DocketNumber： No. 2526-98
Filed Date： 3/27/2000
Status： Non-Precedential
Modified Date： 4/18/2021
2000 Tax Ct. Memo LEXIS 116">*116 Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, JUDGE: Respondent determined deficiencies in petitioner's Federal income tax and a penalty under
Penalty
Year Deficiency
____ __________ _________
1993 $ 130,822 $ 26,164
1994 135,336 27,067
1995 120,550 24,110
In an amendment to answer filed January 7, 1999, respondent contends that petitioner's deficiencies are $ 163,173 for 1993, $ 155,139 for 1994, and $ 141,328 for 1995, and that petitioner is liable for penalties of $ 32,635 for 1993, $ 31,028 for 1994, and $ 28,266 for 1995. 2000 Tax Ct. Memo LEXIS 116">*117 After concessions, the issues for decision are:
1. Whether petitioner may deduct as compensation for Isidore Klein and Steven Klein for 1993, 1994, and 1995, the amounts shown below as the parties contend, or some other amount:
Year Isidore Klein Steven Klein Total
____ _____________ ____________ _____
Petitioner
__________
1993 $ 352,000 $ 500,400 $ 852,400
1994 368,000 450,400 818,400
Year Isidore Klein Steven Klein Total
____ _____________ ____________ _____
1993 $ 200,000 $ 300,000 $ 500,000
1994 200,000 300,000 500,000
1995 5,000 440,000 445,000
2. Whether petitioner is liable for the accuracy-related penalty under
Section references are to the Internal Revenue Code in effect during the years in issue. Rule references are to the Tax Court Rules of Practice and Procedure.
Some of the facts have been stipulated and are so found.
Petitioner is a corporation the principal office of which was in Port Washington, New York, when it filed the petition.
Isidore Klein was born in 1913. He is married to Gertrude Klein. 2000 Tax Ct. Memo LEXIS 116">*119 He was a baker and taught baking at a vocational high school in New York. He also manufactured small metal products that he used in his baking business.
Steven Klein was born in 1942. He is the son of Isidore and Gertrude Klein.
Petitioner manufactures and sells small implements and metal food handling equipment primarily for the bakery industry. Isidore Klein and Victor Lampeh (Lampeh) incorporated petitioner in 1949 in New York, after Isidore Klein developed white lung disease (similar to emphysema) and had to retire from baking. Isidore Klein initially invested only $ 119 in petitioner.
Petitioner issued 4 shares of common stock in 1949. In 1954, Lampeh left the company. From March 1954 to January 1995, Isidore Klein owned 3 shares and Gertrude Klein owned 1 share of petitioner's stock. Before and during the years in issue (until January 1995), the members of petitioner's board of directors were Isidore and Gertrude Klein, and Isidore Klein was chairman of the board of directors.
1. ISIDORE KLEIN
Isidore Klein created, developed, and built petitioner into a profitable business. 2000 Tax Ct. Memo LEXIS 116">*120 His background in the baking industry helped him to understand what bakers needed and to develop products to meet those needs. Isidore Klein worked 12 to 18 hours a day, 6 days a week. He manufactured baking implements during the day and often sold his products to bakers at night while they worked.
Petitioner grew during the 1950's because Isidore Klein invented and manufactured several successful products. For example, he invented a hanging cord dispenser, aluminum anodized cookie display trays in different colors, a line of plastic window display stands, and a motorized carousel tray. Petitioner began producing racks, cabinets, and covers in the 1960's. Isidore Klein continued to invent products in the 1960's and 1970's that petitioner manufactured and sold.
Isidore Klein designed most of the products in petitioner's catalog. He developed many products that became widely accepted in the baking industry in the New York metropolitan area. Baker's Aid, a national seller of baking equipment with annual sales of about $ 40 million during the years in issue, has been an important customer of petitioner's since the 1950's. Baker's Aid became petitioner's biggest customer largely due to2000 Tax Ct. Memo LEXIS 116">*121 Isidore Klein's innovative products.
2. STEVEN KLEIN
Steven Klein worked for petitioner part time and during the summer beginning in the late 1950's when he was in high school. He began working full time for petitioner in September 1963, after he had finished 2 years of college. From 1963 to 1980, he performed most of the jobs in petitioner's business. For example, he worked in the factory, welded, made purchases, and prepared sketches for special orders.
D. PETITIONER'S MOVE TO PORT WASHINGTON AND THE 1984 GUARANTY AGREEMENT
On November 1, 1984, petitioner guaranteed a $ 995,000 industrial development loan to Steven Klein to buy a building in Port Washington to house petitioner. Petitioner moved from New York to Port Washington in 1984. Petitioner's Port Washington building has an office and a factory. Petitioner rented the building from Steven Klein for 15 years under a triple net lease. Under the 1984 guaranty, petitioner promised not to pay cash dividends or to redeem shares of stock for cash except for stock owned by Isidore Klein. However, the bank waived the covenant and consented to petitioner's redemption of Gertrude Klein's stock for cash in 1995.
E. ISIDORE AND STEVEN2000 Tax Ct. Memo LEXIS 116">*122 KLEIN'S WORK FOR PETITIONER FROM 1980 THROUGH THE YEARS IN ISSUE
As discussed next, from 1980 to 1994, Isidore Klein was semiretired, and Steven Klein ran petitioner, subject to Isidore Klein's overall approval.
1. ISIDORE KLEIN
Isidore and Gertrude Klein have lived in Florida since 1980. Isidore Klein had the title of chief executive officer and president of petitioner until he sold his stock in January 1995. Isidore Klein oversaw petitioner's operations in 1993 and 1994. He called Steven Klein at least twice a week in 1993 and 1994 to discuss the business, to monitor the cost of raw materials, labor, and office personnel, and to approve Steven Klein's major business decisions. Steven Klein and Isidore Klein often disagreed about how Steven Klein should run petitioner, which caused a strain in their relationship.
In 1993 and 1994, petitioner's comptroller, Jeffrey Schwaeber, or petitioner's bookkeeper, Karen Macken, sent Isidore Klein weekly financial reports about petitioner. During those years, Isidore Klein called Jeffrey Schwaeber to ask questions about the weekly financial reports. Isidore Klein also corresponded with Richard Schwaeber, petitioner's accountant, in 19932000 Tax Ct. Memo LEXIS 116">*123 and 1994 to monitor petitioner's financial position.
Isidore Klein visited petitioner's facility four to eight times a year in 1993 and 1994. He stayed at least a week each time he visited petitioner. In 1993 and 1994, Isidore Klein did not supervise petitioner's salespeople, warehouses, or day-to-day operations. However, Isidore Klein occasionally provided product support to, or consulted on technical or design questions with, Baker's Aid during those years. He also attended trade shows to look for ideas for new products petitioner could manufacture.
In 1993 and 1994, Isidore Klein designed a portable housing system for use by the military or as emergency housing. He attempted unsuccessfully in 1993 and 1994 to market the housing system to the U.S. military. Petitioner did not pursue the portable housing system after 1994.
2. STEVEN KLEIN
Steven Klein was petitioner's vice president and chief operating officer from 1991 to 1994. Steven Klein reported to his father during those years. He was responsible for petitioner's day- to-day management, which he found to be difficult because he was under the constant scrutiny of his father. He managed petitioner's office staff of four people, 2000 Tax Ct. Memo LEXIS 116">*124 designed petitioner's marketing catalogues, handled special orders for customers, and designed custom-made items for customers. He managed petitioner's sales activities and was the primary contact for petitioner's biggest customer, Baker's Aid, in 1993, 1994, and 1995. Baker's Aid accounted for about one- third of petitioner's sales in those years. Steven Klein was very familiar with petitioner's customers and operations and had good technical knowledge of its products. In 1993 and 1994, Steven Klein worked long hours. Steven Klein became president and chief executive officer (CEO) in January 1995, when Isidore and Gertrude Klein sold their stock in petitioner. In 1995, Steven Klein assumed more responsibility for petitioner. He often received business telephone calls at home during 1993, 1994, and 1995.
3. PETITIONER'S REDEMPTION OF GERTRUDE AND ISIDORE KLEIN'S STOCK AND STEVEN KLEIN'S PURCHASE OF PETITIONER
Around 1988, Steven Klein proposed buying Isidore and Gertrude Klein's stock in petitioner because he wanted to control petitioner and to ensure that he and his children would own the business. Steven Klein negotiated intermittently with Isidore Klein from 1988 to 19942000 Tax Ct. Memo LEXIS 116">*125 to buy the stock. Isidore Klein initially asked Steven Klein to pay $ 3 million for the stock.
On January 30, 1995, petitioner redeemed its stock owned by Gertrude Klein for $ 468,528 and by Isidore Klein for $ 1,405,584, for a total of $ 1,874,112. Petitioner paid Isidore Klein $ 31,472, and gave him a $ 1,374,112 note bearing interest at 8 percent for the balance. Also on that day, petitioner issued 100 shares of its stock to Steven Klein for $ 1,376. Since then, Steven Klein has owned all of petitioner's stock. Petitioner's net worth declined from $ 2,001,654 in 1994 to $ 194,130 in 1995 after the redemption.
1. PETITIONER'S EMPLOYEES
Petitioner had three employees during the 1950's: Isidore Klein and two other people. By 1963, petitioner had nine employees: Steven Klein and three others in the office, and five employees in the factory. By 1993, 1994, and 1995 petitioner had about 13 or 14 employees.
In 1994 and 1995, petitioner had four employees in the office: Steven Klein, Jeffrey Schwaeber, Karin Paterson (Paterson), and Karen Macken (Macken). Jeffrey Schwaeber has an accounting degree and worked at his father's accounting2000 Tax Ct. Memo LEXIS 116">*126 firm from June 1981 to September 1991. His father is Richard Schwaeber, who was petitioner's accountant from 1972 through the years at issue, except for a short time in the late 1970's. Jeffrey Schwaeber worked for petitioner from 1991 to 1997. He was petitioner's vice president for operations, comptroller, and purchasing agent. He set priorities for jobs to be performed in the factory and supervised petitioner's bookkeeper. He signed some of petitioner's quarterly Federal income tax returns and information statements.
Macken was petitioner's bookkeeper from May 1993 through 1995. Paterson worked at petitioner from April 1994 until the end of 1995. Her work included answering phones, taking orders, and printing and mailing invoices.
In 1993, 1994, and 1995, Reinaldo (Ray) Cruz was petitioner's factory foreman, and Felix Ortega received incoming raw material and shipped finished products. Ray Cruz began working for petitioner in 1973, and Felix Ortega in 1985.
2. COMPENSATION PAID BY PETITIONER
a. ISIDORE KLEIN
From 1980 through 1994, Isidore Klein set his own salary based on a percentage of petitioner's gross sales. In 1980, the board of directors (i.e., Isidore and Gertrude Klein) 2000 Tax Ct. Memo LEXIS 116">*127 agreed that petitioner would pay Isidore Klein a salary of 8 percent of gross sales but would not reimburse him for his expenses. In 1993 and 1994, Isidore Klein set his salary at 10 percent of petitioner's gross sales. In 1993 and 1994, petitioner paid Isidore Klein $ 1,000 per week plus $ 70,000, $ 80,000, and $ 80,000, respectively, for the first three quarters, and payments just before yearend of $ 70,000 in 1993 and $ 86,000 in 1994. Petitioner made these quarterly payments after Richard Schwaeber had prepared petitioner's quarterly financial statements.
Petitioner compensated Isidore Klein from 1986 to 1995 as follows:
Percentage of
Year Amount gross sales
____ ______ ___________
1986 $ 226,752 8.0%
1987 238,298 8.0
1988 405,400 12.4
1989 426,068 12.6
1990 304,100 8.3
1991 251,100 7.7
1992 2000 Tax Ct. Memo LEXIS 116">*128 367,400 10.2
1993 352,000 9.9
1994 368,000 10.0
1995 5,000 --
b. STEVEN KLEIN
From sometime in the 1980's until January 1995, Steven Klein and Isidore Klein disagreed about how much petitioner would pay Steven Klein, but Isidore Klein ultimately paid Steven Klein what he requested. Steven Klein set his own pay in 1995. Petitioner compensated Steven Klein from 1991 to 1995 as follows:
Year Amount
____ ______
1991 $ 393,800
1992 476,800
1993 500,400
1994 450,400
1995 820,400
In 1995, petitioner paid Steven Klein: $ 7,700 per week, $ 220,000 on December 26, 1995, and $ 200,000 on December 28, 1995.
Steven Klein discussed with Richard Schwaeber how much petitioner could reasonably pay him in 1995. Richard Schwaeber2000 Tax Ct. Memo LEXIS 116">*129 advised him around the time petitioner redeemed Isidore Klein's stock in January 1995 that, since he was taking on the responsibilities of two jobs (his and Isidore Klein's), a salary of about $ 800,000 in 1995 would be reasonable.
c. OTHER EMPLOYEES
Petitioner paid Jeffrey Schwaeber $ 164,900 in 1992, $ 173,500 in 1993, $ 146,900 in 1994, and $ 148,500 in 1995. In 1993, 1994, and 1995, petitioner had sales representatives to sell its products. Petitioner paid its sales representatives commissions of 5 percent.
In 1980, petitioner's board of directors (i.e., Isidore and Gertrude Klein) authorized Isidore Klein to conduct business on its behalf in Florida. From 1990 to 1996, Howard Appell (Appell) was petitioner's exclusive sales representative in Florida. In 1993, Appell talked to Jeffrey Schwaeber three to five times a week. Appell dealt with Steven Klein several times in 1993, 1994, and 1995, but not with Isidore Klein.
1. PETITIONER'S SALES AND TAXABLE INCOME
Petitioner's sales increased in nominal dollars from 1983 to 1995. Petitioner's net income before taxes declined sharply as follows:
Net income
2000 Tax Ct. Memo LEXIS 116">*130 before officers'
compensation Net income
Year Sales and taxes before taxes
____ _____ _______________ ____________
1983 $ 2,723,342 446,738
1985 2,988,876
1986 2,856,060
1987 2,982,447
1988 3,280,793 $ 526,466 121,066
1989 3,379,488 547,980 121,912
1990 3,648,605 643,168 339,068
1991 3,247,094 741,359 96,459
1992 3,617,493 916,256 72,056
1993 3,549,669 920,277 67,877
1994 3,687,715 878,621 60,221
1995 4,057,464 914,715 89,315
2000 Tax Ct. Memo LEXIS 116">*131 In 1995, $ 4,057,464 equaled $ 2,649,524 in 1983 dollars. See Statistical Abstract of the United States 1998, at 487 (chart 771). Thus, petitioner's sales did not increase from 1983 to 1995 in real dollars.
Petitioner's annual and cumulative retained earnings were as follows:
Year Annual Cumulative
____ ______ __________
1983 $ 157,853 $ 677,686
1984 227,686 905,372
1985 180,807 1,086,179
1986 169,566 1,255,745
1987 145,848 1,401,593
1988 87,068 1,488,661
1989 84,567 1,573,227
1990 205,415 1,778,642
1991 69,412 1,848,054
1992 55,353 1,903,407
1993 51,889 1,955,296
1994 46,2392000 Tax Ct. Memo LEXIS 116">*132 2,001,535
1995 65,212 2,066,747
Petitioner has never paid dividends.
Petitioner's return on the fair market value of its operating assets was 0.97 percent in 1993, 0.70 percent in 1994, and 5.26 percent in 1995.
2. PETITIONER'S FEDERAL INCOME TAX RETURNS
Richard Schwaeber prepared and signed petitioner's tax returns from 1988 through the years at issue. Petitioner attached Schedules E, Compensation of Officers, to its 1993, 1994, and 1995 returns. However, petitioner did not report the percentage of time that its officers devoted to the business.
A taxpayer may deduct payments for compensation if the amount paid is reasonable in amount and for services actually rendered. See
Petitioner paid Isidore Klein $ 352,000 in 1993 and $ 368,000 in 1994, and paid Steven Klein $ 500,400 in 1993, $ 450,400 in 1994, 2000 Tax Ct. Memo LEXIS 116">*133 and $ 820,400 in 1995. Petitioner contends that those amounts were reasonable and were for services they provided to petitioner. Respondent contends that compensation petitioner paid in excess of $ 405,250 for 1993, $ 392,157 for 1994, and $ 451,284 for 1995 was unreasonable, was disguised dividends, and was not for services to petitioner.
In
Both parties called experts to testify about whether the amount of compensation paid to the Kleins was reasonable. Petitioner's expert was Paul Dorf (Dorf), and respondent's expert was Scott D. Hakala (Hakala).
We next apply the factors listed above in deciding whether the amount of compensation petitioner paid to the Kleins was reasonable.
1. THE EMPLOYEE'S ROLE IN THE COMPANY: THE EMPLOYEE'S
POSITION, HOURS WORKED, AND DUTIES PERFORMED, PLUS ANY
SPECIAL DUTIES OR ROLE
From the perspective of an independent investor, we consider whether the employee's role in the taxpaying company, including the employee's position, hours worked, and duties performed, plus any special duties or role (such as personally guaranteeing corporate loans), justify the compensation paid. See
a. ISIDORE KLEIN'S ROLE
Isidore Klein founded petitioner, built it into a profitable business, and was a prolific inventor. However, 2000 Tax Ct. Memo LEXIS 116">*135 Isidore Klein was less actively involved in petitioner's operations in 1993 and 1994 than he had been in earlier years. Isidore Klein had no dealings with petitioner's exclusive sales representative in Florida in 1993 and 1994. Isidore Klein did not manage petitioner day to day after 1980 as he had before he moved to Florida. Isidore Klein spoke frequently on the phone to Steven Klein and approved the major decisions, but day-to-day responsibility had shifted to Steven Klein. We think an independent investor would have objected to an increase in Isidore Klein's salary from 8 percent of gross sales in 1992 to 10 percent of gross sales in 1993 and 1994.
Petitioner contends that part of Isidore Klein's compensation in 1993 and 1994 was catchup pay for years in which he was underpaid. We disagree. Petitioner relies on Dorf's testimony that Isidore Klein's salary in 1993 and 1994 was reasonable because Isidore Klein was somewhat underpaid in earlier years and had no long-term financial incentives and benefits. Dorf's conclusion that Isidore Klein was underpaid in earlier years is unconvincing because he disregarded large bonuses that petitioner paid Isidore Klein in 1984, 1988, and 1989. 2000 Tax Ct. Memo LEXIS 116">*136 Dorf's testimony does not establish and there is no evidence that petitioner intended any of Isidore Klein's pay in 1993 and 1994 to be catchup pay. See
Petitioner points out that Isidore Klein was trying to develop a portable housing system in 1993 and 1994 and contends that it could have increased petitioner's annual revenue from $ 4 million to $ 50 million. However, there is no credible evidence that the portable housing system could have generated $ 50 million of revenue. The fact that Steven Klein abandoned work on the portable housing system as soon as he became owner of petitioner in 1995 suggests that it did not have the profit potential petitioner2000 Tax Ct. Memo LEXIS 116">*137 now claims.
b. STEVEN KLEIN'S ROLE
Petitioner contends that the amount of compensation it paid to Steven Klein during the years in issue was reasonable because of his superior skills and because he was the driving force behind petitioner and solely responsible for its success in 1995. We disagree in part.
Steven Klein ran petitioner with at best moderate success as evidenced by petitioner's modest increase in the real value of sales, below average performance after officers' compensation (according to Hakala), and sharp decrease in profits from 1983 to 1995. We agree with Hakala that these results would not satisfy an independent investor.
We also disagree that Steven Klein's added duties or longer hours in 1995 merit the large raise in his salary in 1995. We do not believe that an independent investor would have been satisfied with Steven Klein's operation of petitioner in light of Steven Klein's assessment that petitioner was not very valuable and that petitioner might not survive the loss of Isidore Klein in 1995. Richard Schwaeber testified that petitioner had a cash- flow problem and that its net worth essentially "disappeared" when it redeemed Isidore Klein's stock in 1995. 2000 Tax Ct. Memo LEXIS 116">*138 We do not believe that an independent investor would have approved doubling Steven Klein's salary in 1995.
Citing
c. PETITIONER'S OTHER CONTENTIONS
Petitioner argues that the compensation paid to Isidore and Steven Klein is justified by the fact that they both guaranteed the 1984 industrial development bond and remained liable on it in 1993 and 1994. We disagree. First, Steven Klein, not petitioner, held title to the building purchased with the proceeds of the industrial development bond. Second, there is nothing about the financing of petitioner's building to justify higher compensation for Steven or Isidore Klein in 1993 and 1994.
Petitioner contends that we should treat it as a personal service company because its success depends on the skill and efforts of its officers, Isidore and Steven Klein, rather than on capital. Petitioner contends that courts are more deferential in deciding whether payments for services to officers of personal service companies are reasonable, citing
This factor favors respondent.
2. POTENTIAL CONFLICTS OF INTEREST: ABILITY TO DISGUISE
DIVIDENDS AS SALARY, PARTICULARLY IF THE EMPLOYEE IS
THE SOLE OR MAJORITY SHAREHOLDER, OR IF A LARGE
PERCENTAGE OF THE COMPENSATION IS PAID AS A BONUS
The ability to disguise dividends as salary, particularly if the employee is the sole or majority shareholder, or if a large percentage of the compensation is paid as a bonus, may suggest that compensation is not reasonable. See
a. ABILITY TO DISGUISE DIVIDENDS PAID TO ISIDORE KLEIN AS COMPENSATION
Isidore Klein set his own salary in 1993 and 1994. Isidore Klein and petitioner did not deal at arm's length in those years because he was the controlling shareholder and chairman of the board of directors. See
b. ABILITY TO DISGUISE DIVIDENDS PAID TO STEVEN KLEIN AS COMPENSATION
Petitioner contends that Steven Klein's salary was reasonable in amount in 1993 and 1994 because he had an arm's- length relationship with his father, Isidore Klein, in those years.
We closely scrutinize intrafamily transactions. See
c. YEAREND BONUSES
The large yearend payments to Isidore and Steven Klein suggest that part of their compensation was disguised dividends. See
The payments to Isidore and Steven Klein left petitioner with a nominal amount of operating profits in 1993 and 1994. Petitioner paid Isidore and Steven Klein 93 percent of its taxable income before officers' compensation in 1993 and 1994, and Steven Klein 90 percent of its taxable income before officers' compensation in 1995. Paying most of petitioner's taxable income as compensation to its officers2000 Tax Ct. Memo LEXIS 116">*144 suggests that its distributions to Isidore and Steven Klein were in part disguised dividends. See
Petitioner contends that petitioner did not pay Steven Klein bonuses in 1995; petitioner contends that the amount of the yearend payments to Steven Klein were determined shortly after the redemption of Isidore Klein's stock in consultation with the outside accountants and that petitioner did not pay it until yearend to protect its cash-flow. We disagree. Unlike the payments to Isidore Klein, petitioner did not compensate Steven Klein based on a compensation formula. Steven Klein owned all of petitioner's stock in 1995 and set his own compensation that year. The large yearend payments to Steven Klein in 1995 suggest that part of his payments were disguised dividends.
We believe that an independent investor would not have been satisfied with the large amount petitioner paid to Steven Klein the last week of 1995 since2000 Tax Ct. Memo LEXIS 116">*145 it appears that profits were being "siphoned out of the company disguised as salary." See
This factor favors respondent.
3. INTERNAL CONSISTENCY IN COMPENSATION: CONSISTENCY OF THE COMPENSATION SYSTEM THROUGHOUT THE COMPANY
Inconsistency of the compensation system throughout the ranks of the company may suggest that the employee's compensation is not reasonable. See
Isidore and Steven Klein paid themselves and Jeffrey Schwaeber generously.
Petitioner contends that it paid all of its employees at or above market rate salaries. We disagree. Petitioner presented no persuasive evidence that it paid all of its employees at or above market rate salaries. On brief, petitioner concedes that it did not have a bonus program during the years in issue. There is no evidence that any of petitioner's employees other than Isidore and Steven2000 Tax Ct. Memo LEXIS 116">*146 Klein shared in the large distribution of profits petitioner made at yearend in 1993, 1994, and 1995. Cf.
4. CHARACTER AND CONDITION OF THE COMPANY: INCLUDING
SALES, NET INCOME, CAPITAL VALUE, AND GENERAL ECONOMIC
FITNESS OF THE COMPANY
From the perspective of an independent investor, the character and condition of the company, including its sales, net income, capital value, and general economic fitness are important in deciding how much compensation to pay to a corporation's top officers. See
We disagree. Petitioner's retained earnings were lower each year from 1991 to 1995 than they were2000 Tax Ct. Memo LEXIS 116">*147 for any year from 1983 to 1990. Petitioner's sales did not increase from 1983 to 1995 in real dollars. Petitioner's net income before taxes declined from $ 279,705 in 1983 to $ 67,877 in 1993, $ 60,220 in 1994, and $ 89,315 in 1995. Petitioner's income declined from 1990 to 1994. Petitioner's sales and income increased from 1994 to 1995, but were still well below the 1983 to 1990 amounts.
We believe petitioner's financial condition in the years in issue would give an independent investor doubts about the performance of petitioner's top management. See
The prime indicator of the return a corporation is earning for its investors is its return on equity. See
We disagree. First, petitioner cites no case in which a court gave significant weight to a high return on equity computed based on a founding shareholder's small2000 Tax Ct. Memo LEXIS 116">*149 initial investment. Courts have relied on other financial factors when a shareholder's capital contribution is small. See, e.g.,
Second, Hakala testified that it is misleading to measure return on equity based on a shareholder's nominal investment in the company because the shareholder may have invested capital or sweat equity and the company may have contributed patents, intellectual property, or other intangibles that2000 Tax Ct. Memo LEXIS 116">*150 do not appear on the balance sheet. He testified that the rate of return on equity is best measured by comparing the company's operating return to the fair market value of its operating assets. Petitioner did not respond to Hakala's analysis on this point. Hakala stated that an independent investor would have expected an average net operating return on assets of about 20 percent in the years in issue, and that petitioner's operating returns, which ranged from 0.7 percent to 5.26 percent in the years in issue, were far below the returns that would have satisfied an independent investor. Thus, we give little weight to petitioner's use of Isidore Klein's $ 119 initial capital contribution to calculate return on equity for 1993, 1994, and 1995.
Petitioner also contends that it did not need to pay dividends because a hypothetical shareholder would be satisfied with the appreciation in value of his or her stock due to petitioner's retention of earnings and the growth in petitioner's annual sales. We disagree. Although Hakala testified that an investor would be happy with a return of $ 1,874,112 (the redemption price of Isidore and Gertrude Klein's stock) on $ 119 (Isidore Klein's capital2000 Tax Ct. Memo LEXIS 116">*151 investment), he also stated that it is inappropriate in this case to analyze rate of return based on Isidore Klein's $ 119 investment.
This factor favors respondent.
5. COMPARISON WITH OTHER COMPANIES: SALARIES PAID TO COMPARABLE EMPLOYEES IN SIMILAR COMPANIES
In deciding whether compensation is reasonable, we compare it to compensation paid to persons holding comparable positions in comparable companies. See
Respondent's expert, Hakala, and petitioner's expert, Dorf, submitted reports in which they analyzed compensation paid to persons holding comparable positions in other companies. Each of their reports provides some basis for us to apply this factor; however, we give less weight to Dorf's opinion because we believe his analysis contains major flaws.
a. DORF
Dorf concluded that the compensation petitioner paid to Isidore Klein in 1993 ($ 352,000) and 1994 ($ 368,000) and Steven Klein in 1993 ($ 500,400), 1994 ($ 450,400), and 19952000 Tax Ct. Memo LEXIS 116">*152 ($ 820,400) "could be deemed reasonable". We believe he overstated the amount of compensation that "could be deemed reasonable" because he: (1) Did not consider petitioner's financial performance from the standpoint of an independent investor, (2) incorrectly assumed that Isidore Klein had been undercompensated in prior years, (3) overstated Isidore Klein's contributions to petitioner in 1993 and 1994, (4) gave too little weight to data from surveys he cited in his report which suggest that Isidore and Steven Klein were overpaid, (5) used as comparables corporations that were more than four times larger than petitioner, (6) analyzed the reasonableness of Steven Klein's compensation based in part on data for which he provided no source and using a method that in effect assumed that Steven Klein's compensation was reasonable, and (7) incorrectly assumed that petitioner's compensation practices were similarly generous to all of petitioner's employees.
The companies which Dorf compared to petitioner had annual revenues averaging $ 17 million, more than four times those of petitioner. He estimated that Isidore Klein was paid about $ 66,000 more in 1993 and about $ 82,000 more in 1994 than2000 Tax Ct. Memo LEXIS 116">*153 the average compensation paid to the CEO's of those companies. Isidore Klein was paid $ 116,000 to $ 178,000 more in 1993 and $ 68,000 to $ 244,000 more in 1994 than CEO's whose compensation ranked in the third quartile of companies that responded to 1993 and 1994 National Executive Compensation and Panel Publication surveys (i.e., CEO's whose pay ranked from the 50th percentile to the 75th percentile). Despite the data from these surveys, Dorf concluded that Isidore Klein was not overpaid.
Dorf estimated how much it would have been reasonable for petitioner to pay Isidore Klein from 1975 to 1994. Dorf added what he estimated was the compensation of a full-time chief executive officer without Isidore Klein's research and development capabilities ($ 211,324 in 1993 and $ 231,538 in 1994), to 50 percent of what he said was the compensation of a full-time research and development professional ($ 187,578 in 1993 and $ 153,712 in 1994). He concluded that petitioner overpaid Isidore Klein by $ 46,887 in 1993 and $ 59,606 in 1994, but he concluded that Isidore Klein's compensation was reasonable in those years in part because it was catchup pay for prior years. We rejected Dorf's suggestion2000 Tax Ct. Memo LEXIS 116">*154 that Isidore Klein was paid catchup pay at paragraph II-B-1-a, above. Dorf's data suggests that compensation paid to Isidore Klein up to $ 305,113 in 1993 and $ 308,394 in 1994 might have been reasonable if he had worked full time. There is no convincing evidence of how much time he worked. We think two-thirds (or somewhat less) time would be a reasonable estimate based on how often he called and visited employees, the fact that he attended some trade shows and worked on the portable housing project, and because he reviewed various records of petitioner's. Dorf's data (which is based on full-time service) suggests that compensation for Isidore Klein of about $ 200,000 per year for 1993 and 1994 would be reasonable.
We start with Dorf's data for the average CEO (i.e., $ 211,324 in 1993 and $ 231,538 in 1994) to decide the reasonableness of Steven Klein's compensation, but we do not increase it based on compensation paid to a person with research and development skills because he lacked Isidore Klein's skills in that area. However, due to Steven Klein's long hours worked, we think Dorf's data suggests the maximum amount of reasonable compensation for Steven Klein would be $ 300,0002000 Tax Ct. Memo LEXIS 116">*155 for 1993 and $ 300,000 for 1994.
b. HAKALA
Hakala testified that the most a similar company would have reasonably paid for the combined services of Isidore and Steven Klein was $ 405,250 in 1993 and $ 392,157 in 1994. He also testified that the most a similar company would have reasonably paid Steven Klein in 1995 was $ 439,284. We believe that he underestimated the total amount Isidore and Steven Klein could reasonably be paid in 1993 and 1994 but that his estimate of Steven Klein's reasonable compensation for 1995 was correct.
Petitioner argues that Hakala relied on companies that were not comparable to petitioner. We disagree. Although Hakala considered Conference Board surveys of larger, public companies, he primarily focused on data from companies that specialized in fabricating metal products and that had annual sales comparable in size to petitioner's (that is, between $ 2 and $ 5 million).
Petitioner contends that Hakala failed to consider that petitioner and the services of Isidore Klein and Steven Klein are unique. Although all companies and corporate officers are in one sense unique, we believe that survey data cited by Hakala (as well as Dorf) is helpful in deciding2000 Tax Ct. Memo LEXIS 116">*156 the amount of Isidore and Steven Klein's reasonable compensation.
Hakala concluded that, from the standpoint of a hypothetical independent investor, the compensation petitioner paid to Isidore and Steven Klein in 1993 and 1994, and to Steven Klein in 1995, was unreasonable. Hakala pointed out that, although petitioner was very profitable before paying officers' compensation, its performance after paying officers' compensation was well below what would satisfy an independent investor. Hakala estimated the maximum amount petitioner could pay Isidore and Steven Klein while paying a reasonable return to an independent investor and concluded that the compensation paid to Isidore and Steven Klein was about twice the maximum reasonable compensation.
Petitioner criticizes Hakala for not separately valuing the services of Steven and Isidore Klein. We agree that having a separate opinion for their reasonable compensation would have been more helpful, but despite that we still find Hakala's analysis to be helpful.
c. BAKER'S AID
Petitioner argues that the best evidence of how much comparable firms pay officers' holding comparable positions was the testimony that the two owners/officers of2000 Tax Ct. Memo LEXIS 116">*157 Baker's Aid (a father and son) each earned $ 1-$ 2 million per year in 1993 and 1994. We disagree because there is no evidence of their duties or accomplishments and because Baker's Aid had annual sales of about $ 40 million in 1993 and 1994, which is more than 10 times petitioner's sales in those years.
d. CONCLUSION
This factor suggests that it would have been reasonable to pay Isidore Klein up to $ 200,000 in 1993 and $ 200,000 in 1994 and to pay Steven Klein up to $ 300,000 in 1993, $ 300,000 in 1994, and $ 439,284, or for simplicity, $ 440,000, in 1995.
We apply each of these five factors from the standpoint of whether a hypothetical independent investor would approve the compensation petitioner paid to Isidore and Steven Klein in the years in issue. See
1. ISIDORE KLEIN
We believe that an independent investor would not have approved the increase in Isidore Klein's longstanding compensation formula from2000 Tax Ct. Memo LEXIS 116">*158 8 percent to 10 percent of sales in view of his lessened contribution to petitioner in 1993 and 1994 and petitioner's financial performance compared to earlier years. We conclude that an independent investor would consider compensation paid to Isidore Klein of $ 200,000 in 1993 and $ 200,000 in 1994 to be reasonable. These amounts are based in part on Dorf's data. However, they are less than the amounts Dorf said might be reasonable, for reasons stated above where we discussed Dorf's analysis. As discussed at paragraph II-B-3-a, above, we estimate that Isidore Klein worked at most two-thirds of the time in 1993 and 1994. Under the circumstances, we think paying Isidore Klein more than $ 200,000, which equaled 5 to 6 percent of sales (about two-thirds of his customary 8 percent of sales) was unreasonable.
2. STEVEN KLEIN
We conclude that an independent investor would not have approved Steven Klein's compensation based on petitioner's performance in those years. We do not think an independent investor would believe that Steven Klein should be paid, in 1 year (1995), more than the cumulative amount petitioner earned in the previous 10 years (1986-95). See
We conclude that compensation paid to Steven Klein in excess of $ 300,000 in 1993 and $ 300,000 in 1994 was unreasonable. Due to Steven Klein's assumption of more responsibilities when he became CEO in 1995 and based on Hakala's estimate of reasonable compensation to Steven Klein for 1995, we conclude that compensation up to $ 440,000 in 1995 was reasonable. These amounts for Steven Klein for 1993 and 1994 are based on Dorf's data but without any additional amounts added for research and development work previously done by Isidore Klein, and with an adjustment for hours worked. Our amount for Steven Klein for 1995 ($ 440,000) is essentially the same as believed reasonable by Hakala ($ 439,284). Dorf did not provide data for 1995; Hakala's data is a suitable substitute.
D. WHETHER PETITIONER IS LIABLE FOR THE PENALTY UNDER
Respondent determined that petitioner is liable for the accuracy-related penalty for substantial understatement for 1993, 1994, and 1995 under
Taxpayers2000 Tax Ct. Memo LEXIS 116">*160 are liable for a penalty equal to 20 percent of the part of the underpayment attributable to negligence or substantial understatement of tax. See
The accuracy-related penalty does not apply to any part of an underpayment if the taxpayer shows that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. See
Petitioner argues that it is not liable for the accuracy- related penalty for the years in issue because the issues in this case are highly technical; petitioner disclosed the deductions on its tax returns for 1993, 1994, and 1995; and Steven Klein reasonably relied on petitioner's2000 Tax Ct. Memo LEXIS 116">*161 accountant to advise petitioner about what would constitute reasonable compensation to pay Steven Klein in 1995.
1. 1993 AND 1994
Petitioner is not liable for the substantial understatement penalty if it had a reasonable basis for, and adequately disclosed the facts relating to, the Kleins' compensation on its 1993, 1994, and 1995 returns. See
Petitioner contends that its failure to list2000 Tax Ct. Memo LEXIS 116">*162 the percentage of time petitioner's officers devoted to the business is not significant because the Kleins each devoted a substantial amount of time to the business. We disagree. See
We do not believe that the issues in this case were highly technical. Petitioner does not contend that it relied on its accountant to advise it on the reasonable compensation issue for 1993 and 1994. Thus, we conclude that petitioner is liable for the accuracy-related penalty under
2. 1995
Respondent argues that petitioner did not have reasonable cause for deducting the compensation it paid to Steven Klein in 1995 because it made no attempt to determine whether the amount it deducted as compensation in 1995 was reasonable. We disagree.
Steven Klein relied on Richard Schwaeber to advise petitioner about the amount of compensation it could reasonably pay him in 1995. Richard Schwaeber told Steven Klein that a salary of about $ 800,000 in 1995 would be reasonable. We hold that petitioner's2000 Tax Ct. Memo LEXIS 116">*163 reliance on Richard Schwaeber was reasonable cause for deducting the compensation it paid to Steven Klein in 1995.
We conclude that petitioner is liable for the accuracy- related penalty under
To reflect the foregoing and concessions,
Decision will be entered under Rule 155.
1. Petitioner bears the burden of proving the reasonableness of compensation it paid in excess of what respondent determined was reasonable. See Rule 142(a). Respondent bears the burden of proving the increases in deficiency and
1. Respondent does not dispute this amount.↩
1. Not in record.↩
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