensby & Kritikos, the two principal shareholder/officers
“exerted substantial influence over these ‘discretionary bonuses,’”
which the court observed involved amounts of money that “were not
the result of a longstanding compensation formula and could hardly
be considered contingent compensation in the fullest sense of that
term.” 819 F.2d at 1329. Similarly, Mr. Brewer clearly held a
position of unmatched control and influence over the business
decisions at BQH. Furthermore, because BQH admittedly did not have
any type of written compensation policy, it becomes hard to argue,
as BQH does, that the amounts of the bonuses paid Mr. Brewer were
part of a “contingent compensation” arrangement.
9. Amount of Compensation Paid to Mr. Brewer in Previous
15
Years
BQH argued before the Tax Court that it underpaid Mr. Brewer
in previous years, particularly in 1992 and 1993. The Tax Court
rejected this argument, finding persuasive the absence of any
corporate minutes reflecting any mention of BQH’s intention to
compensate Mr. Brewer for past years of undercompensation.
Moreover, the Tax Court noted that neither of BQH’s experts could
provide any credible testimony regarding the alleged underpayments
or the specific years in which they occurred, stating that BQH’s
“theory of compensation for prior services [appeared to be] only an
afterthought developed at a time when the reasonableness of the
compensation was already under attack.”
Admittedly, the Tax Court does not perform its reasonable
compensation analysis in a factor-by-factor manner much like the
court in Owensby & Kritikos did. On the other hand, the fact-
finding done by the Tax Court fleshes out many of the relevant
items that support its ultimate redetermination of reasonable
compensation for Mr. Brewer. A similar type of situation existed
in Rutter, where the taxpayer argued that the tax court did not
specifically apply each of the nine factors identified in Owensby
& Kritikos. Rutter, 853 F.2d at 1271. Instead, the taxpayer
argued, the tax court relied solely on the reports and testimony of
expert witnesses regarding only one factor — the prevailing rates
of compensation for comparable positions in comparable concerns —
and did not consider or weigh any of the other eight factors in
16
reaching its decision. Id. This Court observed that the tax
court’s opinion reflected its awareness of the relevant factors and
that the tax court made findings of fact as to each of them, some
of which were considered extensive. Id. at 1272.
Here, the Tax Court cited Owensby & Kritikos nine times
throughout its analysis, suggesting both that it was fully aware of
the relevant precedent and that it considered the necessary factors
in arriving at its conclusion.8 As discussed above, the Tax Court
also made extensive findings of fact relating to all nine factors.
Nevertheless, Rutter held that it was not clearly erroneous for a
court to consider some of the factors “without an extensive
detailed written analysis.” 853 F.2d at 1272. The Tax Court here
has engaged in a thoughtful, well-reasoned analysis that
incorporated, inter alia, the testimony and written reports
provided by the various experts, while commenting on all the
relevant facts necessary to make a reasonable compensation
determination.
CONCLUSION
We conclude that the notice of appeal mailed by BQH on
November 25, 2003, and filed on December 1, 2003, was timely.
Further, we conclude that the Tax Court properly identified the
appropriate standard for determining whether compensation paid an
8
In fact, the Tax Court specifically states: “In determining
the maximum reasonable compensation for [Mr. Brewer]’s services for
the years in issue, we have considered the relevant factors listed
in Owensby & Kritikos, Inc. v. Commissioner.”
17
employee was reasonable. Thus, under the clearly erroneous
standard, the Tax Court’s decision in redetermining Mr. Brewer’s
reasonable compensation was proper. Nevertheless, even if we were
to conclude that the Tax Court did not properly apply the relevant
standard to the facts here, under a de novo review, the Tax Court’s
decision comports with the stated purposes in the relevant Treasury
Regulations, the Internal Revenue Code, and this Circuit’s
precedent. We therefore AFFIRM the decision of the Tax Court for
the reasons cited in its memorandum opinion.
AFFIRMED.
18