Square D Company and Subsidiaries v. Commissioner

121 T.C. No. 11
UNITED STATES TAX COURT
SQUARE D COMPANY AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6067-97. Filed September 26, 2003.
P was a publicly held U.S. corporation and, after
its acquisition by a foreign corporation (S) through a
reverse subsidiary merger, was a U.S. corporation
indirectly owned by S, during the years in issue.
To finance the acquisition of P, S obtained a
commitment from two banks to extend loans to a to-be-
organized subsidiary equal to one-half the acquisition
price, not to exceed $1.125 billion. The subsidiary
was created for the purpose of acquiring P. It was to
use the loan proceeds to purchase P’s outstanding
shares, at which time it would merge into P and cease
to exist. As consideration for the banks’ commitment,
S became obligated to pay the banks a loan commitment
fee and to indemnify the banks for any legal fees
incurred in connection with their agreement to extend
credit for the acquisition. The subsidiary formally
assumed S’s obligations with respect to the banks’
legal fees and became obligated to pay a portion of the
loan commitment fees. After initially resisting the
acquisition, P agreed to it and as a consequence of the
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merger assumed the subsidiary’s obligations. P paid
the legal fees directly. S invoiced P for the full
cost of the loan commitment fee, and P reimbursed S for
those costs in a subsequent year.
Held, P is entitled to amortization deductions for
its payments for the loan commitment and legal fees
because, by virtue of its merger with S’s subsidiary,
the costs were incurred on P’s behalf and eventually
paid by P.
In 1990, prior to S’s acquisition of P, certain
executives of P who were “disqualified individuals”
within the meaning of sec. 280G(c), I.R.C., obtained
employment agreements (1990 agreements) under which
they were entitled, upon a change in ownership or
control of P, to certain lump-sum payments if they
chose to terminate their employment during the 13th
month after the acquisition or if their employment was
involuntarily terminated within 3 years of the
acquisition. The lump-sum payments would have been
parachute payments within the meaning of sec.
280G(b)(2), I.R.C.
S’s acquisition of P in May 1991 triggered the
executives’ rights to the parachute payments under the
1990 agreements. S sought to retain the executives’
services for P beyond the 13th month after the
acquisition, rather than have the executives terminate
their employment at that time to obtain the parachute
payments. To that end, S negotiated new employment
agreements (1991 agreements) with the executives. The
executives used their rights to parachute payments
under the 1990 agreements as leverage to secure lump-
sum payments under the 1991 agreements. The lump-sum
payments provided in the 1991 agreements were larger
than the parachute payments and, further, were
conditioned on the executives’ either remaining in
petitioner’s employment, or ceasing employment only
under specified circumstances, for approximately 3
years through 1994. The 1991 agreements were
subsequently amended to accelerate the payment of the
lump sums (in a reduced amount) to December 1992 in
exchange for an extension of the employment term for an
additional year through 1995.
Held, under the facts of this case, the lump-sum
payments (excluding a portion conceded by R to be
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otherwise) paid under the 1991 agreements as amended,
were contingent on a change in ownership or effective
control within the meaning of sec. 280G(b)(2)(A)(i),
I.R.C., because they would not have been made but for
the change in ownership or control. The phrase
“contingent on a change in the ownership or effective
control” of sec. 280G(b)(2)(A)(i), I.R.C., is
interpreted in light of legislative history.
Accordingly, the payments are parachute payments for
purposes of sec. 280G(b)(2), I.R.C.
Held, further, whether P has established that any
portion of the parachute payments was reasonable
compensation for purposes of sec. 280G(b)(4)(A),
I.R.C., must be determined on the basis of a
multifactor test, considering all the facts and
circumstances. Exacto Spring Corp. v. Commissioner,
196 F.3d 833 (7th Cir. 1999), revg. Heitz v.
Commissioner, T.C. Memo. 1998-220, applying an
independent investor test to determine reasonable
compensation for purposes of sec. 162(a), I.R.C.,
distinguished.
Held, further, extent to which P has met burden of
showing by clear and convincing evidence that any
portion of parachute payments was reasonable
compensation within the meaning of sec. 280G(b)(4)(A),
I.R.C., determined.
Robert H. Aland, Gregg D. Lemein, Tamara L. Meyer, Oren S.
Penn, David G. Noren, John D. McDonald, and Holly K. McClellan,
for petitioner.
Lawrence C. Letkewicz and Dana E. Hundrieser, for
respondent.
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CONTENTS
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . . 7
I. Background . . . . . . . . . . . . . . . . . . . . . . . . 7
II. Loan Commitment and Legal Fees Arising From Acquisition of
Petitioner . . . . . . . . . . . . . . . . . . . . . . . . 8
A. The Commitment Letter . . . . . . . . . . . . . . . . 8
B. Takeover Events and Litigation . . . . . . . . . . 10
C. Commitment Letter Addendum . . . . . . . . . . . . 12
D. The Bridge Loan . . . . . . . . . . . . . . . . . . 13
E. The Term Loan . . . . . . . . . . . . . . . . . . . 14
F. Payment of the Commitment and Legal Fees . . . . . 15
III. Executive Compensation . . . . . . . . . . . . . . . . . 15
A. Background . . . . . . . . . . . . . . . . . . . . 15
Barb. 1990 Employment Agreements . . . . . . . . . . . . 16
C. Importance of Schneider’s Retaining Petitioner’s Key
Executives . . . . . . . . . . . . . . . . . . . . 20
D. Negotiations Between Retained Executives and Schneider
Over New Employment Agreements . . . . . . . . . . 21
E. 1991 Employment Agreements . . . . . . . . . . . . 24
F. Mr. Garrett’s Termination . . . . . . . . . . . . . 29
G. The 1992 Amendments . . . . . . . . . . . . . . . . 29
H. Other 1992 Compensation of Retained Executives . . 32
I. Retained Executives’ Pre- and Postacquisition
Compensation . . . . . . . . . . . . . . . . . . . 34
J. Retained Executives’ Duties and Responsibilities . 35
IV. Tax Returns, Notice of Deficiency, and Petition . . . . 36
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
I. Loan Commitment and Legal Fees . . . . . . . . . . . . . 37
A. The Legal Obligation To Pay the Loan Costs . . . . 40
B. Reimbursed Expenses . . . . . . . . . . . . . . . . 45
II. Parachute Payments . . . . . . . . . . . . . . . . . . . 51
A. General Requirements of Section 280G . . . . . . . . 52
B. Whether Payments Were Contingent on a Change in Control
. . . . . . . . . . . . . . . . . . . . . . . . . 54
C. Reasonable Compensation--Applicable Test . . . . . . 65
D. Determination of Reasonable Compensation . . . . . . 74
1. Overview of Expert Testimony . . . . . . . . . 74
2. Historical Compensation . . . . . . . . . . . . 78
3. Analysis of Comparables . . . . . . . . . . . . 82
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a. Relevant Period for Reasonable Compensation
Comparison . . . . . . . . . . . . . . . 82
b. Aggregate Versus Individual Compensation 86
c. Retained Executives’ 1992 Compensation . 88
(i) Perquisites . . . . . . . . . . . . 89
(ii) LTIP Compensation . . . . . . . . . 90
(iii) 1991 SRP Benefits . . . . . . . . . 93
(iv) Summary . . . . . . . . . . . . . . 98
d. Determination of Comparable Executives and
Their Compensation . . . . . . . . . . . 98
(i) Selection of Comparable Companies . 99
(ii) Selection of Comparable Executives and
Their 1992 Compensation . . . . . . 101
e. Range of Reasonable Compensation . . . . 103
f. Reasonable Compensation Established for Each
Retained Executive . . . . . . . . . . . 106
(i) Mr. Brink . . . . . . . . . . . . . 106
(ii) Mr. Denny . . . . . . . . . . . . . 109
(iii) Mr. Kurczewski . . . . . . . . . . 112
(iv) Messrs. Garrett, Richardson, Thompson,
and Williams . . . . . . . . . . . 114
(aa) Mr. Garrett . . . . . . . . . 116
(bb) Mr. Richardson . . . . . . . 117
(cc) Mr. Thompson . . . . . . . . 118
(dd) Mr. Williams . . . . . . . . 118
(v) Messrs. Francis, Free, Hite, and Pugh
. . . . . . . . . . . . . . . . . . 118
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GALE, Judge: Respondent determined deficiencies in
petitioner’s Federal income taxes of $7,420,227, $28,971,522, and
$15,285,996 for the taxable years 1990, 1991, and 1992,
respectively. Petitioner claims overpayments of $12,486,577 and
$18,289 for taxable years 1990 and 1992, respectively.
After concessions, the issues remaining for decision1 are:
(1) Whether petitioner may deduct in 1991 a loan commitment
fee incurred in connection with the provision of financing for
petitioner’s acquisition. We hold that petitioner may.
(2) Whether petitioner may deduct in 1991 legal fees
incurred in connection with the provision of financing for
petitioner’s acquisition. We hold that petitioner may.
(3) Whether certain lump-sum payments made by petitioner to
senior executives in 1992 and deducted in that year were
contingent on a change in the ownership or effective control of
petitioner within the meaning of section 280G(b)(2)(A)(i).2 We
hold that they were.
(4) What part, if any, of the foregoing payments constituted
reasonable compensation in 1992 within the meaning of section
1
An additional issue involving the application of sec.
267(a)(3) has been addressed in a separate opinion. See Square D
Co. & Subs. v. Commissioner, 118 T.C. 299 (2002).
2
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for taxable years 1991 and 1992,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
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280G(b)(4)(A). We hold that petitioner has established that a
portion of the payments was reasonable compensation.
FINDINGS OF FACT
I. Background
Some of the facts have been stipulated and are so found. We
incorporate by this reference the stipulation of facts, the first
and second supplemental stipulation of facts, and accompanying
exhibits.
Square D Co., a Delaware corporation with its principal
executive offices in Palatine, Illinois, is the common parent of
an affiliated group of corporations making a consolidated return
(collectively, petitioner).
Prior to its 1991 acquisition by Schneider S.A. (Schneider),
discussed below, petitioner was a publicly held company whose
stock was traded on the New York Stock Exchange. During the
years in issue, petitioner was engaged in the United States and
abroad in the manufacture and sale of electrical distribution and
industrial control products. Electrical distribution products
included items such as circuit breakers, safety switches,
transformers, and surge suppressors; industrial control products
included push buttons, relays, control switches, voltage
controls, data communication systems, power protection systems,
and computerized control and data gathering systems. By 1990,
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“Square D” was a well-regarded brand in the electrical equipment
industry throughout North America.
During the years in issue, Schneider, a French corporation
with its principal executive offices in Paris, France, was,
through its subsidiaries, a multinational manufacturer and
marketer of electrical distribution and industrial control
equipment, among other activities. Schneider owned, directly or
indirectly, five major subsidiaries, including Merlin Gerin S.A.
(MGSA) and Telemecanique S.A. (TESA), both French corporations.
II. Loan Commitment and Legal Fees Arising From Acquisition of
Petitioner
A. The Commitment Letter
Around late 1990 or early 1991, Schneider began taking steps
to initiate a hostile takeover of petitioner. In this regard,
Schneider sought financing from two French banks, Societe
Generale and Banque Paribas (collectively, the French banks).
The French banks sent Schneider a commitment letter dated
February 18, 1991 (Commitment Letter), in which they agreed
(subject to various conditions) to (1) provide a “bridge” or
temporary loan (Bridge Loan) to a to-be-organized subsidiary for
the purpose of acquiring petitioner, equal to one-half of the
purchase price of petitioner, up to a maximum of $1 billion; and
(2) underwrite permanent financing of one-half of the purchase
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price of petitioner, up to a maximum of $900 million (the Term
Loan).3
As consideration for the French banks’ financing commitment,
the Commitment Letter required Schneider to pay a nonrefundable
loan commitment fee equal to 0.3 percent per annum on $1 billion,
payable monthly in advance from the date that receipt of the
Commitment Letter was acknowledged by Schneider (February 18,
1991) until the Bridge Loan was disbursed, but no later than
December 31, 1991.4 The Commitment Letter set forth the basic
3
Schneider and its subsidiaries agreed to provide the
remainder of the acquisition price to its acquisition subsidiary
in the form of capital contributions and subordinated loans.
4
The Commitment Letter, addressed to Schneider
specifically, stated at section D.(a):
Your Company shall pay our two Banks * * * a
commitment fee of 0.30% * * * per annum payable monthly
in advance from the date of acknowledgment of the
receipt of their commitment letter until the bridge
loan is disbursed on US$ 1,000,000,000 (one billion
U.S. dollars), the maximum amount specified for the
bridge loan. Any commitment fee received shall become
the property of the Banks. The receipt of this
commitment fee shall cease upon extension of the bridge
loan, or not later than December 31, 1991, barring an
extension approved by our two Banks and your Group.
The Commitment Letter further provided that “Your Company
guarantees that it will have this letter signed by MERLIN GERIN,
TELEMECANIQUE [i.e., MGSA and TESA] and S.P.E.P. [Schneider’s
controlling shareholder]”. In a section entitled “GROUPE
SCHNEIDER’S COMMITMENTS”, the Commitment Letter stated:
Your Group (i.e. SCHNEIDER and the subsidiaries subject
to consolidation) agrees * * * not to proceed to
acquire new interests other than those of * * *
(continued...)
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terms of the Bridge and Term Loans, including commitment fees of
0.3 percent per annum on any amounts of the Bridge or Term Loans
not disbursed. Schneider also agreed to indemnify the French
banks for any legal fees associated with their agreement to
commit funds to Schneider. A letter from Schneider to the French
banks, which the Commitment Letter required, contained the
following provision: “We herewith declare that our Company
agrees to indemnify your two Banks * * * as to all the costs,
expenses or liabilities or [sic] any kind whatsoever arising
from” the credit facility.
The Commitment Letter specified that the Bridge and Term
Loans would be made to a Schneider subsidiary that was to be
newly organized for the purpose of acquiring petitioner. Thus,
while Schneider obtained the commitment to finance, it never
intended to be the borrower.
B. Takeover Events and Litigation
On February 19, 1991, Schneider submitted to petitioner’s
4
(...continued)
[petitioner] * * * in net annual amounts greater than
its annual consolidated available cash flow.
* * * * * * *
Your Company guarantees compliance with this provision
by all the subsidiaries in which it has a controlling
interest * * *
* * * * * * *
To permit our two Banks to monitor this commitment on
the part of your Group, your Company and S.P.E.P. will
provide them * * * with all the necessary accounting
data.
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board of directors a proposal to acquire all outstanding shares
of petitioner’s stock for $78 per share, or a total purchase
price of approximately $2 billion. Petitioner’s board of
directors rejected the proposal on February 27, 1991, and the
next day petitioner filed complaints in Federal District Court
and New York State court designed to thwart the Schneider
takeover. The French banks were named as codefendants in the
Federal complaint.
On February 28, 1991, Schneider, MGSA, and TESA organized
Square D Acquisition Co. (ACQ) as a transitory entity to serve as
a vehicle for the acquisition of petitioner. Schneider, MGSA,
and TESA together owned 100 percent of ACQ. On March 4, 1991,
ACQ made a hostile cash tender offer of $78 per share (Tender
Offer) to petitioner’s shareholders. On March 10, 1991,
petitioner’s board of directors rejected the Tender Offer as
inadequate and recommended that petitioner’s shareholders do the
same.
On April 12, 1991, petitioner filed a petition with the
Board of Governors of the U.S. Federal Reserve System requesting
a determination that the role of the French banks in the Tender
Offer violated U.S. banking laws and regulations. Banque Paribas
incurred legal costs with respect to the petition, as well as the
Federal and State actions discussed above.
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On April 23, 1991, Schneider indicated it was willing to
increase the price of the Tender Offer, and on May 11, 1991,
officials of both companies agreed on a price of $88 per share
(Revised Tender Offer). The following day, May 12, petitioner’s
board of directors approved and recommended to petitioner’s
shareholders the Revised Tender Offer, which amounted to a total
purchase price of approximately $2.25 billion. Petitioner and
Schneider also agreed to dismiss with prejudice (with each party
bearing its own costs and litigation expenses) all pending
proceedings between petitioner, Schneider, ACQ, and their
respective affiliates, including the action filed in Federal
District Court naming the French banks as codefendants, the
action filed in New York State court, and the petition filed with
the Federal Reserve. That same day (May 12), petitioner,
Schneider, and ACQ entered into an Agreement and Plan of Merger
(Merger Agreement).
C. Commitment Letter Addendum
To finance the higher acquisition price in the Revised
Tender Offer, Schneider and the French banks executed an addendum
to the Commitment Letter on May 13, 1991, in which the French
banks agreed to increase the Bridge and Term Loans by an
additional $125 million, for a total loan commitment of $1.125
billion, or one-half of the revised acquisition price of $2.25
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billion (Commitment Letter Addendum).5 The Commitment Letter
Addendum specifically provided that the conditions enumerated in
section D.(a) of the Commitment Letter (i.e., Schneider’s
obligation to pay loan commitment fee, see supra note 4), applied
to the additional funds described in the Commitment Letter
Addendum.
D. The Bridge Loan
On May 30, 1991, the French banks and ACQ (as borrower)
entered into the Bridge Loan agreement contemplated by the
Commitment Letter. The French banks agreed to lend ACQ $1.125
billion to purchase petitioner’s outstanding shares. Section 2.2
of the Bridge Loan agreement provided:
Commitment Fee. On July 12, 1991, the Borrower [ACQ]
agrees to pay to Societe Generale for distribution pro
rata to each of the Banks, according to its Commitment,
a commitment fee from and including the date of
signature hereof [May 30, 1991] to and including July
12, 1991 (or such earlier date as the Total Commitments
of the Banks shall have been terminated). The
commitment fee shall be payable in U.S. dollars at the
rate of three tenths of one percent (0.30%) per annum
on the daily average unutilized amount of the
Commitment of the Banks during such period. * * *
The Bridge Loan Agreement contained no provisions under which ACQ
assumed Schneider’s obligation to pay a loan commitment fee under
the Commitment Letter or by which Schneider was relieved of its
5
Schneider and its subsidiaries agreed to provide the
remainder of the acquisition price to ACQ in the form of capital
contributions and subordinated loans.
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obligation to pay a commitment fee from February 18, 1991 until
the Bridge Loan was disbursed.
Regarding the legal fees, the Bridge Loan agreement stated:
The Borrower [ACQ] shall: * * * (iii) indemnify each
Bank, its officers, directors, employees,
representatives and agents from and hold each of them
harmless against any and all losses, liabilities,
claims, damages or expenses incurred by any of them
arising out of or by reason of any investigation,
litigation or other proceeding related to the
Acquisition,[6] or the Borrower’s or any other party’s
entering into and performance of this Agreement * * *,
including the reasonable fees and disbursements of
counsel incurred in connection with any such
investigation, litigation or other proceeding * * *
The French banks disbursed the Bridge Loan of $1.125 billion to
ACQ on June 12, 1991.7
E. The Term Loan
On August 19, 1991, petitioner signed the Term Loan
agreement, and the French banks and a syndicated group of other
banks disbursed the funds that same day. The Term Loan agreement
contained language regarding the payment of a commitment fee and
legal expenses similar to that contained in the Bridge Loan
agreement. Petitioner used the Term Loan proceeds to repay the
Bridge Loan made to ACQ. Effective August 22, 1991, ACQ merged
6
“Acquisition” was defined in the Bridge Loan agreement as
ACQ’s acquisition of petitioner’s capital and preferred stock
pursuant to the offer of purchase, dated Mar. 4, 1991, as
supplemented.
7
ACQ used the proceeds of the Bridge Loan, together with
Schneider’s capital contributions and subordinated loans, to
acquire petitioner’s shares pursuant to the Revised Tender Offer.
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into petitioner, which assumed ACQ’s obligations as the surviving
corporation.8 Under the terms of the merger, petitioner’s
shareholders who had not tendered their shares received cash for
their shares. After the merger, Schneider indirectly owned 100
percent of petitioner’s shares.
F. Payment of the Commitment and Legal Fees
Schneider paid a $1,056,020 commitment fee to the French
banks and in December 1991 sent an invoice for reimbursement of
that amount to petitioner. In March 1993 petitioner paid
$1,056,020 to Schneider as reimbursement.
In August 1991, Rogers & Wells submitted an invoice to
Banque Paribas for $699,027 covering services performed and costs
incurred in the period of March 21 through July 31, 1991,
relating to the litigation and Federal Reserve Board proceedings.
Banque Paribas forwarded the Rogers & Wells invoice to Schneider
in August 1991 and petitioner paid it in September of that year.
III. Executive Compensation
A. Background
In December 1990, prior to its acquisition by Schneider,
petitioner, as a result in part of concerns about a possible
8
The form of this transaction is typically known as a
reverse subsidiary merger. See Ginsburg & Levin, Mergers,
Acquisition, and Buyouts, par. 202, at 2-15 (2002).
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hostile takeover, entered into employment agreements (1990
Employment Agreements) with its 18 most senior executives.
For several years prior to the execution of the 1990
Employment Agreements, petitioner’s senior executives had
received an industry-typical executive compensation package,
which included salary, participation in a short-term incentive
compensation plan (STIP), restricted stock (including dividends
on such stock), nonqualified stock options, and perquisites. The
STIP was awarded annually and guaranteed each executive a bonus
if certain company performance objectives were met. Petitioner
also maintained a supplemental retirement plan (SRP) for certain
executives, including the 18 senior executives noted above, who
were also participants in petitioner’s qualified pension plan.
The purpose of the SRP was to provide supplemental retirement
benefits to selected key executives.
B. 1990 Employment Agreements
The 1990 Employment Agreements provided for a 3-year
employment period that was triggered by a “change of control”,
defined in the agreements to include the acquisition of 20
percent or more of the common stock or voting power of
petitioner. The parties have stipulated that a change of
control, both for purposes of triggering the 3-year employment
period provided in the 1990 Employment Agreements and for
purposes of section 280G(b)(2)(A), occurred on May 29, 1991. The
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employment period provided under the 1990 Employment Agreements
therefore began on May 29, 1991, and ended on May 28, 1994.
The 1990 Employment Agreements further provided for
substantial lump-sum payments to an executive in the event his
employment was either terminated by petitioner without cause9 or
by the executive for “good reason”. “Good reason” for this
purpose included generally any diminution in the executive’s
preacquisition position or duties, any change in the executive’s
employment location or required travel, or any failure to be paid
the compensation provided in the agreement. The executive’s good
faith determination regarding whether the elements of “good
reason” obtained was conclusive. Further, the 1990 Employment
Agreements provided that any reason would be deemed “good reason”
during the 30-day period following the first anniversary of the
change in control; i.e., May 30 through June 28, 1992 (hereafter,
the June 1992 Window). Thus, the 1990 Employment Agreements
granted each executive who entered them substantial payments if,
during the 3 years after a change in control, the executive (i)
was involuntary terminated (without “cause”), (ii) ceased
employment voluntarily upon a modification of his duties,
9
“Cause” was defined for this purpose as generally the
executive’s willful and continued failure to perform his duties
with the company or his willful engagement in gross misconduct
materially injurious to the company or illegal conduct.
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location, or travel burden, or (iii) at his complete discretion,
ceased employment during the June 1992 Window.
The payment to which an executive became entitled under the
1990 Employment Agreements upon the occurrence of any of the
foregoing contingencies was a lump sum consisting of (a) unpaid
annual salary, STIP award, deferred compensation, and vacation
pay accrued but not paid through the date of termination, (b) a
payment (Termination Award) defined as an amount equal to three
times the sum of his annual salary and highest STIP award, and
(c) a payment (SRP Cashout) equal to the greater of (i) the
present value of his accrued benefits under the SRP or (ii) the
present value of a monthly benefit, equal to a percentage of the
executive’s final average monthly compensation (as defined in the
SRP), based on the total of his age and years of service, less
the present value of any benefit which the executive was entitled
to receive under petitioner’s qualified pension plan. Payment of
the SRP Cashout would have fulfilled petitioner’s obligations to
the executive under the SRP.10
Seven of the 18 senior executives who were parties to the
1990 Employment Agreements terminated their employment either
10
If the executive’s employment was terminated by
petitioner for cause or by the executive without good reason
during the 3-year employment period, the executive was entitled
to receive only accrued but unpaid annual salary, deferred
compensation, and certain other benefits; he was not entitled to
receive either the Termination Award or the SRP Cashout.
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voluntarily or involuntarily in 1991 (or, in one case, 1992) and
received the Termination Award and SRP Cashout under the 1990
Employment Agreements. Petitioner treated these payments as
parachute payments for purposes of section 280G. The remaining
11 senior executives who were parties to the 1990 Employment
Agreements (Retained Executives) entered into new employment
agreements with petitioner on November 14, 1991 (1991 Employment
Agreements), covering their services after that date, which
replaced the 1990 Employment Agreements.11 The 1991 Employment
Agreements are described more fully hereinafter. The Retained
Executives and their pre- and post-control-change titles were as
follows:
11
Two Retained Executives did not execute their 1991
Employment Agreements until early 1992.
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Name Preacquisition Title Postacquisition Title
William P. Brink Corporate vice president, Vice president, chief
financial
controller officer and controller
Charles W. Denny Executive vice president, Executive vice president,
chief
electrical distribution operating officer
sector
Philip H. Francis Corporate vice president, Vice president, corporate
corporate technology technology and quality
center
Dexter S. Free Corporate vice president, Corporate vice president,
treasurer and assistant treasurer and assistant
secretary secretary
John C. Garrett Executive vice president, Executive vice president,
industrial sector industrial controls
Charles L. Hite Corporate vice president, Corporate vice president,
human resources human resources
Walter W. Kurczewski Corporate vice president, Corporate vice president,
general counsel and general counsel and
secretary secretary
David L. Pugh Vice president, general Vice president, general
manager,
manager, power equipment equipment business unit
business
Chris C. Richardson Vice president, general Vice president, general
manager,
manager, utilities utilities business
business, and president,
Anderson Prods.
Clive N. Thompson Vice president, distribution Vice president, distribution
equipment business unit equipment business unit
Robert D. Williams Vice president, general Vice president, general
manager
manager, transformer transformer business
business
C. Importance of Schneider’s Retaining Petitioner’s Key
Executives
One of Schneider’s top priorities after its acquisition of
petitioner was to retain key executives of petitioner in order to
assure petitioner’s continued successful business operations and
protect Schneider’s $2.25 billion investment. Schneider had been
advised by a management consultant that retaining petitioner’s
current management would be critical to the company’s continued
success in the event it was acquired by Schneider. Moreover,
Schneider’s management did not believe it could feasibly replace
petitioner’s existing management team with French executives from
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Schneider affiliates or with executives recruited from other U.S.
companies in the electrical equipment industry.
D. Negotiations Between Retained Executives and Schneider
Over New Employment Agreements
Schneider’s chairman was aware from petitioner’s SEC filings
that the 1990 Employment Agreements provided for substantial
lump-sum payments for several of petitioner’s executives if they
decided to terminate their employment with petitioner following
the 1-year anniversary of petitioner’s acquisition by Schneider.
He feared that the 1990 Employment Agreements provided incentives
for the executives to leave and wanted to devise alternative
compensation arrangements that would create incentives for the
executives to remain employed by petitioner beyond the first year
after the acquisition.
The departure of the Retained Executives during June 1992
would have posed substantial risks to petitioner’s continued
successful business operations, and Schneider’s chairman was
prepared to pay a premium in order to keep the Retained
Executives.
The 1990 Employment Agreements had a significant impact on
Schneider’s negotiations with the Retained Executives over new
Employment Agreements. An executive compensation consultant
retained by Schneider advised it regarding compensation proposals
that would “preserve the present value of the parachute payments”
to which the Retained Executives were entitled under the 1990
- 22 -
Employment Agreements. The Retained Executives’ entitlement to
the Termination Awards and SRP Cashouts under the 1990 Employment
Agreements gave them additional leverage in their negotiations
with Schneider over the terms of their future employment.
From July 23 to July 25, 1991, Schneider’s chairman met with
the Retained Executives and attempted to convince them to remain
in the employment of, and enter into new agreements with,
petitioner. The Retained Executives were presented with a
compensation proposal containing an “integration long-term
incentive plan” (Integration LTIP), which required revocation of
the 1990 Employment Agreements and granted a performance award of
up to 600 percent of each executive’s salary.
The Retained Executives reacted negatively to this proposal,
concluding in a July 29 meeting that the proposal attached too
much risk to future compensation payments, given the Termination
Award and SRP Cashout payments guaranteed to each executive under
the 1990 Employment Agreements. As one of the Retained
Executives remarked at this meeting: “a bird in the hand is worth
two in the bush”.
That same day, petitioner’s chairman wrote Schneider’s
chairman explaining that the Retained Executives were
disappointed with Schneider’s compensation proposal and
suggesting that the “golden parachutes” contained in the 1990
Employment Agreements be cashed out as a prerequisite to entering
- 23 -
into new employment contracts with the Retained Executives.
Schneider’s position, as articulated in a fax sent that day by
Schneider’s chief financial officer to Schneider’s executive
compensation consultants, remained that Schneider intended to
stick to a proposal that would put “most of the money ahead of
[the executives] and not behind them.”
The next day, one Retained Executive wrote to Schneider’s
chief financial officer on behalf of the group, stating that “One
way or the other, * * * [the] parachute payments will be paid”,
and that “Not one officer is willing to give up what they are
entitled to under their [1990 Employment Agreement] contract”.
The letter further stated that “The decision by Schneider is very
simple * * * Pay now or pay later.”
By August 1, 1991, Schneider had revised its executive
compensation plan, but bonus payments under its Integration LTIP,
which were intended to compensate the Retained Executives for
forgoing their Termination Awards and SRP Cashout, were still
based on future company performance. The plan was again revised
on August 13, 1991, but the performance component remained. Mr.
Hite, a Retained Executive, who had been assigned to negotiate on
behalf of the group, continued to meet with Schneider’s
representatives throughout August and September in an effort to
arrive at a mutually acceptable compensation arrangement for
periods after 1991. By the beginning of October, Schneider had
- 24 -
agreed to drop the proposal for an Integration LTIP based on
future company performance and to develop instead a “retention
award” plan tied to the length of future employment.
As originally proposed by Schneider, the retention award
plan would have provided each Retained Executive a bonus of 300
percent of base salary plus a 1992 STIP award if that executive
remained with petitioner through December 31, 1994. The bonus
percentage would have increased to 350 percent if certain company
performance objectives were met. As more fully described below,
the final agreement reached by Schneider and the Retained
Executives provided for awards payable to each Retained Executive
based on specified periods of service, without regard to future
company performance, but with a minimum or “floor” amount
designed to compensate the Retained Executives for the
relinquishment of their rights to Termination Awards and SRP
Cashouts under the 1990 Employment Agreements.
E. 1991 Employment Agreements
The Retained Executives entered into the 1991 Employment
Agreements on November 14, 1991.12 The 1991 Employment
Agreements nullified and replaced the 1990 Employment Agreements.
12
Messrs. Francis and Richardson did not enter new
employment contracts until early 1992, but their agreements were
essentially the same as the agreements signed by the other
Retained Executives. Hereinafter, unless otherwise noted, the
term “1991 Employment Agreements” shall include the agreements
signed by Messrs. Francis and Richardson in early 1992.
- 25 -
By signing the 1991 Employment Agreements, the Retained
Executives surrendered their rights to Termination Awards and SRP
Cashouts under the 1990 Employment Agreements.
Petitioner and the Retained Executives had no explicit or
implicit legal obligation under the 1990 Employment Agreements or
any other agreements to enter into the 1991 Employment
Agreements. There were no understandings between Schneider and
the Retained Executives prior to the change in control with
regard to their continued employment by petitioner after the
change in control (other than that contained in the 1990
Employment Agreements).
The 1991 Employment Agreements established a fixed
employment period for each Retained Executive from the date of
the agreement through December 31, 1994, unless terminated sooner
in accordance with the provisions of the agreement. The 1991
Employment Agreements generally increased the 1991 base salaries
for each Retained Executive and provided for a 20-percent
increase in 1992 base salaries and an annual bonus (i.e., STIP
award). The 1991 Employment Agreements also entitled each
Retained Executive to participate in a long-term incentive
compensation plan (LTIP). The 1991 Employment Agreements further
provided that if a Retained Executive remained continuously
employed by petitioner until December 31, 1994, he would receive
a lump-sum payment (Retention Payment) equal to 3.7 times his
- 26 -
base salary plus targeted STIP award13 for 1992 and a payment of
his supplemental retirement benefits (1991 SRP Benefit) equal to
the greater of (a) the SRP Cashout, if any, that would have been
payable as of December 31, 1991,14 under his 1990 Employment
Agreement if petitioner had terminated him without cause under
his 1990 Employment Agreement on that date, plus interest from
December 31, 1991, through the date of payment; or (b) his vested
accrued SRP benefit as of the date of termination, in either case
reduced by any amount previously paid to the Retained Executive
under the SRP. Any 1991 SRP Benefit paid to a Retained Executive
would be treated as an offset against any future SRP benefits
which that Retained Executive might become entitled to receive.
The 1991 SRP Benefit plus interest for each Retained Executive
exceeded the amount of his vested accrued SRP benefit on December
31, 1991.
If a Retained Executive’s employment was terminated prior to
December 31, 1994, either by petitioner without “cause” or by the
executive for “good reason”, the executive would receive his 1991
SRP Benefit plus interest, and a prorated Retention Payment,
computed by multiplying the same base of 1992 salary and STIP
13
The targeted STIP award equaled the STIP award an
executive would have received if petitioner achieved, but did not
exceed, the financial objectives in its business plan.
14
In the case of Mr. Richardson, the operative date was
Feb. 29, 1992.
- 27 -
award by a multiplier of 2.8 (rather than 3.7) plus 0.005625 for
each week of employment completed after November 1991,15 not to
exceed 3.7.16 “Cause” and “good reason” for purposes of the 1991
Employment Agreements were defined in all material respects as in
the 1990 Employment Agreements, except that “good reason” no
longer included a change in the executive’s travel burden and the
executive’s good faith determination of “good reason” was no
longer conclusive. In addition, there was no comparable
provision in the 1991 Employment Agreements to the effect that
any reason constituted “good reason” during a specified period.
Under the 1991 Employment Agreements, an executive who
terminated his employment for “good reason” (or was dismissed by
petitioner without “cause”) on the day the agreements took effect
would have been entitled to his 1991 SRP Benefit (plus interest)
and a prorated Retention Payment computed as the sum of the
Retained Executive’s base salary and targeted STIP award for
15
For Mr. Francis, the factor equaled 3.0 plus 0.004545 for
each week of employment completed after Jan. 17, 1992; for Mr.
Richardson, 2.8 plus 0.006294 for each week of employment
completed after Mar. 15, 1992.
16
A Retained Executive whose employment was terminated by
petitioner for “cause” or by the executive without “good reason”
would forfeit his right to a Retention Payment but not his 1991
SRP benefit, which would be paid to him along with accrued but
unpaid annual salary. If he left voluntarily for “good reason”
(but not involuntarily for “cause”), he would in addition receive
a payment equal to 80 percent of the sum of his salary and target
STIP for 1992.
- 28 -
1992, multiplied by a factor equal to 2.817 (because the number
of weeks worked after the stated date would have been zero). The
prorated Retention Payment so payable exceeded the Termination
Award to which each Retained Executive would have been entitled
under the 1990 Employment Agreements if he had elected to
terminate employment with petitioner during the June 1992 Window.
A comparison of the Termination Award payable to each Retained
Executive under the 1990 Employment Agreements upon a June 1992
elective termination, with the prorated Retention Payment payable
at the inception of the 1991 Employment Agreements, follows:
17
For Mr. Francis, the factor would have been 3.0.
- 29 -
Termination Award Retention Payment Payable
Payable Under 1990 at Inception of 1991
Employment Agreements Employment Agreements
Brink $699,150 $910,224
Denny 1,320,000 1,792,000
Francis 666,600 702,000
Free 646,200 837,406
Garrett 948,939 1,137,780
Hite 853,314 1,029,420
Kurczewski 773,202 854,000
Pugh 635,598 812,122
Richardson 531,000 644,448
Thompson 742,869 928,428
Williams 593,205 758,520
F. Mr. Garrett’s Termination
Effective December 31, 1992, petitioner terminated the
employment of Mr. Garrett without cause and made a prorated
Retention Payment and 1991 SRP Benefit payment in December 1992
under the provisions of his 1991 Employment Agreement.
G. The 1992 Amendments
On December 18, 1992, in anticipation of proposed increases
in individual income tax rates and proposed limitations on the
deductibility of executive compensation for Federal income tax
purposes, petitioner and the Retained Executives (other than Mr.
Garrett) executed amendments to the 1991 Employment Agreements
(1992 Amendments). The 1992 Amendments extended the employment
period provided by the 1991 Employment Agreements by 1 year, from
December 31, 1994, to December 31, 1995, and provided for the
early payment of the Retention Payment and 1991 SRP Benefit, on
- 30 -
or before December 31, 1992 (instead of February 1995). Under
the 1992 Amendments, the Retention Payment payable at yearend
1992 was computed as the portion of the Retention Payment that a
Retained Executive would have received under the 1991 Employment
Agreement if he had terminated his employment for “good reason”,
or if petitioner had terminated his employment without “cause”,
on December 31, 1992. In addition, the 1992 Amendments contained
a “clawback” clause, which provided that if a Retained
Executive’s employment was terminated by petitioner for “cause”
or by the Retained Executive for other than “good reason” prior
to December 31, 1995, the executive was obligated to repay the
entire Retention Payment that he had received in 1992, plus
interest. Finally, the 1992 Amendments provided that petitioner
would pay the 1991 SRP Benefit plus interest, as provided in the
1991 Employment Agreements, on or before December 31, 1992. No
“clawback” clause or comparable provision applied to the 1991 SRP
Benefit paid under the 1992 Amendments, in the event a Retained
Executive’s employment ceased prior to the expiration of the
employment period on December 31, 1995.
Pursuant to the 1991 Employment Agreements, as amended by
the 1992 Amendments, petitioner paid Retention Payments and 1991
SRP Benefits (including interest) to the Retained Executives in
December 1992 as follows:
- 31 -
SRP
Retained Retention 1991 SRP Total
Executive Payment Benefit Interest Total Payment
Brink $1,014,453 0 0 0 $1,014,453
Denny 1,997,200 $728,977 $62,468 $791,445 2,788,645
Francis 703,839 358,854 30,751 389,605 1,093,444
Free 933,297 804,477 68,937 873,414 1,806,711
Garrett1 1,268,066 406,292 34,816 441,108 1,709,174
Hite 1,147,298 540,333 46,302 586,635 1,733,933
Kurczewski 982,997 367,304 31,475 398,779 1,381,776
Pugh 969,769 0 0 0 969,769
Richardson 705,290 426,642 36,560 463,202 1,168,492
Thompson 1,108,652 0 0 0 1,108,652
Williams 845,377 227,380 19,485 246,865 1,092,242
Total 11,676,238 3,860,259 330,794 4,191,053 15,867,291
1
Mr. Garrett was terminated by petitioner without “cause”, effective Dec. 31, 1992, and did not
enter into a 1992 Amendment. The figures for him are amounts paid under his 1991 Employment
Agreement as a result of his termination in December 1992.
The following table compares the Termination Awards payable
under the 1990 Employment Agreements had a Retained Executive
elected to terminate employment with petitioner during the June
1992 Window, the prorated Retention Payment payable at the
inception of the 1991 Employment Agreements, and the prorated
Retention Payment actually paid under the 1992 Employment
Agreements (except with respect to Mr. Garrett) in December 1992.
Termination Award Retention Payment Retention Payment
Retained Payable Under 1990 Payable at Inception of Paid in Dec. 1992
Executive Employment Agreement 1991 Employment Agreement Under 1992
Amendment
Brink $699,150 $910,224 $1,014,453
Denny 1,320,000 1,792,000 1,997,200
Francis 666,600 702,000 703,839
Free 646,200 837,406 933,297
1
Garrett 948,939 1,137,780 1,268,066
Hite 853,314 1,029,420 1,147,298
Kurczewski 773,202 854,000 982,997
Pugh 635,598 812,122 969,769
Richardson 531,000 644,448 705,290
Thompson 742,869 928,428 1,108,652
Williams 593,205 758,520 845,377
1
For Mr. Garrett, this figure was paid under his 1991 Employment Agreement as a
result of his termination in December 1992.
- 32 -
H. Other 1992 Compensation of Retained Executives
In 1992, the Retained Executives earned, in addition to the
Retention Payments and 1991 SRP Benefits paid to them in
December, a salary, STIP award, and perquisites. Also, the 1991
Employment Agreements provided that each Retained Executive was
entitled to participate in an LTIP that was to be devised. The
LTIP was finalized, and copies were provided to each Retained
Executive, on January 6, 1993. Certain Retained Executives were
actively involved in the development of the LTIP arrangements and
received relevant documents, including drafts, during 1992. The
LTIP was designed to motivate petitioner’s executives to achieve
petitioner’s long-term financial objectives. The LTIP was based
on performance over the 3-year period 1992-94, and an award
thereunder was equal to a percentage of the sum of a Retained
Executive’s annual base salary for each year in the period. LTIP
awards were paid in July 1995 for the 1992-94 performance cycle.
A pro rata portion of the LTIP award was generally earned by each
Retained Executive in each year of the performance cycle.18 The
18
If an executive eligible for an LTIP award left
voluntarily before the end of a performance cycle, he would
forfeit his award. If involuntarily terminated, he would receive
a partial payment of his award at the discretion of Schneider
executives. If he reached normal retirement age within a cycle,
he would receive a pro rata portion of his award.
Mr. Garrett, involuntarily terminated by petitioner
effective Dec. 31, 1992, was the only Retained Executive who did
not receive an LTIP award in July 1995. All Retained Executives
(continued...)
- 33 -
compensation earned in 1992 by each Retained Executive is
summarized in the following table:
Interest
Retained Retention2 1991 SRP on 1991 SRP Perquisites
Executive Salary STIP LTIP1 Payment Benefit Benefit Allowance Total
Brink $216,720 $123,748 $197,400 $466,616 0 0 $89,129 $1,093,613
Denny 400,000 252,000 441,095 918,648 $728,977 $62,468 28,066 2,831,254
Francis 156,000 71,136 115,737 351,023 358,854 30,751 33,738 1,117,239
Free 213,624 97,413 233,926 429,287 804,477 68,937 18,152 1,865,816
3
Garrett 270,900 154,413 0 1,268,066 406,292 34,816 37,753 2,172,240
Hite 245,100 139,953 220,030 527,720 540,333 46,302 25,088 1,744,526
Kurczewski 210,000 119,910 188,278 452,147 367,304 31,475 27,707 1,396,821
Pugh 207,174 118,090 95,388 480,977 0 0 91,009 992,638
Richardson 159,833 72,884 120,629 360,251 426,642 36,560 14,845 1,191,644
Thompson 236,844 135,001 205,127 549,858 0 0 18,918 1,145,748
Williams 193,500 88,236 148,665 388,846 227,380 19,485 14,180 1,080,292
1
Prorated (1/3) portion of LTIP paid in 1995 with respect to services rendered during 1992-94,
except with respect to Mr. Pugh, whose LTIP covered 1992 and 1993 only, and is therefore prorated
one-half to 1992.
2
Portion of the total Retention Payment paid in 1992 that was deducted by petitioner in that
year. Petitioner concluded that deduction of the remainder of the Retention Payment paid to each
Retained Executive (except Mr. Garrett) should be deferred under sec. 461(a) and (h) until
economic performance occurred in 1993, 1994, and 1995.
3
Includes $20,838 in accrued vacation pay.
After receiving their Retention Payments in December 1992,
four of the Retained Executives (Messrs. Francis, Free, Pugh, and
Thompson) ceased employment with petitioner before the expiration
on December 31, 1995, of the employment period provided in the
1991 Employment Agreements as modified by the 1992 Amendments.
None of the four was required to repay any portion of the
Retention Payment under the “clawback” clause of the 1992
Amendments, because their employment was not terminated by
petitioner for “cause” or by them for other than “good reason”.
18
(...continued)
(except Mr. Garrett) received LTIP awards in July 1995. Mr.
Pugh, terminated effective Apr. 15, 1994, received an LTIP
covering the years 1992 and 1993.
- 34 -
I. Retained Executives’ Pre- and Postacquisition
Compensation
The total compensation earned by each Retained Executive in
1990 is summarized in the following table:
Restricted Nonqualified
Retained Restricted Stock Stock Perquisite
Executive Salary STIP Stock Dividend Options Allowance Total
Brink $56,061 $22,229 $40,969 0 $178,969 $25,872 $324,100
Denny 275,151 93,333 44,620 $18,136 259,200 6,940 697,380
Francis 141,115 37,445 16,490 1,556 160,859 43,709 401,174
Free 150,601 41,803 19,400 8,605 166,602 12,748 399,759
Garrett 191,832 61,170 24,250 6,875 165,788 6,185 456,100
Hite 180,161 59,543 30,070 11,359 212,113 12,132 505,378
Kurczewski 154,054 53,195 26,190 10,716 207,946 10,936 463,038
Pugh 120,853 55,521 10,670 3,528 10,670 3,789 205,031
Richardson 138,863 35,000 9,700 3,586 9,700 21,643 218,492
Thompson 171,851 56,592 22,310 4,899 171,675 71,147 498,474
Williams 102,420 54,062 10,670 3,072 10,670 1,425 182,320
In 1991, the Retained Executives received various forms of
compensation under the 1990 Employment Agreements, including
stock options, restricted stock and payments in lieu thereof, as
a result of provisions in the 1990 Employment Agreements
triggered by the change in control of petitioner. This
compensation totaled, in the aggregate for the 11 Retained
Executives, $8,752,996. In addition, the Retained Executives
received “gross up” payments in 1991, totaling $2,143,946,
designed to compensate them for any imposition on them of the
section 4999 excise tax on parachute payments with respect to the
aforementioned stock-related payments.
- 35 -
J. Retained Executives’ Duties and Responsibilities
The Retained Executives were competent in their positions,
had considerable management experience, worked well together as a
management team, and were major contributors to the successful
operations of petitioner. Under the 1991 Employment Agreements,
the Retained Executives had greater responsibilities, duties, and
authority than they had under the 1990 Employment Agreements.
In 1992, the Retained Executives were managing a company
that had undergone a leveraged buyout and undertaken substantial
debt obligations. Consequently, they had to rapidly develop a
cashflow orientation in running petitioner’s business and raise
cash by selling certain assets that did not fit within
petitioner’s core business of electrical equipment manufacturing.
The departure of Mr. Stead, petitioner’s most senior executive,
shortly after petitioner’s acquisition by Schneider increased the
pressure on the Retained Executives. Furthermore, due to a
recession in the United States, the Retained Executives were
faced with the additional burden of managing a highly leveraged
business in an unfavorable economic climate. In addition, the
Retained Executives had to integrate petitioner’s North American
and European operations with those of Schneider and its other
affiliates. Finally, petitioner’s competitors began lowering
their prices in an effort to take petitioner’s market share,
forcing petitioner to aggressively price its own products and
- 36 -
placing an additional burden on the Retained Executives. Despite
these challenges, petitioner met its business plan for 1992.
IV. Tax Returns, Notice of Deficiency, and Petition
On its 1992 Federal income tax return, petitioner claimed a
deduction for $10,384,490 of the aggregate $15,867,291 in
Retention Payments and 1991 SRP Benefits paid to the Retained
Executives in December 1992. (See supra p. 31 table.)
Petitioner concluded that the $5,482,801 balance of such payments
should be deferred under section 461(a) and (h) until economic
performance occurred in 1993, 1994, and 1995. In a notice of
deficiency, respondent determined that $7,586,105 of the
deduction claimed in 1992 should be disallowed as excess
parachute payments under section 280G.
On its 1991 Federal income tax return, petitioner claimed a
deduction under section 162(a) for the $699,027 it paid to Rogers
& Wells for the firm’s services to Banque Paribas in connection
with the litigation surrounding the acquisition of petitioner by
Schneider. In the notice of deficiency, respondent determined
that this deduction should be disallowed.
Petitioner did not claim a deduction on its 1991 return for
the $1,056,020 it paid to Schneider as reimbursement for
Schneider’s 1991 payment of the loan commitment fees. In an
amendment to its petition, petitioner asserted entitlement to a
deduction in 1991 for the foregoing amount. In his answer to the
- 37 -
amended petition, respondent denied petitioner’s entitlement to
the deduction.
OPINION
I. Loan Commitment and Legal Fees
In its amended petition, petitioner asserted entitlement to
a deduction in 1991 for the $1,056,020 that Schneider billed
petitioner that year to reimburse Schneider for paying the loan
commitment fee.19 Also, petitioner claimed a deduction on its
1991 return for legal fees it paid to Rogers & Wells in that
year. Respondent disputes petitioner’s entitlement to both.
As a preliminary matter, we note that respondent has not
suggested that these costs are typical acquisition costs, which
must be capitalized as costs of the asset acquired. See, e.g.,
INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); A.E. Staley
Manufacturing Co. & Subs. v. Commissioner, 105 T.C. 166 (1995),
revd. and remanded 119 F.3d 482 (7th Cir. 1997). Petitioner
asserts that the costs at issue are loan acquisition costs, which
are capitalized as the cost of the loan and may be amortized over
the life of the loan to which they relate.20 See Anover Realty
19
Petitioner paid Schneider’s invoice in 1993.
20
We note that, to the extent the loan commitment fee and
related legal fees are treated as petitioner’s costs, they might
be considered stock reacquisition costs, the deduction of which
is generally prohibited under sec. 162(k)(1). However, sec.
162(k) expressly distinguishes between “amounts properly
allocated to indebtedness and amortized over the term of such
(continued...)
- 38 -
Corp. v. Commissioner, 33 T.C. 671 (1960) (loan acquisition costs
amortized over the life of a loan, regardless of the loan’s
purpose or use of funds); Rev. Rul. 81-160, 1981-1 C.B. 312,
313.21 Respondent does not dispute this assertion; instead,
respondent’s sole argument is that the loan costs at issue are
Schneider’s, not petitioner’s, and accordingly petitioner may not
deduct them.22 Thus, the question before us is whether a
20
(...continued)
indebtedness” and other stock reacquisition costs, exempting the
former from the prohibition on deductions. Sec.
162(k)(2)(A)(ii); see Fort Howard Corp. v Commissioner, 107 T.C.
187 (1996), supplementing 103 T.C. 345 (1994). We assume the
amounts at issue would be exempted from sec. 162(k)(1)’s
restrictions; in any event, neither party has raised this issue.
21
Rev. Rul. 81-160, 1981-1 C.B. 312, 313, states in
pertinent part:
A loan commitment fee in the nature of a standby charge
is an expenditure that results in the acquisition of a
property right, that is, the right to the use of money.
Such a loan commitment fee is similar to the cost of an
option, which becomes part of the cost of the property
acquired upon exercise of the option. Therefore, if
the right is exercised, the commitment fee becomes a
cost of acquiring the loan and is to be deducted
ratably over the term of the loan. See Rev. Rul.
75-172, 1975-1 C.B. 145, and Francis v. Commissioner,
T.C.M. 1977-170. If the right is not exercised, the
taxpayer may be entitled to a loss deduction under
section 165 of the Code when the right expires. See
Rev. Rul. 71-191, 1971-1 C.B. 77.
22
Petitioner asserts the loan costs in question are
deductible in 1991, as opposed to amortizable over a longer
period, because they relate solely to the Bridge Loan, which
lasted fewer than 12 months during 1991. Respondent does not
contest this assertion or otherwise suggest that the payments
(continued...)
- 39 -
subsidiary corporation may deduct the costs of obtaining a loan
for which it is the borrower (through an assumption of its merger
partner’s obligations), where its parent procured the loan
commitment and originally committed to pay those costs.
Petitioner makes three arguments to support its entitlement
to these deductions: (1) That under the terms of the Commitment
Letter and the Bridge Loan agreement, petitioner, as successor to
ACQ, was obligated to pay the commitment fee and the legal fees,
and therefore may deduct them; (2) that as the borrower of the
Bridge Loan, petitioner (as successor to ACQ) is entitled to
deduct the costs associated with obtaining the loan; and (3) that
even if the costs were Schneider’s, petitioner is entitled to
deduct them because they directly benefited petitioner.
Respondent disagrees, asserting that petitioner was not legally
obligated to pay the loan commitment or legal fees under the
Commitment Letter or the Bridge Loan agreement, and that
Schneider, rather than petitioner, benefited from the loan
commitment fee.
As discussed more fully below, we conclude that Schneider
incurred the costs in question on behalf of petitioner and that
petitioner is entitled to deduct such costs.
22
(...continued)
should be amortized over a period that includes the life of the
Term Loan. We shall therefore treat these payments as deductible
in 1991, if they are deductible by petitioner.
- 40 -
A. The Legal Obligation To Pay the Loan Costs
Respondent contends that the critical question concerns who
is legally obligated to pay the loan acquisition costs.
Petitioner disputes this, but asserts it was so obligated. Thus,
we begin by considering whether petitioner or Schneider was
legally obligated to pay the commitment and legal fees in
question. In the case of the commitment fee owed under the
Commitment Letter, it is clear Schneider alone was obligated.
The Commitment Letter obligated Schneider to pay the fee up until
the Bridge Loan was funded. The Commitment Letter, which was
addressed to Schneider, states in relevant part:
Your Company shall pay our two Banks * * * a
commitment fee of * * * [stated terms] * * * The
receipt of this commitment fee shall cease upon * * *
[stated circumstances] * * * barring an extension
approved by our two Banks and your Group. [Emphasis
added.]
We find that “Your Company” refers to Schneider, the addressee of
the letter. Petitioner argues that the words “Your Company”
refer to Schneider and its affiliates, and that the reference at
the end of the paragraph to “your Group” supports a finding that
the two terms are used interchangeably. However, while the
Commitment Letter does not define the term “Your Company”, it
does parenthetically clarify the meaning of “Your Group” as
“(i.e., SCHNEIDER and the subsidiaries subject to
consolidation)”. Moreover, the Commitment Letter provides at one
- 41 -
point “Your Company guarantees that it will have this letter
signed by MERLIN GERIN [i.e., MGSA], TELEMECANIQUE [i.e., TESA]”
and at another “Your Company guarantees compliance with this
provision by all the subsidiaries in which it has a controlling
interest”, indicating that “Your Company” does not include
Schneider subsidiaries. Finally, in the section entitled “GROUPE
SCHNEIDER’S COMMITMENTS”, the Commitment Letter states
Your Group agrees * * * not to proceed to acquire new
interests other than those of [petitioner] * * * in net
annual amounts greater than its annual consolidated
available cash flow.
* * * * * * *
To permit our two Banks to monitor this commitment on
the part of your Group, your Company and S.P.E.P. will
provide them * * * with all the necessary accounting
data.
This further demonstrates “Your Company” and “Your Group” are not
interchangeable terms. Moreover, ACQ had not been created at the
time the Commitment Letter was signed (it was organized 10 days
later), and although it is referenced as NEWCO in the Commitment
Letter, no provision requires NEWCO to pay the commitment fee.
Finally, although ACQ was created well before the Commitment
Letter was amended to increase the loan commitment to $1.125
billion on May 13, 1991, the amendment does not obligate ACQ to
pay the commitment fee. We conclude that Schneider, not
petitioner, was obligated to pay the commitment fee due under the
Commitment Letter.
- 42 -
When the Bridge Loan agreement was signed (on May 30, 1991),
ACQ agreed to pay a commitment fee on any funds not disbursed.
The fee was set at the same level as the fee in the Commitment
Letter. Nothing in the Bridge Loan agreement obligated ACQ to
assume Schneider’s obligation to pay the fee under the Commitment
Letter, nor did the Bridge Loan agreement expressly relieve
Schneider of its obligation under the Commitment Letter to pay a
commitment fee until the funds were disbursed. Thus, from May
30, when the Bridge Loan agreement was signed, until June 12,
when the Bridge Loan was disbursed, both ACQ (under the Bridge
Loan agreement) and Schneider (under the Commitment Letter) were
legally obligated to pay a commitment fee equal to 0.3 percent of
the undisbursed funds.23
Respondent asserts he is challenging only the commitment fee
incurred by Schneider under the Commitment Letter; i.e., the fee
provided in the Commitment Letter covering the period from
February 18 through June 12, 1991. Thus, respondent contends, he
is not challenging the deduction of any fees owed under the
Bridge Loan agreement (for which ACQ was the obligor). We
disagree. Since both Schneider and ACQ were obligated for a
commitment fee equal to 0.3 percent of undisbursed funds for the
23
The Term Loan also provided for a commitment fee to be
paid with respect to any undisbursed funds, but none was paid
because execution of the loan documents and disbursement occurred
on the same day.
- 43 -
period from May 30 to June 12, 1991, and the $1,056,020 at issue
represents the fee owed from February 18 through June 12, 1991,24
the amount at issue covers periods where Schneider alone was
legally obligated to pay, and a brief period where both Schneider
and ACQ were obligated to pay. Thus, the commitment fee
respondent has challenged includes amounts for which ACQ, as well
as Schneider, was obligated.
In the case of the legal fees, the question of who was
obligated to pay them is more difficult. It is clear that
Schneider was initially obligated to pay the legal fees. A
letter from Schneider to the French banks, which was required by
the Commitment Letter, contains the following provision: “We
herewith declare that our Company agrees to indemnify your two
Banks * * * as to all costs, expenses or liabilities or [sic] any
kind whatsoever arising from” the Bridge Loan. As with the
Commitment Letter itself, we find that “our Company” refers to
Schneider; thus, Schneider was initially obligated.
The Bridge Loan agreement, on the other hand, provides as
follows:
24
There has been no suggestion that Schneider and ACQ each
owed separate 0.3 percent loan commitment fees with respect to
the same undisbursed funds. Thus, unless the banks charged no
commitment fee under the Bridge Loan agreement, or charged a
separate fee that does not appear in the record, the $1,056,020
at issue would appear to include payments made under both the
Commitment Letter and Bridge Loan agreement.
- 44 -
The Borrower [ACQ] shall * * * indemnify each Bank
* * * and hold each of them harmless against any and
all losses, liabilities, claims, damages or expenses
incurred by any of them arising out of or by reason of
any investigation, litigation or other proceeding
related to the Acquisition, or the Borrower’s or any
other party’s entering into and performance of this
Agreement * * * including the reasonable fees and
disbursements of counsel incurred in connection with
any such investigation, litigation or other proceeding;
* * *
Although it is clear from the language presented here that ACQ,
and later petitioner as ACQ’s successor, was obligated, it is not
clear whether petitioner was obligated for fees incurred by
Schneider before the Bridge Loan agreement was signed, or only
fees incurred from the date of the Bridge Loan agreement forward.
While it would have been clearer had the agreement specifically
identified past costs, the phrase “related to the Acquisition”
contains no temporal limitations25 and is reasonably read to
cover all costs, including those costs incurred while the
takeover attempt was hostile. Respondent has provided no
evidence or argument to suggest a different reading, and we
accordingly find ACQ assumed responsibility to pay the legal
costs associated with the Commitment Letter.
Thus, Schneider was originally obligated to pay both the
commitment fee and legal fees at issue. Schneider caused ACQ
25
The Bridge Loan agreement defined “Acquisition” as the
ACQ’s acquisition of petitioner’s capital and preferred stock
pursuant to the offer of purchase, dated Mar. 4, 1991, as
supplemented.
- 45 -
(and consequently petitioner) to become legally obligated to pay
some of the commitment fee and all of the legal fees. At the
same time, Schneider, which was originally responsible for both,
was not absolved of its responsibility.
While we conclude that Schneider, and not petitioner, bore
the legal obligation to pay most of the commitment fee and
originally bore the obligation for the legal fees, this is not
dispositive of whether petitioner is entitled to deduct these
amounts. As more fully discussed below, a corporation may in
certain circumstances deduct expenditures incurred on its behalf
by a shareholder, where it makes reimbursement.
B. Reimbursed Expenses
As a general matter, a taxpayer may not deduct payments
voluntarily made on another’s behalf, even where there is a moral
obligation to do so. Williams v. Commissioner, T.C. Memo. 1960-
19. Indeed, this is true even where the cost would have been
deductible had the taxpayer incurred it. Id. Moreover,
corporations generally may not deduct payments made that
discharge shareholder obligations. Justice Steel, Inc. v.
Commissioner, T.C. Memo. 1980-466.
Petitioner advances two arguments to support its contention
that legal obligation does not control under these facts. First,
petitioner argues that the costs associated with obtaining a loan
are deductible by the person who receives the loan proceeds.
- 46 -
Petitioner asserts it is the borrower of the Bridge Loan, as the
successor to ACQ. Petitioner relies on Rev. Rul. 81-160, 1981-1
C.B. 312, which holds that a loan commitment fee constitutes a
cost of acquiring a loan and therefore must be deducted ratably
over the term of the loan, revoking an earlier ruling that
permitted a full deduction in the year paid. The issue at hand,
however, is who may deduct a loan commitment fee where the person
who procures the loan commitment is different from, albeit
related to, the borrower. Rev. Rul. 81-160, supra, offers little
guidance on that score.
Petitioner’s second argument is that it should be allowed to
deduct the expenses because it “directly benefited” from the
payment thereof. Petitioner relies on Lohrke v. Commissioner, 48
T.C. 679 (1967), and similar cases for this proposition.26 In
26
In all, petitioner cites 14 cases, including Lohrke v.
Commissioner, 48 T.C. 679 (1967); Fall River Gas Appliance Co. v.
Commissioner, 42 T.C. 850, 857-858 (1964), affd. 349 F.2d 515(1st Cir. 1965); Snow v. Commissioner, 31 T.C. 585 (1958);
Fishing Tackle Prods. Co. v. Commissioner, 27 T.C. 638 (1957);
Dinardo v. Commissioner, 22 T.C. 430 (1954); L. Heller & Son,
Inc. v. Commissioner, 12 T.C. 1109, 1112 (1949); Scruggs-
Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779, 785-788
(1946); Robert Gaylord, Inc. v. Commissioner, 41 B.T.A. 1119(1940); Miller v. Commissioner, 37 B.T.A. 830 (1938); First Natl.
Bank of Skowhegan, Maine v. Commissioner, 35 B.T.A. 876 (1937);
Cepeda v. Commissioner, T.C. Memo. 1993-477, affd. without
published opinion 56 F.3d 1384 (5th Cir. 1995); Coulter Elecs.,
Inc. v. Commissioner, T.C. Memo. 1990-186, affd. without
published opinion 943 F.2d 1318 (11th Cir. 1991); Tex. & Pac. Ry.
Co. v. Commissioner, a Memorandum Opinion of this Court dated
Mar. 25, 1943; and Shasta Water Co. v. Commissioner, a Memorandum
(continued...)
- 47 -
opposition, respondent asserts petitioner did not benefit from
the expenditures. Rather, he asserts Schneider alone benefited
from the commitment and legal fees.
First, as a factual matter, petitioner did benefit from
Schneider’s procuring the loan commitment. While ACQ did not
exist when the Commitment Letter was signed, it was identified in
the letter as the borrower. It was organized soon after and
received the Bridge Loan proceeds. As the recipient of those
funds, ACQ was clearly benefited by the banks’ commitment, as was
petitioner, as the surviving entity after its merger with ACQ.
Schneider benefited as well, because the commitment to provide
financing enabled it to achieve its business goal of acquiring
petitioner, but Schneider’s benefit was not exclusive. Moreover,
while petitioner may initially have been hostile, and some of the
costs at issue arose because of petitioner’s hostility,
petitioner eventually approved the transaction. Petitioner
stands in the shoes of ACQ, which benefited from the loan by
virtue of its receipt and use of the loan proceeds. Thus, even
though some of the loan costs may have been incurred because
petitioner was initially hostile, petitioner ultimately obtained
and used the loan proceeds through its merger with ACQ.
26
(...continued)
Opinion of the Board of Tax Appeals dated Feb. 6, 1942.
- 48 -
More to the point, however, petitioner’s reliance on the
Lohrke line of cases and respondent’s counter argument regarding
who benefited are misplaced because mere benefit is, in general,
not dispositive regarding deductibility.27 While it is true that
Lohrke and like cases allow a taxpayer to deduct expenses that
are the legal obligation of another where the taxpayer benefits,
this exception has been construed narrowly. Under Lohrke and
similar cases, it is not the character of the expense as
benefiting the taxpayer that renders it deductible. Rather, it
is the circumstances surrounding the payment of the expense.
Where the taxpayer can show that the payment of another’s expense
protected or promoted its own business, then such payment gives
rise to a deduction under Lohrke and like cases. Typically in
these circumstances, the original obligor is unable to make
payment, and the taxpayer satisfies the obligation to protect or
promote its own interests. See Hood v. Commissioner, 115 T.C.
172, 180-181 (2000), and cases cited therein. Petitioner has
made no such showing here. There is no suggestion that Schneider
27
Respondent’s argument regarding who benefited from the
loan commitment and legal fees suggests the question of whether
petitioner’s payment of these costs should be considered a
constructive dividend to Schneider, and therefore not deductible
by petitioner. Cf. Hood v. Commissioner, 115 T.C. 172 (2000)
(where controlling shareholder is primary beneficiary of
corporate expenditure, such expenditure is constructive dividend
not deductible by corporation). However, respondent has not
raised this issue, and we accordingly decline to consider it.
- 49 -
was unable to pay the loan commitment or legal fees or that
petitioner’s failure to pay would have adversely affected
petitioner; indeed, Schneider remained legally obligated, and it
initially paid the loan commitment fee.
Nonetheless, we agree with petitioner that legal obligation
is not dispositive and conclude that the loan commitment and
legal fees are deductible by petitioner because Schneider
incurred those costs on behalf of ACQ, and by extension
petitioner, so that petitioner could obtain the Bridge Loan.
The facts and holding of Waring Prods. Corp. v. Commissioner, 27
T.C. 921 (1957), are instructive. The taxpayer was a corporation
organized to hold and exploit certain patents. It attempted to
enter into a contract with a manufacturer to assemble and ship
its patented products, but the manufacturer refused because of
the taxpayer’s poor credit rating. To aid the taxpayer, a major
corporate shareholder, who later acquired all the taxpayer’s
stock, becoming its parent, agreed to enter into a contract
directly with the manufacturer, “pledging its own credit on
behalf of” the taxpayer. Id. at 924. The manufacturer at first
invoiced the shareholder, but later the taxpayer, for the
finished products, and the taxpayer made all payments on the
invoices. The shareholder, however, was never relieved of its
obligations to the manufacturer under the contract.
- 50 -
A dispute arose under the contract, wherein the manufacturer
sought recovery of certain production costs. The dispute was
ultimately settled by the taxpayer’s transfer of property to the
manufacturer. The taxpayer sought to deduct the value of the
property transferred to settle the dispute, but the Commissioner
argued the amount was not deductible because the taxpayer was not
legally obligated to make the transfer. We rejected the
Commissioner’s argument, stating:
We know of no requirement that there must be an
underlying legal obligation to make an expenditure
before it can qualify as an ‘ordinary and necessary’
business expense under section 23(a)(1), Internal
Revenue Code of 1939. The basic question is whether,
in all the circumstances, the expenditure is ordinary
and appropriate to the conduct of the taxpayer's
business. * * * [Id. at 929.]
Thus, it was immaterial that whatever legal obligation might
exist was the shareholder’s, as opposed to the taxpayer’s.
The facts here are quite similar to those in Waring Prods.
Corp. ACQ was in no position to obtain a loan. Accordingly,
Schneider negotiated a loan commitment and agreed to pay loan
commitment and legal fees on behalf of its to-be-organized
subsidiary ACQ. After ACQ’s creation, petitioner, as the
surviving entity after its merger with ACQ, formally assumed some
of the costs (the legal fees), which it paid directly, and agreed
to (and did) reimburse Schneider for other costs (the commitment
fee) in response to Schneider’s invoice. Thus, the costs at
- 51 -
issue here relate to an asset--the loan--that petitioner
obtained, much as the expenditures in Waring Prods. Corp. related
to services performed for the taxpayer, albeit under a contract
to which the taxpayer was not a party. Under the circumstances
of this case, where the loan acquisition costs were incurred on
behalf of petitioner and then paid by petitioner, it is
appropriate to allow petitioner to deduct the costs it paid.
II. Parachute Payments
Respondent disallowed $7,586,105 of the deduction claimed by
petitioner in 1992 with respect to the Retention Payments and
1991 SRP Benefits paid to the Retained Executives in that year,
on the grounds that this amount constituted “excess parachute
payments” within the meaning of section 280G.28 After
concessions, the parties dispute two issues underlying
respondent’s determination. First, the parties dispute whether
28
On brief, respondent concedes that a portion of the 1991
SRP Benefits was not contingent on a change in control within the
meaning of sec. 280G(b)(2)(A)(i) on the grounds that it falls
within a safe harbor provided in sec. 1.280G-1, A-24(c), Proposed
Income Tax Regs., 54 Fed. Reg. 19399 (May 5, 1989), because
payment of that portion was substantially certain, regardless of
the change in control, if the Retained Executives continued to
work for petitioner until the vesting of their rights to these
payments. Further, the parties have stipulated that the interest
component of the 1991 SRP Benefits is deductible by petitioner
under sec. 163 in 1992 and does not constitute a “parachute
payment” within the meaning of sec. 280G. For convenience, we
hereinafter refer to the portion of the 1991 SRP Benefits whose
deductibility remains in dispute as the “disputed 1991 SRP
Benefits” and the portion conceded by respondent as deductible as
the “noncontingent 1991 SRP Benefits”.
- 52 -
the Retention Payments and the disputed 1991 SRP Benefits were
“contingent on a change in the ownership or effective control” of
petitioner within the meaning of section 280G(b)(2)(A)(i)(I).
Second, the parties disagree about the extent to which petitioner
has established that the foregoing amounts constitute reasonable
compensation within the meaning of section 280G(b)(4)(A).
A. General Requirements of Section 280G
In general terms, section 280G disallows a deduction for any
payment in the nature of compensation to certain individuals
performing services for a corporation (i) if the payment is
contingent on a change in ownership or control of the
corporation, (ii) if and to the extent the payment exceeds three
times the individual’s annual compensation in periods preceding
the change in control, and (iii) if and to the extent the payment
has not been shown by the taxpayer to constitute reasonable
compensation for services rendered before or after the change in
ownership or control.
More specifically, section 280G(a) disallows a deduction for
any “excess parachute payment”, defined in section 280G(b)(1) as
“an amount equal to the excess of any parachute payment over the
portion of the base amount allocated to such payment.”
“[P]arachute payment”, as relevant to the instant case, is
defined in section 280G(b)(2)(A) as follows:
- 53 -
(A) In general.--The term “parachute payment” means any
payment in the nature of compensation to (or for the
benefit of) a disqualified individual if--
(i) such payment is contingent on a
change--
(I) in the ownership or
effective control of the
corporation, or
(II) in the ownership of a
substantial portion of the assets
of the corporation, and
(ii) the aggregate present value of the
payments in the nature of compensation to (or
for the benefit of) such individual which are
contingent on such change equals or exceeds
an amount equal to 3 times the base amount.
For purposes of clause (ii), payments not treated as
parachute payments under paragraph (4)(A) * * * [i.e.,
section 280G(b)(4)(A), regarding reasonable
compensation, set out below] shall not be taken into
account.
As provided in the foregoing flush language, the amount treated
as a “parachute payment” (and therefore also an “excess parachute
payment”) does not include the portion of a contingent-on-
control-change payment that the taxpayer proves is reasonable
compensation, as provided in section 280G(b)(4)(A):
(4) Treatment of amounts which taxpayer
establishes as reasonable compensation.--In the case of
any payment described in paragraph (2)(A) [i.e.,
section 280G(b)(2)(A), set out above]--
(A) the amount treated as a parachute
payment shall not include the portion of such
payment which the taxpayer establishes by
clear and convincing evidence is reasonable
compensation for personal services to be
- 54 -
rendered on or after the date of the change
described in paragraph (2)(A)(i) * * *
The parties agree that the Retention Payments and 1991 SRP
Benefits that petitioner deducted and respondent disallowed were
in the nature of compensation to disqualified individuals within
the meaning of section 280G(b)(2)(A). The parties also agree as
to the “base amount” under section 280G for each Retained
Executive. The parties disagree, and we must decide, whether the
Retention Payments and the disputed 1991 SRP Benefits were
contingent on a change in ownership or control within the meaning
of section 280G(b)(2)(A)(i) and, if so, whether any portion of
such payments constituted reasonable compensation for personal
services rendered after29 the change in control, within the
meaning of section 280G(b)(4)(A).
B. Whether Payments Were Contingent on a Change in Control
Respondent contends that the Retention Payments and the
disputed 1991 SRP Benefits were contingent on a change in
petitioner’s ownership or control within the meaning of the
statute; petitioner contends that the payments in question were
not so contingent because they were made pursuant to an agreement
29
The statute also provides that the amount treated as an
excess parachute payment shall be reduced by the amount
demonstrated to be reasonable compensation for personal services
actually rendered before the change in ownership or control.
Sec. 280G(b)(4)(B). However, petitioner does not contend that
this provision applies in the instant case.
- 55 -
entered into after the change in control. For the reasons
outlined below, we agree with respondent.
The phrase “contingent on a change in the ownership or
effective control of the corporation” as used in section 280G is
not further defined in the statute. However, the legislative
history of that section provides that “a payment is to be treated
as contingent on a change of ownership or control * * * if such
payment would not in fact have been made to the disqualified
individual had no change in ownership or control occurred.” H.
Rept. 98-861, at 851 (1984), 1984-3 C.B. (Vol. 2) 1, 105; see
also Cline v. Commissioner, 34 F.3d 480, 486 (7th Cir. 1994)
(adopting foregoing standard), affg. Balch v. Commissioner, 100
T.C. 331 (1993). Furthermore, the General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984 states
that “A payment generally is to be treated as one which would not
have in fact been made unless it is substantially certain, at the
time of the change, that the payment would have been made whether
or not the change occurred.” Staff of Joint Comm. on Taxation,
General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984, at 201 (J. Comm. Print 1984). In this
regard, a payment may be treated as contingent on a change in
ownership or control even if the employment of the disqualified
individual receiving the payment is not voluntarily or
- 56 -
involuntarily terminated. See H. Rept. 98-861, supra at 851,
1984-3 C.B. (Vol. 2) at 105.
In 1989 the Commissioner issued proposed regulations under
section 280G in question and answer (Q&A) format.30 See sec.
1.280G-1, Proposed Income Tax Regs., 54 Fed. Reg. 19390 (May 5,
1989) (as corrected by 54 Fed. Reg. 25879 (June 20, 1989) and 54
Fed. Reg. 29061 (July 11, 1989)) (hereinafter, proposed
regulations). Q&A-22 of the proposed regulations defines
“contingent on a change in the ownership or effective control” in
a manner consistent with the legislative history:
In general, a payment is treated as “contingent” on a
change in ownership or control if the payment would
not, in fact, have been made had no change in ownership
or control occurred. A payment generally is to be
treated as one which would not, in fact, have been made
in the absence of a change in ownership or control
unless it is substantially certain, at the time of the
change, that the payment would have been made whether
or not the change occurred. * * *
30
The Commissioner issued revised proposed regulations on
Feb. 20, 2002, and final regulations under sec. 280G on Aug. 4,
2003. See sec. 1.280G-1, Proposed Income Tax Regs., 67 Fed. Reg.
7630 (Feb. 20, 2002); sec. 1.280G-1, Income Tax Regs. These
regulations are not applicable here because they apply to
payments contingent on a change in ownership or control that
occurs on or after Jan. 1, 2004. See sec. 1.280G-1, Q&A-48,
Proposed Income Tax Regs., 67 Fed. Reg. 7656 (Feb. 20, 2002);
sec. 1.280G-1, Q&A-48, Income Tax Regs. Where, as here, the
change in ownership or control occurred prior to Jan. 1, 2004,
the Commissioner has conceded that taxpayers may rely on the 1989
proposed regulations. See Preamble to sec. 1.280G-1, Income Tax
Regs., 68 Fed. Reg. 45745 (Aug. 4, 2003); see also Preamble to
sec. 1.280G-1, Proposed Income Tax Regs., 67 Fed. Reg. 7630 (Feb.
20, 2002).
- 57 -
Sec. 1.280G-1, A-22(a), Proposed Income Tax Regs., 54 Fed. Reg.
19398 (May 5, 1989). The next Q&A clarifies this rule with
respect to payments made under agreements entered after a change
in control. Q&A-23 of the proposed regulations states:
Q-23: May a payment be treated as contingent on a
change in ownership or control if the payment is made
under an agreement entered into after the change?
A-23: (a) No. Payments are not treated as
contingent on a change in ownership or control if they
are made (or to be made) pursuant to an agreement
entered into after the change. For this purpose, an
agreement that is executed after a change in ownership
or control, pursuant to a legally enforceable agreement
that was entered into before the change, will be
considered to have been entered into before the change.
* * * [Sec. 1.280G-1, Q&A-23, Proposed Income Tax
Regs., 54 Fed. Reg. 19399 (May 5, 1989); emphasis
added.]
Both petitioner and respondent have framed the “contingent
on control change” issue as turning upon the precise meaning of
the phrase “pursuant to” in Q&A-23 of the proposed regulations.31
While proposed regulations are not competent authority and “carry
no more weight than a position advanced on brief by the
31
We note that the revised proposed and final regulations
under sec. 280G (see supra note 28), modified Q&A-23 to provide
that where a taxpayer gives up rights under an agreement entered
into before a change in control as consideration for rights under
a new agreement, entered into after a change in control, the
payments under the post-change agreement will be considered
contingent on a change in control to the extent payments under
the post-change agreement have the same value as those due under
the pre-change agreement. See sec. 1.280G-1, Q&A-23, Proposed
Income Tax Regs., 67 Fed. Reg. 7630 (Feb. 20, 2002); sec. 1.280G-
1, Q&A-23, Income Tax Regs.
- 58 -
respondent”, F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233,
1265-1266 (1970); see also Houston Oil & Minerals Corp. v.
Commissioner, 92 T.C. 1331, 1338 (1989), affd. 922 F.2d 283 (5th
Cir. 1991); Driggs v. Commissioner, 87 T.C. 759, 771 n.10 (1986);
Miller v. Commissioner, 70 T.C. 448, 460 (1978), respondent has
conceded that petitioner may rely on these proposed regulations
with respect to a change in ownership or control that occurs
prior to January 1, 2004, see Preamble to sec. 1.280G-1, 68 Fed.
Reg. 45745 (Aug. 4, 2003); see also Preamble to sec. 1.280G-1,
Proposed Income Tax Regs., 67 Fed. Reg. 7630 (Feb. 20, 2002).
Even though petitioner is entitled to rely on the version of Q&A-
23 contained in the 1989 proposed regulations, that version does
not support petitioner’s position.
In an effort to bring the payments at issue within the
exception in Q&A-23 to treatment as contingent on a change in
control, petitioner offers considerable argument in support of
the claim that the Retention Payments and disputed 1991 SRP
Benefits were made “pursuant to” the 1991 Employment Agreements
(as amended in 1992) rather than the 1990 Employment Agreements.
This is not the issue, however. No one seriously disputes that
the payments in question where made “pursuant to” the 1991
Employment Agreements, as amended in 1992; the dispute concerns
whether the 1991 Employment Agreements were executed “pursuant
to” the 1990 Employment Agreements. To the extent we can
- 59 -
interpret petitioner as addressing the latter point, petitioner
seems to suggest that a pre-control-change agreement must have
imposed a legal obligation on, or there must have existed at
least an informal pre-control-change understanding requiring, the
parties to enter into the post-control-change agreement under
which the payments are made in order for such payments to be
treated as contingent on a change in control within the meaning
of section 280G. As petitioner observes on brief:
In the instant case neither Petitioner nor the
executives were under any legal obligation to enter
into the 1991 Employment Agreements or the 1992
Amendments [citations omitted]; they could have gone in
separate directions from the legal standpoint. * * *
Thus, the payments necessarily were made “pursuant to”
the new [i.e., 1991 and 1992] agreements and were not
contingent on a change in control of Petitioner. * * *
* * * * * * *
[I]n the instant case there was no formal or informal
pre-acquisition understanding that the parties would
enter into the 1991 Employment Agreements or the 1992
Amendments and that the * * * [retention] payments [and
1991 SRP Benefits] would be made under those
agreements.
Respondent interprets “pursuant to” as used in Q&A-23's
reference to the relationship between pre- and post-control-
change agreements in the sense of the earlier agreement’s
functioning as a proximate cause of certain terms of the later
agreement. Thus, if a legally enforceable pre-control-change
agreement is the proximate cause of provisions in an agreement
entered into after the change in control, the latter agreement is
- 60 -
treated as executed “pursuant to” the former within the meaning
of the proposed regulations. As a consequence, under the
proposed regulations, the latter agreement is “considered to have
been entered into before the change.” Sec. 1.280G-1, A-23,
Proposed Income Tax Regs., supra. Respondent’s argument is that
the Retained Executives were able to obtain key terms of the 1991
Employment Agreements--which entitled each to a Retention Payment
and a 1991 SRP Benefit calculated to exceed the value of his
Termination Award and SRP Cashout--because of the 1990 Employment
Agreements which, in the event of a change in control, entitled
each Retained Executive to a Termination Award and SRP Cashout at
his sole discretion. The Retained Executives’ entitlement to the
Termination Awards and SRP Cashouts under the 1990 Employment
Agreements thus gave them “a significant degree of leverage in
their negotiations with Schneider” over the 1991 Employment
Agreements, respondent argues. In respondent’s view, “the 1991
Employment Agreements were executed pursuant to the 1990
Employment Agreements, within the meaning of Prop. Treas. Reg. §
1.280G-1, Q&A-23, because the terms of the post-acquisition
agreements were dictated by the parachute provisions of the pre-
acquisition agreements.”
We conclude that respondent’s construction of “pursuant to”
is consistent with the meaning of “contingent on a change in the
ownership or effective control of the corporation” used in
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section 280G(b)(2)(A)(i), as that meaning has been clarified in
the legislative history of the statute. Petitioner’s
construction, by contrast, would contravene the meaning intended
by Congress. As noted, the legislative history provides that a
payment is to be deemed contingent on a change in control if the
payment “would not in fact have been made to the disqualified
individual had no change in ownership or control occurred”, H.
Rept. 98-861, supra at 851, 1984-3 C.B. (Vol. 2) at 105; in sum,
Congress intended a factual “but for” test. Respondent’s
construction of “pursuant to”, which interprets it as conveying a
factual, causal nexus rather than legal or contractual necessity,
accords with the legislative history. Petitioner’s construction,
which would find the “pursuant to” relationship to exist between
pre- and post-control-change agreements only where the former
legally required the latter, produces a far narrower construction
of “contingent on a change in * * * control” than Congress
intended. We therefore reject it. Thus, section 1.280G-1, A-23,
Proposed Income Tax Regs., supra, is no help to petitioner.
Absent section 1.280G-1, Q&A-23, Proposed Income Tax Regs.,
supra, we think respondent easily prevails in his claim that the
Retention Payments and the disputed 1991 SRP Benefits were
contingent on a change in control within the meaning of section
280G. Both this Court and the Court of Appeals for the Seventh
Circuit, to which appeal of this case would ordinarily lie, have
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endorsed the previously quoted legislative history’s gloss on the
meaning of “contingent on a change in * * * control” as used in
the statute. See Cline v. Commissioner, 34 F.3d 480 (7th Cir.
1994). In Cline, the taxpayer entered into a severance agreement
that would have subjected the taxpayer to an excise tax for
parachute payments under section 4999 and his employer to a
deduction disallowance under section 280G. To avoid this result,
the taxpayer and his employer renegotiated the agreement to
reduce the severance payment below the threshold level. The
employer then agreed to use its best efforts to employ the
taxpayer so as to make up the amount subtracted from the original
agreement. In the end, the taxpayer received a bonus almost
equivalent to the reduction in the parachute payment. The
Seventh Circuit affirmed this Court, which found that the later
payment, negotiated after the change in control, was properly
considered as contingent on a change of control. Cline v.
Commissioner, supra at 485.
On this record, we have no difficulty concluding that the
Retention Payments and the disputed 1991 SRP Benefits “would not
in fact have been made * * * had no change in ownership or
control occurred.” H. Rept. 98-861, supra at 851, 1984-3 C.B.
(Vol. 2) at 105. The facts in this case are that Schneider had
no feasible alternative to retaining the Retained Executives in
order to protect its $2.25 billion investment in petitioner, that
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the Retained Executives were aware of Schneider’s plight, and
that the Retained Executives used their entitlement to the
Termination Awards and SRP Cashouts as a sword in their
negotiations with Schneider concerning the terms of their
compensation for continued employment. As one Retained Executive
expressed it in a letter to a negotiator for Schneider, “One way
or the other, * * * [the] parachute payments will be paid”, and
“Not one officer is willing to give up what they are entitled to
under their [1990 employment] contract”.
Schneider ultimately agreed to Retention Payments and 1991
SRP Benefits that exceeded the Termination Awards and SRP
Cashouts payable under the 1990 Employment Agreements if the
Retained Executives had elected to terminate their employment
during the June 1992 Window. Indeed, as reflected in our
findings of fact, the Retention Payment payable to each Retained
Executive if his employment terminated (other than for cause) on
the first day the 1991 Employment Agreements became effective--
that is, without his providing any services--exceeded the
Termination Award to which the executive was entitled if he
unilaterally terminated his employment during the June 1992
Window under the 1990 Employment Agreements. The role of the
1991 SRP Benefit in replacing the SRP Cashout provided in the
1990 Employment Agreements is similarly transparent. The 1991
SRP Benefit was in general computed as an amount equal to the SRP
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Cashout under the 1990 Employment Agreements for a termination as
of December 31, 1991, plus interest to the date paid.
In sum, the circumstances surrounding the negotiations that
secured the Retained Executives’ rights to the Retention Payments
and 1991 SRP Benefits under the 1991 Employment Agreements, and
the relationship between these payments and the Termination
Awards and SRP Cashouts under the 1990 Employment Agreements,
convince us, and we so find, that the Retention Payments and 1991
SRP Benefits were obtained by the Retained Executives as
consideration in exchange for relinquishing their rights to the
Termination Awards and SRP Cashouts.32 Since the latter payments
were indisputably contingent on a change in control, and they
were relinquished in exchange for the Retention Payments and 1991
SRP Benefits, we are persuaded that the Retention Payments and
the disputed 1991 SRP Benefits would not in fact have been made
absent the change in ownership. Accordingly, we hold that the
32
Although it is true that a Retained Executive’s right to
receive a Termination Award was essentially unconditional (during
the June 1992 Window), while his right to a Retention Payment was
conditioned upon either (i) involuntary termination without
cause, (ii) voluntary termination for “good reason”, or (iii)
completion of an approximately 3-year employment period, we
believe that a Retained Executive was compensated for the
assumption of these new restrictions by the amount by which the
Retention Payment exceeded the Termination Award. Specifically,
the Retention Payment payable to each Retained Executive on the
first day the 1991 Employment Agreement was effective exceeded
his Termination Award, and the Retention Payment increased pro
rata for each week of employment after the effective date of the
1991 Employment Agreement.
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Retention Payments and the disputed 1991 SRP Benefits were
contingent on a change in ownership or effective control within
the meaning of section 280G(b)(2)(A).
Concededly, the Retention Payments and disputed 1991 SRP
Benefits also served in part as consideration for future
services, as the Retained Executives were generally required to
serve out a 3-year (later amended to 4-year) term of employment
to receive them (unless terminated for cause or “good reason”).
However, the statute contemplates situations where such
contingent payments that fall within the definition of “parachute
payment” may also serve as consideration for future services, and
provides a mechanism for exempting amounts from parachute payment
treatment that the taxpayer can show are serving the latter
function; namely, by proving that they are reasonable
compensation for services rendered or to be rendered. See sec.
280G(b)(4). The parties dispute whether the amounts determined
by respondent to be contingent on a change in control constitute
reasonable compensation within the meaning of section
280(G)(b)(4), and it is to that dispute that we now turn.
C. Reasonable Compensation--Applicable Test
Since the Retention Payments and the disputed 1991 SRP
Benefits were contingent on a change in control, they are
parachute payments for purposes of section 280G except to the
extent that petitioner can establish by clear and convincing
- 66 -
evidence that any portion of those payments constituted
reasonable compensation for services to be rendered on or after
the change in ownership or control.33 Respondent does not
contest the deductibility as reasonable compensation of any other
payments received by the Retained Executives in 1992.
In deciding whether petitioner has shown that any portion of
the payments at issue constituted reasonable compensation for
purposes of section 280G(b)(4), we are faced with the threshold
question of the appropriate test or standard to use for assessing
the reasonableness of compensation. In Cline v. Commissioner,
34 F.3d 480 (7th Cir. 1994), the Court of Appeals for the Seventh
Circuit, to which an appeal in this case would ordinarily lie,
approved our use of a multifactor test as a means of determining
whether compensation is reasonable for purposes of section 280G.
More recently, however, the Court of Appeals rejected the use of
a multifactor test to determine reasonable compensation for
purposes of section 162(a)(1), holding that an “independent
33
Sec. 280G(b)(4) provides in part:
(4) Treatment of amounts which taxpayer
establishes as reasonable compensation.--In the case of
any payment described in paragraph (2)(A)--
(A) the amount treated as a parachute
payment shall not include the portion of such
payment which the taxpayer establishes by
clear and convincing evidence is reasonable
compensation for personal services to be
rendered on or after the date of the change
described in paragraph (2)(A)(i) * * *
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investor” test must instead be used.34 Exacto Spring Corp. v.
Commissioner, 196 F.3d 833 (7th Cir. 1999), revg. Heitz v.
Commissioner, T.C. Memo. 1998-220. As Exacto Spring Corp.
concerned reasonable compensation for purposes of section 162(a),
it is distinguishable from the instant case, and therefore we are
not bound by Golsen v. Commissioner, 54 T.C. 742 (1970), affd.
445 F.2d 985 (10th Cir. 1971), to follow it here.
Nonetheless, the disfavor with which the Court of Appeals
views the traditional multifactor test for reasonable
compensation prompts us to consider carefully whether it is
appropriate to extend the independent investor test of Exacto
34
In Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th
Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo. 1998-220, the
Court of Appeals for the Seventh Circuit rejected a multifactor
test for reasonable compensation in a sec. 162(a)(1) context
(which examined such factors as the employee’s skills and duties,
prior earning capacity, the prevailing compensation paid to
employees with comparable jobs, etc.) because, inter alia, the
factors conventionally used in a multifactor test “do not bear a
clear relation * * * to the primary purpose of section 162(a)(1),
which is to prevent dividends (or in some cases gifts), which are
not deductible from corporate income, from being disguised as
salary, which is.” Id. at 835. The Court of Appeals held
instead that the independent investor test, which “dissolves the
old [multifactor test] and returns the inquiry to basics”, id. at
838, must be used. The independent investor test as fashioned by
the Court of Appeals for the Seventh Circuit looks solely at the
rate of return that has been generated for the corporation’s
owners by its “managers” (i.e., its high-level employees whose
compensation is at issue). If the rate of return (after
compensating the managers) is one that would, according to expert
opinion, be acceptable to an independent investor, considering
the risks of the investment, then the managers’ compensation is
presumptively reasonable. Id. at 838-839.
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Spring Corp. to circumstances where reasonable compensation must
be measured for purposes of section 280G. We do not do so,
because we conclude that use of the independent investor test to
determine reasonable compensation for purposes of section 280G
would contravene congressional intent.
“Reasonable compensation” as that term is used in section
280G(b)(4) is not further defined in the statute. Neither the
committee nor conference reports accompanying the enactment of
original section 280G in the Deficit Reduction Act of 1984, Pub.
L. 98-369, 98 Stat. 494, provide any guidance regarding how
“reasonable compensation” as employed in section 280G(b)(4) is to
be determined. However, the Joint Committee on Taxation’s
General Explanation covering the legislation states:
In the case of an employment contract, whether payments
under it would be deemed reasonable would depend on all
the facts and circumstances, including the individual’s
historic compensation, the duties to be performed under
the contract, and the compensation of individuals of
comparable skills outside of an acquisition context.
[Staff of Joint Comm. on Taxation, General Explanation
of the Revenue Provisions of the Deficit Reduction Act
of 1984, at 204 (J. Comm. Print 1984).]
An amendment to the statute 2 years after section 280G was
enacted contains direct legislative history concerning the intent
underlying “reasonable compensation”. In 1986, Congress amended
section 280G(b)(4) to provide, in cases where the taxpayer
establishes that a parachute payment constitutes reasonable
compensation, for different treatment where the reasonable
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compensation is for services provided before, or after, the date
of the change in ownership or control. See Tax Reform Act of
1986, Pub. L. 99-514, sec. 1804(j)(2), 100 Stat. 2808. In
connection with this amendment of the reasonable compensation
provisions of section 280G, the Finance Committee report states:
The committee intends that evidence that amounts
paid to a disqualified individual for services to be
rendered that are not significantly greater than
amounts of compensation (other than compensation
contingent on a change in ownership or control or
termination of employment) paid to the disqualified
individual in prior years or customarily paid to
similarly situated employees by the employer or by
comparable employers will normally serve as clear and
convincing evidence of reasonable compensation for such
services. [S. Rept. 99-313, at 919-920 (1986), 1986-3
C.B. (Vol. 3) 1, 919-920; see also H. Rept. 99-426, at
902 (1985), 1986-3 C.B. (Vol. 2) 1, 902 (containing
substantially identical language).]
The foregoing legislative history convinces us that Congress
intended that reasonable compensation for purposes of section
280G(b)(4) was generally to be determined under the conventional
multifactor test. The factors enumerated in the Finance
Committee report--that is, the employee’s compensation in prior
years and the compensation paid to similarly situated employees
of the taxpayer or of comparable employers--are archetypal
factors of the conventional multifactor test.35 We accordingly
35
Similar factors are also included in Q&A-40 of the
proposed, revised proposed, and final regulations. Sec. 1.280G-
1, Proposed Income Tax Regs., 54 Fed. Reg. 19406 (May 5, 1989),
as corrected by 54 Fed. Reg. 25879 (June 20, 1989) and further
(continued...)
- 70 -
conclude that extension of the Court of Appeals for the Seventh
Circuit’s independent investor test for determining reasonable
compensation under section 162(a) to the golden parachute context
would be contrary to congressional intent.
Our conclusion is buttressed by consideration of the
differing purposes served by sections 162(a)(1) and 280G(b)(4).
As pointed out by the Court of Appeals in Exacto Spring Corp.,
section 162(a)(1) is designed to address the problem created by a
closely held corporation’s controlling shareholder-employee’s
incentive to mischaracterize a nondeductible dividend as
deductible compensation for services. The independent investor
test addresses this abuse by testing the claimed compensation
against the result that market forces would produce: That is,
the compensation that an independent investor, not affected by
the tax incentives operating on an investor-employee, would be
willing to pay a corporate manager producing a given rate of
return.
In enacting section 280G, Congress set out to address a
different problem: The deleterious effect, in Congress’s view,
of golden parachute contracts on the acquisition process for
publicly traded corporations, because such arrangements
35
(...continued)
corrected by 54 Fed. Reg. 29061 (July 11, 1989); sec. 1.280G-1,
Proposed Income Tax Regs., 67 Fed. Reg. 7654 (Feb. 20, 2002);
sec. 1.280G-1, Income Tax Regs.
- 71 -
discouraged would-be acquirers, created conflicts of interest
between the managers and shareholders of such corporations, and
tended to reduce the share of the acquisition proceeds that
should go to the seller’s shareholders. Staff of Joint Comm. on
Taxation, General Explanation of the Revenue Provisions of the
Deficit Reduction Act of 1984, at 199-200 (J. Comm. Print 1984).
In this context, Congress concluded that golden parachutes should
be strongly discouraged by exacting a “tax penalty” if they are
paid. S. Prt. 98-169 (Vol. 1), at 195 (1984).
The purpose of section 280G, then, is to impose a tax
penalty on a corporation that pays golden parachutes, defined
generally as payments that are extraordinarily large in relation
to the recipient’s historical compensation and are contingent on
a change in control of the corporate payor. Moreover, the
statute provides that such payments are presumptively
unreasonable compensation. We do not believe that an independent
investor test for reasonable compensation is well designed to
accomplish Congress’s goal, since it asks only whether an
independent investor would have been satisfied with his return
after payment of the parachute payments (plus any other
compensation) to management. Presumably, when golden parachutes
are present, an acquisition goes forward because the acquirer–-
who is an actual, not merely hypothetical, independent investor-–
believes that his rate of return after paying the golden
- 72 -
parachutes will be satisfactory. Otherwise, the acquirer would
not proceed with the transaction.36 Thus it would appear that in
any case where an acquisition of a publicly traded corporation
has been consummated, triggering the payment of golden parachutes
contingent thereon, the amounts so paid (at least where connected
to services) would tend to be found reasonable compensation under
an independent investor test. Accordingly, applying the
independent investor test to segregate reasonable from
unreasonable compensation in the acquisition context may not
produce results that are meaningful in light of the intent of
section 280G.37
Instead, we believe the touchstone of reasonable
compensation that Congress intended for section 280G(b)(4) is, as
phrased in the legislative history, the amount that would be paid
“outside of an acquisition context.” Staff of Joint Comm. on
36
A would-be acquirer will typically have knowledge of the
existence of golden parachute contracts, as did Schneider in this
case, because such compensation arrangements are generally
required to be disclosed in a publicly traded corporation’s proxy
statements filed with the Securities and Exchange Commission.
See 17 C.F.R. sec. 229.402(b)(2)(v)(A)(2) (2000).
37
One can imagine other situations where reasonable
compensation must be determined, yet an independent investor test
may not be readily applied. For example, the payment of
unreasonable compensation to an employee of a sec. 501(c)(3)
organization may constitute private inurement in violation of
that section. See, e.g., B.H.W. Anesthesia Found., Inc. v.
Commissioner, 72 T.C. 681 (1979). However, the concept of an
appropriate return on investment would appear inapposite in the
case of a nonprofit enterprise.
- 73 -
Taxation, General Explanation of the Revenue Provisions of the
Deficit Reduction Act of 1984, at 204 (J. Comm. Print 1984). The
independent investor test takes no account of the existence or
absence of an acquisition context. The conventional multifactor
test, which considers, inter alia, historical (preacquisition)
compensation as well as compensation paid by comparable companies
that have not been recently acquired, is better designed to
identify the amount of compensation that would have been paid
outside an acquisition context, and it is this amount that we
conclude Congress intended to treat as reasonable compensation
for purposes of section 280G(b)(4).38
38
Even if the independent investor test were applied in
this case, petitioner has failed to demonstrate by clear and
convincing evidence that its after-tax return on equity in 1992
would have been satisfactory to a hypothetical independent
investor.
Based on its audited financial statements, petitioner’s
after-tax return on equity for 1992 was negative. After making a
series of adjustments that purportedly eliminate the effects of
its acquisition and associated indebtedness, petitioner contends
that its return on equity was more than 20 percent in 1992. We
need not decide whether petitioner has demonstrated clearly and
convincingly that these adjustments are appropriate because, in
any event, petitioner has failed to demonstrate what the rates of
return for comparable companies would be if similar adjustments
were made to their earnings and stockholders’ equity.
Accordingly, even if an independent investor test were
applicable, petitioner has not shown that the compensation paid
to the Retained Executives was reasonable thereunder.
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D. Determination of Reasonable Compensation
1. Overview of Expert Testimony
Having decided to apply a multifactor test, we turn to a
consideration of whether petitioner has met its burden of showing
by clear and convincing evidence that the Retention Payments and
disputed 1991 SRP Benefits constitute reasonable compensation.
Both parties presented expert testimony on the reasonableness of
the Retained Executives’ compensation under the 1991 Employment
Agreements, as amended in 1992.39 Petitioner’s expert, Pearl
Meyer, is an executive compensation consultant with more than 40
years’ experience. Respondent’s expert, Arthur Rosenbloom, is a
financial consultant and investment banker specializing in
securities valuation and mergers and acquisitions with more than
30 years’ experience. Both Ms. Meyer and Mr. Rosenbloom authored
opening and rebuttal expert reports and testified at trial.
39
Petitioner also argues that the compensation of the
Retained Executives under the 1991 Employment Agreements was
reasonable because it was the product of arm’s-length bargaining.
The short answer to petitioner’s argument is that, while the
negotiations may have been at arm’s length, they were
indisputably skewed by the Retained Executives’ right to collect
their substantial Termination Awards and SRP Cashouts in June
1992, without providing any future services. Thus, as reflected
in our findings, a significant portion of the Retention Payments
and 1991 SRP Benefits served to compensate the Retained
Executives for the relinquishment of their rights to the
Termination Awards and SRP Cashouts, not for their future
services. Consequently, the arm’s-length nature of the
bargaining provides no assurance that the amounts paid were
arm’s-length consideration for the services to be rendered.
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We evaluate the opinions of experts in light of the
qualifications of each expert and all other evidence in the
record. Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th
Cir. 1973), affg. 54 T.C. 493 (1970); Parker v. Commissioner, 86
T.C. 547, 561 (1986). We have broad discretion to evaluate “‘the
overall cogency of each expert’s analysis.’” Sammons v.
Commissioner, 838 F.2d 330, 333 (9th Cir. 1988) (quoting Ebben v.
Commissioner, 783 F.2d 906, 909 (9th Cir. 1986), affg. in part
revg. and remanding in part T.C. Memo. 1983-200), affg. in part,
revg. in part T.C. Memo. 1986-318. We are not bound by the
opinion of an expert when that opinion is contrary to our
judgment. Orth v. Commissioner, 813 F.2d 837, 842 (7th Cir.
1987), affg. Lio v. Commissioner, 85 T.C. 56 (1985); Estate of
Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg.
T.C. Memo. 1954-139. While we may accept the opinion of an
expert in its entirety, Buffalo Tool & Die Manufacturing Co. v.
Commissioner, 74 T.C. 441, 452 (1980), we may be selective in the
use of any portion of such an opinion, Parker v. Commissioner,
supra at 562.
Both experts considered numerous factors, including the
skills and responsibilities of each Retained Executive before and
after the merger and the compensation of purportedly comparable
executives of other companies. Mr. Rosenbloom conducted an
analysis of compensation paid by petitioner to the Retained
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Executives before and after the acquisition by Schneider, as well
as a comparison of the Retained Executives’ compensation paid in
1992 with compensation paid in 1992 to executives of other
companies. Ms. Meyer conducted what she termed an internal
analysis, focusing on aspects of petitioner’s financial condition
and need for skilled executives, and three external analyses,
which measured the Retained Executives’ compensation packages
against those of executives working at other companies.
We conclude that two of Ms. Meyer’s external analyses fall
considerably short of providing clear and convincing evidence of
the reasonableness of the compensation of the Retained Executives
in 1992. One such analysis employs data from “executive
compensation surveys” prepared by Towers Perrin, Watson Wyatt
Data Services, and William M. Mercer, Inc. As described in Ms.
Meyer’s opening report, these surveys include compensation data
from anywhere from 250 to 1,000 organizations, many of which are
conceded to be outside the electrical equipment industry. We
reject this analysis because it employs data from companies that
have not been shown to be comparable to petitioner. Although
section 280G itself does not address the use of comparable
companies and their executives as a basis for determining
reasonable compensation, the legislative history of the 1986
amendment of section 280G(b)(4) specifically endorses the use of
“similarly situated employees” working for “comparable employers”
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as a means of determining reasonable compensation. S. Rept. 99-
313, supra at 919-920, 1986-3 C.B. (Vol. 3) at 919-920; H. Rept.
99-426, supra at 902, 1986-3 C.B. (Vol. 2) at 902. In our view,
if the designation of “comparable employers” is to have
meaningful content, it must be more restrictive than data sources
for these surveys, which include an many as 1,000 organizations.
In a second external analysis, Ms. Meyer examined
compensation arrangements between (i) companies engaged in the
electrical equipment or substantially similar industries, and
(ii) executives of those companies, focusing on compensation paid
to executives for purposes of recruitment, promotion, or
retention. However, of the 22 arrangements examined by Ms.
Meyer, only one involved calendar year 1992. Consequently, the
relevance of Ms. Meyer’s findings under this approach to the
ascertainment of reasonable compensation in 1992 has not been
clearly established, and we reject them.
A third external analysis performed by Ms. Meyer is more
promising. In it, she utilized publicly available disclosures of
executive compensation contained in proxy statements filed by
publicly traded companies with the Securities and Exchange
Commission (SEC) to compare the compensation of purportedly
comparable executives to the compensation of the Retained
Executives. Mr. Rosenbloom used a similar approach based on SEC
proxy materials. These comparisons based on SEC proxy materials
- 78 -
constitute a principal basis for each expert’s opinion regarding
the reasonableness of the Retained Executives’ compensation. We
shall consider the experts’ differences in more detail
hereinafter.
2. Historical Compensation
As noted, Mr. Rosenbloom also performed an analysis of the
Retained Executives’ compensation before and after the
acquisition by Schneider. Notably absent from Ms. Meyer’s
opening report is any serious consideration of the Retained
Executives’ historical compensation.40 The legislative history
of section 280G makes clear that one factor to be considered in
determining reasonable compensation for purposes of section
280G(b)(4) is “compensation * * * paid to the disqualified
40
Ms. Meyer addressed historical compensation only in her
rebuttal report, by way of criticizing Mr. Rosenbloom’s analysis.
In connection therewith, Ms. Meyer reached the conclusion that
the appropriate historical comparison should be between the
compensation paid to all of petitioner’s senior executives prior
to the acquisition and the compensation paid to all such
executives after the acquisition. In Ms. Meyer’s computations,
the increase in these two figures was only 48 percent between
1988 and 1992, which she found unremarkable. In reaching this
figure, however, Ms. Meyer omitted entirely the Retention
Payments and 1991 SRP Benefits paid to the Retained Executives in
1992, notwithstanding the fact that petitioner has stipulated
that a substantial portion of the former and all of the latter
were earned by the Retained Executives in that year. Moreover,
as discussed more fully hereinafter, we reject the notion that
compensation payments of this magnitude can be ignored in
measuring the reasonableness of the Retained Executives’
compensation in 1992. Accordingly, we accord no weight to Ms.
Meyer’s attempt at an historical analysis of the Retained
Executives’ compensation.
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individual in prior [i.e., to the change in control] years”. S.
Rept. 99-313, supra at 919-920, 1986-3 C.B. (Vol. 3) at 919-920;
H. Rept. 99-426, supra at 920, 1986-3 C.B. (Vol. 2) at 902.
Mr. Rosenbloom analyzed the increases in the Retained
Executives’ compensation from 1990 to 1992 and concluded that the
increases ranged from 159 to 537 percent. Ms. Meyer faulted
several aspects of Mr. Rosenbloom’s methodology, including his
treatment of stock options, restricted stock, perquisites, and
LTIP payouts. Aside from the LTIP payouts, the parties entered
stipulations, apparently subsequent to the drafting of the expert
reports, that establish the amounts of the foregoing compensatory
payments that were earned in 1990 and 1992. On the basis of the
compensation which it has been stipulated the Retained Executives
earned, a comparison of 1990 and 1992 compensation is possible,
and the results are comparable to Mr. Rosenbloom’s.41 Without
treating any portion of the LTIP payout as earned in 1992
(notwithstanding that the payout was determined with respect to
services in 1992, 1993, and 1994), the Retained Executives’ 1990
41
Mr. Rosenbloom’s computation of the increase from 1990 to
1992 is conservative in one important respect, because he
includes in 1992 compensation only 25 percent of the Retention
Payments and 1991 SRP Benefits paid to the Retained Executives in
that year. The parties have stipulated that a substantially
larger portion of the Retention Payments, and all of the 1991 SRP
Benefits, were earned by the Retained Executives in 1992. When
the stipulated amounts are added to 1992 compensation, the
increase over 1990 is augmented to that extent.
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and 1992 compensation, and the percentage increase therein, is as
follows:
Retained 1990 1992 Percentage
Executive Compensation Compensation Increase
Brink $324,100 $896,213 177
Denny 697,380 2,390,159 243
Francis 401,174 1,001,502 150
Free 399,759 1,631,890 308
Garrett 456,100 2,172,240 376
Hite 505,378 1,524,496 202
Kurczewski 463,038 1,208,543 161
Pugh 205,031 897,250 338
Richardson 218,492 1,071,015 390
Thompson 498,474 940,621 89
Williams 182,320 931,627 411
If the Retained Executives are treated as having earned one-third
of their LTIP payout in 1992 (which we elsewhere conclude is
appropriate when measuring reasonable compensation for purposes
of section 280G), the percentage increase in their compensation
from 1990 to 1992 is as follows:
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Retained 1990 1992 Percentage
Executive Compensation Compensation1 Increase
Brink $324,100 $1,093,613 237
Denny 697,380 2,831,254 306
Francis 401,174 1,117,239 178
Free 399,759 1,865,816 367
2
Garrett 456,100 2,172,240 376
Hite 505,378 1,744,526 245
Kurczewski 463,038 1,396,821 202
3
Pugh 205,031 992,638 384
Richardson 218,492 1,191,644 445
Thompson 498,474 1,145,748 130
Williams 182,320 1,080,292 493
1
Includes 1/3 of LTIP payout.
2
Mr. Garrett did not receive an LTIP payout.
3
Includes 1/2 of LTIP payout.
In developing a comparison of pre- and postacquisition
compensation, we believe that 1990 is the most appropriate
measure of preacquisition compensation because in 1991 the
Retained Executives received $10,896,942 in compensation that was
triggered by the acquisition.42 Thus, 1991 compensation does not
reflect preacquisition levels of compensation. The dramatic
increase between the 1990 (preacquisition) compensation and 1992
(postacquisition) compensation of the Retained Executives
provides support for the conclusion that the Retention Payments
and 1991 SRP Benefits earned in 1992 were not reasonable
compensation for purposes of section 280G(b)(4). Petitioner has
42
This figure consists of $8,752,996 in stock-related
payments under the 1990 Employment Agreements, plus $2,143,946 in
“gross up” payments to compensate the Retained Executives for
nondeductible excise taxes they incurred as a result of their
receipt of the stock-related payments.
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not shown that any comparable executives, outside an acquisition
context, received similar increases in their compensation over
this period.
3. Analysis of Comparables
As noted previously, the two experts’ use of compensation of
purportedly comparable executives disclosed in SEC proxy filings
to test the reasonableness of the Retained Executives’
compensation was a principal basis for their conclusions and, of
Ms. Meyer’s various “external” analyses, the only one we have not
rejected. However, the approach used by Ms. Meyer raises two
threshold methodological issues that must be resolved.
a. Relevant Period for Reasonable Compensation
Comparison
In developing her comparables analysis, Ms. Meyer generally
considered compensation data for the aggregate period of 1992
through 1995 in her opening report; in her rebuttal report she
considered data for 1992 only. Mr. Rosenbloom generally
considered such data for 1992 only. Ms. Meyer’s use of 4-year
aggregate figures in her analysis presents a threshold
methodological issue. Ms. Meyer and petitioner, on brief, take
the position that the reasonableness of the Retained Executives’
compensation under the 1991 Employment Agreements (as amended)
should be assessed on the basis of the total compensation paid to
the Retained Executives over the approximately 4-year period
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covered by the Agreements (i.e., late 1991 through 1995), as
compared to the total compensation paid to comparable executives
over a similar period. In the view of petitioner and Ms. Meyer,
this aggregate approach is appropriate because the Retention
Payments covered approximately 4 years of services;43 thus, the
Retention Payments should be combined with the other compensation
earned by the Retained Executives for these 4 years of services
(e.g., salary, STIP, LTIP) and the resulting 4-year total
compared to the 4-year total compensation earned by comparable
executives to determine reasonableness.
We disagree. Section 280G(b)(4) provides that a parachute
payment “shall not include the portion of such payment which the
taxpayer establishes by clear and convincing evidence is
reasonable compensation for personal services to be rendered on
or after the date of the change” in control. Sec. 280G(b)(4)(A).
While the statute is broad enough to encompass a contingent-on-
control-change payment made for services spanning more than one
taxable year, we believe that proof by clear and convincing
evidence requires a taxpayer to demonstrate the reasonableness of
43
We note that the Retention Payments paid in December 1992
were subject to a “clawback” provision if a Retained Executive
failed to serve out the 4-year term of his 1991 Employment
Agreement (as amended). However, the 1991 SRP Benefits paid in
December 1992 were not subject to any similar forfeiture.
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the compensation paid with respect to the services rendered in a
given taxable year.
In December 1992, petitioner paid Retention Payments and
1991 SRP Benefits to the Retained Executives totaling
$15,867,291. Of this amount, petitioner deducted $10,384,490--
consisting of the total44 of the 1991 SRP Benefits payments and
related interest paid to the Retained Executives in 1992
($4,191,053), plus that portion of the aggregate Retention
Payments paid in 1992 with respect to which petitioner took the
position that “economic performance” (within the meaning of
section 461(h)) had occurred in 1992 ($6,193,437).45 The
remaining $5,482,801 in Retention Payments paid in 1992 was
deferred, according to petitioner, pursuant to section 461(h) and
deducted ratably in petitioner’s 1993, 1994, and 1995 taxable
years.
Having thus taken the position that $10,384,490 in Retention
Payments and 1991 SRP Benefits was earned by the Retained
Executives in 1992, it is incumbent upon petitioner in our view
to demonstrate clearly and convincingly that these amounts, when
44
Petitioner contends that the entire 1991 SRP Benefits
payment (plus interest) was deductible when paid in 1992 because,
unlike the Retention Payments, such amount was not subject to
clawback.
45
Petitioner has also stipulated that the amount of the
Retention Payments and 1991 SRP Benefits that was earned by the
Retained Executives in 1992 was $10,384,490.
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added to the other compensation earned by the Retained Executives
in that year, constituted reasonable compensation for the
services rendered in 1992.46 Ms. Meyer’s opening report, which
compares the Retained Executives’ total compensation47 (including
Retention Payments) over the period 1992-95 with the total
compensation over the same period earned by comparable
executives, fails to demonstrate what amount of compensation was
reasonable for the services rendered in 1992. Ms. Meyer’s 4-year
aggregate approach effectively treats the Retention Payments and
1991 SRP Benefits as having been earned ratably over 4 years,48
when in fact they were lump-sum payments totaling $15,867,291
made in 1992, more than 65 percent of which petitioner treated in
its return as earned by the Retained Executives in 1992. Nothing
46
The parties generally disregard the fact that some
portion of the Retention Payments is theoretically allocable to
the 46 days in 1991 covered by the 1991 Employment Agreements.
As we do not consider this allocation material, we shall likewise
disregard it.
47
Ms. Meyer excludes from the Retained Executives’
compensation any portion of the 1991 SRP Benefits that was paid
to them in December 1992. As more fully discussed infra, we do
not agree that such amounts are appropriately excluded from 1992
compensation. Moreover, we believe Ms. Meyer’s treatment of the
1991 SRP Benefits conflicts with petitioner’s stipulation that
they were earned in 1992.
48
More precisely, Ms. Meyer did not treat the 1991 SRP
Benefits as having been earned ratably over the period. Instead,
she took the position that the payment of the 1991 SRP Benefits
in 1992 should be disregarded in determining whether the
challenged payments to the Retained Executives constituted
reasonable compensation. See supra note 47.
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in Ms. Meyer’s opening report suggests how much compensation, of
the total amount calculated as reasonable for the 1992-94 period,
was reasonable for the services rendered in 1992. Accordingly,
the 4-year aggregate approach utilized by Ms. Meyer and urged by
petitioner is not persuasive in showing that the Retention
Payments and disputed 1991 SRP Benefits that petitioner treated
as earned in 1992 constituted reasonable compensation for
services rendered in that year--certainly not where petitioner
has the burden of demonstrating the foregoing by clear and
convincing evidence.
Perhaps sensing the flaw in her 4-year aggregate approach,
Ms. Meyer in her rebuttal report confined her analysis to 1992
alone. Because we reject the 4-year aggregate approach, we draw
heavily on Ms. Meyer’s rebuttal report in evaluating her opinions
in this case.
b. Aggregate Versus Individual Compensation
A second threshold methodological dispute concerns whether
the reasonableness of compensation for purposes of section
280G(b)(4) may be assessed on the basis of the Retained
Executives as a group or individually. Ms. Meyer and petitioner
take the position that the reasonableness of the Retained
Executives’ compensation need only be demonstrated in the
aggregate. That is, so long as the total aggregate compensation
of the 11 Retained Executives is reasonable in comparison to the
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total compensation of a comparable group of executives, it should
be treated as reasonable for purposes of section 280G(b)(4) even
though the individual compensation of certain Retained Executives
was unreasonable.49
We conclude that petitioner’s and Ms. Meyer’s position is
unsupportable as a matter of law. First, the legislative history
of section 280G indicates that Congress contemplated that the
test for reasonableness of compensation would be applied on an
individual basis.
The committee intends that evidence that amounts
paid to a disqualified individual for services to be
rendered that are not significantly greater than
amounts of compensation * * * paid to the disqualified
individual in prior years * * * will normally serve as
clear and convincing evidence of reasonable
compensation for such services. [S. Rept. 99-313,
supra at 919-920, 1986-3 C.B. (Vol. 3) at 919-920; see
also H. Rept. 99-426, supra at 902, 1986-3 C.B. (Vol.
2) at 902 (containing substantially identical
language); emphasis added.]
Moreover, the Finance Committee’s description of the test
comports with longstanding caselaw requiring the determination of
reasonable compensation for purposes of section 162(a)(1) on an
individual rather than group basis. See, e.g., Hendricks
Furniture, Inc. v. Commissioner, T.C. Memo. 1988-133; RTS Inv.
49
In her opening report, Ms. Meyer’s comparisons
demonstrated that, on an individual basis, four of the Retained
Executives received unreasonable compensation, but she
disregarded this result in light of her view that the aggregate
compensation of the Retained Executives as a group was
demonstrated as reasonable.
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Corp. v. Commissioner, T.C. Memo. 1987-98, affd. 877 F.2d 647(8th Cir. 1989), affd. without published opinion sub nom. Hilt v.
Commissioner, 899 F.2d 1225 (9th Cir. 1990); Schanchrist Foods,
Inc. v. Commissioner, T.C. Memo. 1977-129; William E. Davis &
Sons, Inc. v. Commissioner, T.C. Memo. 1975-229; Natl.
Underwriters, Inc. v. Commissioner, T.C. Memo. 1974-14. The
legislative history and the authorities under section 162(a)(1)
persuade us that reasonable compensation for purposes of section
280G(b)(4) should be determined on an individual basis. The
analyses provided by Ms. Meyer as well as Mr. Rosenbloom
facilitate such an approach, which we take hereinafter.
c. Retained Executives’ 1992 Compensation
Under a comparables approach, the initial step in assessing
whether the Retention Payments and disputed 1991 SRP Benefits
deducted by petitioner in 1992 constitute reasonable compensation
involves a determination of the compensation earned by the
Retained Executives for 1992 other than the challenged payments.
The amounts received by the Retained Executives as base salary
and STIP for 1992 are undisputed herein. However, the parties
and their experts disagree on how to account for certain other
compensatory payments related to 1992, including perquisites,
LTIP compensation, and the 1991 SRP Benefits payments.
As noted, both experts obtained compensation information for
comparable executives from SEC proxy filings. Their
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disagreements concerning the 1992 compensation of the Retained
Executives in the main concern the appropriate adjustments to be
made to the Retained Executives’ 1992 compensation to make it
conform to the reporting conventions used in such SEC filings.
(i) Perquisites
Because the SEC proxy filings utilized by the experts
generally did not disclose perquisites paid to a reporting
company’s executives unless the perquisites’ value exceeded in
the aggregate the lesser of either $50,000 or 10 percent of
salary and bonus,50 Ms. Meyer took the position that perquisites
of the Retained Executives should be excluded from their 1992
compensation when comparing it to the compensation of executives
as reported in proxy filings. Mr. Rosenbloom, by contrast,
included all perquisites in the Retained Executives’ 1992
compensation, regardless of amounts. We agree with Ms. Meyer
that the perquisites of the Retained Executives for 1992 should
be disregarded insofar as they fall below SEC reporting
thresholds, to conform with the conventions underlying the
disclosed compensation of executives to which they are being
compared.51 However, we find that Ms. Meyer erred in
50
See 17 C.F.R. sec. 229.402(b)(2)(iii)(C)(1) (1993).
51
We also agree with Ms. Meyer’s position that
reimbursements for moving expenses should be excluded from
perquisites for purposes of comparisons to compensation reported
in proxy filings. We therefore disregard $77,371 in moving
(continued...)
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disregarding all perquisites for all Retained Executives. Two of
the Retained Executives-–Mr. Brink and Mr. Francis-–received
perquisites in 1992 that, according to petitioner’s own
calculations, exceeded the SEC reporting thresholds. The 1992
perquisites of Mr. Brink ($89,129) and of Mr. Francis ($33,738)
exceeded 10 percent of their respective salary and bonus for that
year. Accordingly, we conclude that the perquisites of these two
Retained Executives should be included in their 1992 compensation
for purposes of comparing it to the compensation of other
executives.
(ii) LTIP Compensation
Petitioner made payments totaling $5,803,439 to the Retained
Executives in July 1995, pursuant to the LTIP arrangements, with
respect to petitioner’s financial performance for the years 1992,
1993, and 1994.52 In her opening report, Ms. Meyer included the
LTIP payouts in the Retained Executives’ compensation for the 4-
year period 1992-95. However, in measuring the Retained
Executives’ 1992 compensation in her rebuttal report, Ms. Meyer
took the position that no portion of the LTIP payouts should be
included in 1992 compensation because such amounts were not
51
(...continued)
expenses paid to Mr. Pugh in 1992. Mr. Pugh’s remaining 1992
perquisites fall below SEC reporting thresholds.
52
Mr. Garrett did not receive an LTIP award, and Mr. Pugh’s
award covered only 1992 and 1993. See supra note 18.
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vested until the end of 1994 and not paid until 1995. Further,
Ms. Meyer contended, such long-term incentive compensation awards
are not reported in SEC proxy filings until the conclusion of the
performance period53 and thus inclusion of any portion in 1992
would be inconsistent with the conventions under which the
compensation of comparable executives was disclosed. Mr.
Rosenbloom took the position that a ratable portion (i.e., 33
percent) of a Retained Executive’s LTIP award should be treated
as compensation earned in 1992.
For purposes of establishing reasonable compensation under
section 280G(b)(4), we believe Ms. Meyer’s position is untenable.
Ms. Meyer would have us ignore compensatory payments to the
Retained Executives that were generally nearly triple their
annual base salaries, even though it is undisputed that the
payments were earned over a 3-year period that began with 1992.54
Further, Ms. Meyer’s contention that the LTIP award was not
vested until the completion of the 1992-94 performance period is
belied by the evidence in this case. Mr. Pugh, whose employment
was terminated effective April 15, 1994, received an LTIP based
on his services in 1992 and 1993. Moreover, Ms. Meyer’s
53
See 17 C.F.R. sec. 229.402(b)(2)(iv)(C) (1993).
54
Although the Retained Executives were not advised of the
final terms of the LTIP until early 1993, their rights to an LTIP
award were secured in the 1991 Employment Agreements, and certain
of the Retained Executives participated in the development of the
LTIP arrangements during 1992.
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insistence on adherence to SEC disclosure conventions in this
circumstance actually produces significant distortions.
Specifically, Ms. Meyer would exclude any portion of the LTIP
payout from the measurement of the Retained Executives’ 1992
compensation, while at the same time she includes in the 1992
compensation of her purportedly comparable executives any long-
term incentive compensation payouts to them that happen to be
disclosed for 1992. Such amounts are included in the 1992
compensation of her purportedly comparable executives even where
they represent compensation for multiple years.55 Thus, the
version of conformity to SEC disclosure conventions that Ms.
Meyer advocates systematically inflates the 1992 compensation of
her purported comparables in relation to her computation of the
1992 compensation of the Retained Executives, which generates a
distorted comparison favoring petitioner’s position. We
accordingly reject it.
We believe that a clear and convincing showing of reasonable
compensation for purposes of section 280G(b)(4) in this case must
take some account of the substantial LTIP payouts made to the
Retained Executives. Mr. Rosenbloom’s determination to treat the
55
For example, Ms. Meyer includes in the 1992 compensation
of comparable executives Bielenski and Baisley, of W.W. Grainger,
Inc., their long-term incentive compensation payouts in 1992 of
$71,300 and $56,300, respectively, even though that company’s
proxy materials in the record disclose that the payouts covered 3
fiscal years (1990-92).
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LTIP payouts as earned ratably over the 3-year period covered by
the LTIP arrangements is reasonable, and we accept it.56 We
accordingly shall treat the Retained Executives’ 1992
compensation for purposes of determining its reasonableness in
this case as including 33 percent of the LTIP payout covering the
period 1992-94, except in the case of Mr. Pugh, whose LTIP payout
covered only 1992 and 1993 and is therefore allocated 50 percent
to 1992.
(iii) 1991 SRP Benefits
Petitioner made payments of 1991 SRP Benefits and related
interest totaling $4,191,053 to the Retained Executives in
December 1992, under the terms of the 1991 Employment Agreements
as amended in 1992. Petitioner deducted these amounts in 1992
and takes the position herein that these amounts were fully
earned by the Retained Executives in 1992 because, unlike the
Retention Payments, they were not subject to clawback if a
56
Ms. Meyer faults Mr. Rosenbloom’s inclusion on a pro rata
basis, arguing that if any amount of the LTIP payout is to be
included in the Retained Executives’ 1992 compensation, it should
be 20, not 33, percent, because the LTIP arrangements weighted
petitioner’s financial performance in 1992, 1993, and 1994 at 20,
30, and 50 percent, respectively, in computing the amount of an
LTIP award.
Without further evidence, we are not persuaded that ratable
inclusion should be supplanted by a weighted inclusion
corresponding to the weighting of petitioners’s annual financial
performance used in computing the LTIP award.
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Retained Executive failed to complete the 4-year term of
employment provided in the 1991 Employment Agreements as amended.
Ms. Meyer, for purposes of measuring the Retained
Executives’ 1992 compensation to test it for reasonableness, took
a position similar to her position regarding the LTIP payouts;
namely, that the 1991 SRP Benefits should be disregarded. Ms.
Meyer would disregard this aggregate payment exceeding $4
million, made to the Retained Executives in 1992, on the grounds
that the 1991 SRP Benefits were similar to the supplemental
retirement plans of the purportedly comparable executives and
that, under SEC disclosure conventions, the value of such
supplemental retirement plans would not be included in the
compensation of these comparable executives disclosed in the SEC
proxy materials. Thus, inclusion of the 1991 SRP Benefits would
inflate the Retained Executives’ compensation in relation to the
compensation of the comparable executives as reported in the SEC
proxy materials, in Ms. Meyer’s view. Mr. Rosenbloom treated the
1991 SRP Benefits identically to the Retention Payments,
including a pro rata portion of the 1992 payment based on the
number of years during the 1992-95 period that a Retained
Executive remained employed with petitioner.
We conclude that neither expert has satisfactorily accounted
for the 1991 SRP Benefits for purposes of assessing the
reasonableness of the compensation of the Retained Executives.
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Ms. Meyer’s decision to disregard the payment cannot withstand
scrutiny. Even if one were to accept Ms. Meyer’s contention that
the purportedly comparable executives she utilized had
supplemental retirement plans similar to the Retained
Executives’, Ms. Meyer has not shown that the comparable
executives received lump-sum payouts from these plans absent
retirement or termination of employment, as occurred with the
Retained Executives. Ms. Meyer claimed in trial testimony that
many executives received payouts from supplemental retirement
plans in 1992 in anticipation of an increase in Federal income
tax rates in 1993, but her report contains no documentation that
this occurred in the case of any of her purportedly comparable
executives. We are unpersuaded that the lump-sum payouts of
retirement benefits that the Retained Executives received in 1992
in the form of the 1991 SRP Benefits are so similar to the
supplemental retirement plans of comparable executives that they
can be ignored. To the contrary, the lump-sum payouts of the
1991 SRP Benefits, which ranged from 1.6 to more than 4 times a
Retained Executive’s 1992 base salary, were extraordinary in
circumstance and amount. Any attempt to demonstrate the
reasonableness of the Retained Executives’ 1992 compensation that
simply disregards the 1991 SRP Benefits falls far short of “clear
and convincing”, in our view.
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While it is possible that some portion of the 1991 SRP
Benefits is theoretically allocable to services provided in years
other than 1992, petitioner has made no showing in this regard
and instead has stipulated that the 1991 SRP Benefits were
“earned” by the Retained Executives in 1992. In addition, the
1991 SRP Benefits were paid in 1992 and deducted in full by
petitioner in that year. In these circumstances, giving due
regard to the fact that petitioner bears a “clear and convincing”
burden of proof, we find that the 1991 SRP Benefits are allocable
in full to the Retained Executives’ 1992 compensation.57
As earlier noted, supra note 28, respondent has conceded
that a portion of the 1991 SRP Benefit paid to each Retained
Executive should not be treated as contingent on a change of
control under Q&A-24(c) of the proposed regulations. See sec.
1.280G-1, Q&A-24(c), Proposed Income Tax Regs., 54 Fed. Reg.
19399 (May 5, 1989). Respondent maintains his position that the
remainder of the 1991 SRP Benefits not excluded from parachute
57
As noted, we are also unpersuaded by Mr. Rosenbloom’s
position that the 1991 SRP Benefits should be allocated ratably
over the years in the period 1992-95 in which a Retained
Executive remained employed by petitioner, the same treatment he
applied to the Retention Payments. Since the Retention Payments
were subject to clawback while the 1991 SRP Benefits were not, we
do not believe that the same treatment is appropriate for both
types of payments. Moreover, the ratable allocation advocated by
Mr. Rosenbloom conflicts with the parties’ stipulation that the
1991 SRP Benefits were “earned” in 1992.
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payment treatment under Q&A-24(c) are parachute payments.58 The
total 1991 SRP Benefits paid to each Retained Executive,59 the
amount conceded by respondent as not contingent on a change in
control under Q&A-24(c) of the proposed regulations, and the
remainder that respondent contends is a parachute payment are as
follows:
1991 SRP Noncontingent
Benefit Amount Remainder
Denny $728,977 $728,977 0
Francis 358,854 118,422 $249,432
Free 804,477 596,260 208,217
Garrett 406,292 166,580 239,712
Hite 540,333 270,166 270,167
Kurczewski 367,304 143,249 224,055
Richardson 426,642 0 426,642
Williams 227,380 0 227,380
Because we conclude that the 1991 SRP Benefits should be
treated as compensation earned by the Retained Executives in
1992, those portions of the 1991 SRP Benefits conceded by
respondent as excluded from parachute payment treatment under
Q&A-24(c) are treated as part of the Retained Executives’ 1992
compensation for purposes of assessing whether petitioner has
shown that the Retention Payments and the disputed 1991 SRP
58
The parties have also stipulated that the amounts
denominated as “interest” paid with respect to the 1991 SRP
Benefits are deductible by petitioner in 1992 pursuant to sec.
163(a).
59
Messrs. Brink, Pugh, and Thompson did not receive any
1991 SRP Benefits.
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Benefits constitute reasonable compensation for purposes of
section 280G(b)(4).
(iv) Summary
Applying the foregoing determinations regarding the
appropriate measure of the Retained Executives’ 1992 compensation
produces the amounts of 1992 compensation (excluding the
Retention Payments and the disputed 1991 SRP Benefits) summarized
in the following table:
Retained Noncontingent
Executive Salary STIP LTIP1 1991 SRP Benefit Perquisites Total
Brink $216,720 $123,748 $197,400 0 $89,129 $626,997
Denny 400,000 252,000 441,095 $728,977 0 1,822,072
Francis 156,000 71,136 115,737 118,422 33,738 495,033
Free 213,624 97,413 233,926 596,260 0 1,141,223
Garrett 270,900 154,413 0 166,580 0 591,893
Hite 245,100 139,953 220,030 270,166 0 875,249
Kurczewski 210,000 119,910 188,278 143,249 0 661,437
Pugh 207,174 118,090 95,388 0 0 420,652
Richardson 159,833 72,884 120,629 0 0 353,346
Thompson 236,844 135,001 205,127 0 0 576,972
Williams 193,500 88,236 148,665 0 0 430,401
1
Prorated (1/3) portion of LTIP paid in 1995 with respect to services rendered during 1992-94,
except for Mr. Pugh, whose proration for 1992 is one-half, because he rendered services only in
1992 and 1993.
d. Determination of Comparable Executives and Their
Compensation
The experts differed regarding the choice of comparable
executives and the determination of their compensation. We next
consider those differences in determining the extent to which
petitioner has clearly and convincingly demonstrated the amount
of compensation that was reasonable for the Retained Executives
in 1992.
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(i) Selection of Comparable Companies
The experts differed to some extent in their choices of
companies they considered comparable to petitioner. In her
rebuttal report, Ms. Meyer used 18 companies she considered
comparable, chosen from what she termed the “labor market” of the
Retained Executives, which she defined somewhat crudely to
include any company that “electricity runs through” and that met
one of two additional criteria: (i) The company was one for
which the Retained Executives would be qualified to work, or (ii)
it was one from which petitioner could draw executives to replace
any of its own executives who decided to leave. Mr. Rosenbloom’s
list was confined to 10 of the companies used by Ms. Meyer. Mr.
Rosenbloom considered only companies in the Value Line electrical
equipment industry group, which group contained petitioner,
thereby excluding electrical equipment manufacturers that were
primarily defense contractors or tied to telecommunications,
satellite, or other high technology industries. These excluded
high technology companies, he explained, were in less stable
markets and thus not comparable to petitioner, whose business was
based on a mature technology with products that changed only
incrementally. In line with this reasoning, Mr. Rosenbloom
specifically criticized Ms. Meyer’s use of four companies as
comparables--General Instrument Corp., Litton Industries, Inc.,
Rockwell International Corp., and Varian Associates, Inc.--on the
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grounds that all were substantially dissimilar from petitioner,
either as primarily defense contractors or as high technology
companies involved in an industry characterized by rapid
technological change and growth.
We find Mr. Rosenbloom’s critique persuasive. We are
convinced that petitioner was engaged in a relatively mature
industry characterized by incremental product changes, in
distinct contrast to the high technology companies and defense
contractors included as comparables by Ms. Meyer. As noted, the
legislative history of section 280G(b)(4) specifically endorses
the use of “similarly situated employees” working for “comparable
employers” as a means of determining reasonable compensation. S.
Rept. 99-313, supra at 919-920, 1986-3 C.B. (Vol. 3) at 919-920;
H. Rept. 99-426, supra at 902, 1986-3 C.B. (Vol. 2) at 902. The
differences highlighted by Mr. Rosenbloom persuade us that some
of the companies used by Ms. Meyer are not “comparable
employers”. Finding Mr. Rosenbloom’s analysis persuasive, we
accept as comparable the 10 companies common to both experts’
lists.60 We reject as comparables the four companies noted above
60
Those companies are Cooper Industries, Inc.; Emerson
Electric Co.; General Signal Corp.; W.W. Grainger, Inc.;
Honeywell, Inc.; Hubbell, Inc.; Johnson Controls, Inc.; Magnetek,
Inc.; Thomas & Betts Corp.; and Westinghouse Electric Corp.
However, Magnetek, Inc., is generally disregarded because its
1992 proxy materials in the record are not comparable in format
to the other companies.
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used by Ms. Meyer. In the absence of a specific critique from
Mr. Rosenbloom, we accept as comparable three of the remaining
four companies used by Ms. Meyer but not by Mr. Rosenbloom;
namely, AMP, Inc.; Baldor Electric Co.; and Danaher Corp.61
(ii) Selection of Comparable Executives and Their
1992 Compensation
The experts also differed in some instances in their choice
of the executives of a comparable company that they deemed
comparable to a given Retained Executive. Upon review of their
differences, we are persuaded that Ms. Meyer’s choices were in
general better reasoned. For example, in the case of Mr. Denny,
executive vice president and chief operating officer of
petitioner, Mr. Rosenbloom chose the chief administrative officer
of Honeywell, Inc., rather than the chief operating officer
(relied upon by Ms. Meyer). In the case of Mr. Kurczewski,
corporate vice president, general counsel, and secretary of
petitioner, Mr. Rosenbloom failed to include Messrs. Smith and
Kennedy, who were vice president, general counsel, and secretary
of General Signal and Johnson Controls, respectively, and Mr.
Grayson, who was vice president and general counsel of Honeywell,
Inc., all three of whom were included by Ms. Meyer. Accordingly,
we have generally deferred to Ms. Meyer’s judgment concerning the
61
The fourth, Raychem Corp., is disregarded because its
1992 proxy materials in the record are not comparable in format
to the other companies’.
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executives that were comparable to a specific Retained Executive
in circumstances where the experts differed, except as
specifically noted.
In a similar vein, even where the two experts agreed that a
given executive was comparable to a Retained Executive, they
frequently differed regarding the amount of 1992 compensation
they attributed to the executive. In resolving this difference,
we rely on the fact that Ms. Meyer demonstrated several instances
where Mr. Rosenbloom’s methodology diverged from standard
practice and/or SEC disclosure conventions. In addition to Mr.
Rosenbloom’s treatment of perquisites in a manner inconsistent
with SEC disclosure conventions (discussed above), Ms. Meyer
convincingly demonstrates that Mr. Rosenbloom used nonstandard
methods for valuing stock options, restricted stock, and the
costs of defined benefit and defined contribution plans.62
Frequently, though not always, Ms. Meyer’s compensation figure
for a comparable executive was less than Mr. Rosenbloom’s figure,
a position that disfavored the position of petitioner, her
client. Overall, given the demonstrated idiosyncracies in Mr.
Rosenbloom’s methods of computing compensation, we defer to Ms.
62
Respondent even concedes on brief that some of Mr.
Rosenbloom’s methodology in valuing compensation merits
criticism.
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Meyer’s computations of a comparable executive’s compensation in
instances where the experts differ.
e. Range of Reasonable Compensation
Using their selection of comparable executives, each expert
developed a range of compensation he or she considered
reasonable. For each Retained Executive, Mr. Rosenbloom computed
a median of the compensation paid to the executives he deemed
comparable. He then chose a range of compensation he considered
reasonable, based on his assessment of the duties and
responsibilities of the Retained Executive compared with those of
the comparable executives. He considered reasonable compensation
to fall within a narrow range of compensation; in several cases
that narrow range contained the median figure, and in several
cases the range was less than the median. Thus, in several cases
Mr. Rosenbloom found that the maximum reasonable compensation for
a given Retained Executive was less than the median compensation
of the executives he had selected as comparable. Mr.
Rosenbloom’s limited view of what constitutes reasonable
compensation makes it appear that a substantial number of the
executives he deemed comparable executives were paid compensation
in excess of a reasonable amount, calling into question the
validity of the assumptions underlying his analysis. At the very
least Mr. Rosenbloom does not sufficiently explain his conclusion
that reasonable compensation for the Retained Executives was an
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amount near or less than the median of compensation of
purportedly comparable executives. For this reason, we reject
his conclusions regarding an appropriate range of reasonable
compensation.
Ms. Meyer’s approach was broadly similar, but her
assumptions and conclusions reflect important differences. Like
Mr. Rosenbloom, Ms. Meyer generated a list of purportedly
comparable executives for each of the Retained Executives.
However, in addition to computing the median of the range of
compensation for each Retained Executive, she also computed the
75th and 90th percentiles. Based on her review of the duties and
responsibilities of the Retained Executives’ positions, and on
petitioner’s strategic need to maximize its retention of the
Retained Executives, she believed that compensation was
reasonable if it fell within the 75th and 90th percentile of the
range of compensation paid to comparable executives. We agree
with Ms. Meyer.
Petitioner’s specialized circumstances at the time support
Ms. Meyer’s conclusion that petitioner would have expected to pay
premium compensation to the Retained Executives. First of all,
the Retained Executives were required to assume the duties of
seven former executives, who left petitioner’s employment
following the change in control, including petitioner’s chairman
and chief executive officer, vice president and chief financial
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officer, and corporate vice president-sales. Moreover, we are
persuaded that, as Schneider’s management itself believed and the
Retained Executives were aware, Schneider’s options for obtaining
senior management other than the Retained Executives to manage
petitioner’s operations were quite limited, which would tend to
add a premium to what the Retained Executives would be paid,
without regard to any leverage they possessed by virtue of their
rights to the Termination Awards. In addition, petitioner had
been restructured from a publicly traded U.S. company to a wholly
owned subsidiary of a foreign corporation. As one Retained
Executive testified, this increased various risks to petitioner’s
executives, resulting from, for instance, potential limits on
upward mobility due to a preference for promoting foreign
nationals, the increased likelihood of assignment overseas, and
the potential clash of business cultures. For these reasons, we
find that petitioner should have expected to pay compensation at
the upper end of the reasonable compensation range to retain the
services of the Retained Executives. Thus, we believe petitioner
has shown clearly and convincingly that reasonable compensation
for each Retained Executive would have been an amount not
exceeding the 90th percentile of the range of compensation paid
to comparable executives working for comparable companies.
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f. Reasonable Compensation Established for Each
Retained Executive
Having concluded that 13 of the companies identified by the
experts are comparable, that Ms. Meyer’s selection of comparable
executives within those companies and her computation of their
1992 compensation is more reliable than Mr. Rosenbloom’s, and
that reasonable compensation in 1992 for the Retained Executives
would be an amount not exceeding the 90th percentile of the range
of compensation paid to comparable executives in that year, we
proceed to consider each Retained Executive and the amount of
compensation shown to have been reasonable for him in 1992.
(i) Mr. Brink
Ms. Meyer identified 13 executives in her rebuttal report
that she considered comparable to Mr. Brink in 1992. We conclude
that three of those executives should be disregarded, as follows:
Mr. Casey of Litton Industries, Inc., due to our previous
determination that Litton Industries, Inc., is not comparable to
petitioner; plus Mr. Reiland of Magnetek, Inc., and Mr. Everett
of Raychem Corp., because as noted the proxy disclosures of those
companies for 1992 are not comparable to the remaining companies,
having been made prior to October 1992 regulatory changes
governing disclosure formats. We conclude that the 10 remaining
executives are comparable.
For the reasons previously outlined, we use Ms. Meyer’s
computation of their 1992 compensation. However, one significant
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adjustment is required with respect to the treatment of long-term
incentive plan compensation. In the case of one comparable
executive (Mr. Bielinski), Ms. Meyer included the entire amount
of a payout of long-term incentive compensation in his 1992
compensation because the payout occurred in 1992, even though the
payment covered multiple years of services. Conversely, in the
case of another comparable executive (Mr. Galvin), Ms. Meyer did
not include any portion of a long-term incentive compensation
payout, even though the proxy materials of Mr. Galvin’s employer
indicate that he received a $778,790 payout in 1993, paid with
respect to 5 years of services including 1992. Consistent with
our earlier analysis and conclusions concerning the LTIP payouts
to the Retained Executive, we conclude that a ratable portion of
a long-term incentive compensation payout should be included in
compensation for any year on which the payout was based. We
accordingly adjust the 1992 compensation of the comparable
executives to do so, as described in greater detail in the
footnotes to the following table, which summarizes the 1992
compensation of the executives determined to be comparable to Mr.
Brink.
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1992 Compensation
Executive/Title Per Ms. Meyer
Nagy, SVP & CFO, $450,000
General Signal Corp.
Babcock, VP-Finance, 437,000
Thomas & Betts Corp.
1
Galvin, SVP Finance & 473,300
Controller, Emerson
Elec. Co.
Rowell, EVP-CFO, 783,500
Hubbell, Inc.
2
Roell, VP-CFO, 537,200
Johnson Controls, Inc.
Cross, SVP-Finance, 603,500
Cooper Indus., Inc.
3
Bielinski, VP & CFO, 594,800
W.W. Grainger, Inc.
Savidge, EVP-CFO, 400,700
AMP, Inc.
Davis, CFO, Secy, 215,900
Baldor Elec. Co.
Allender, SVP & CFO, 519,000
Danaher Corp.
1
Added to the total compensation computed by Ms. Meyer is 20 percent
(or approximately $155,800) of a long-term incentive compensation plan
payout in 1993 of $778,790, which the Emerson Elec. Co. proxy materials
in the record disclose was paid with respect to a 5-year performance
period that included 1992.
2
Ms. Meyer’s figure includes a long-term incentive compensation plan
payout of $18,700 which, according to the Johnson Controls, Inc., proxy
materials in the record, is the 1992 portion of a long-term incentive
performance award covering the period 1992-94.
3
Excludes $47,800 of the total compensation computed by Ms. Meyer,
representing 67 percent of a $71,300 long-term incentive compensation
plan payout in 1992 that Ms. Meyer included in full, since the 1992
payout, according to the W.W. Grainger, Inc., proxy materials in the
record, covered the company’s 3 fiscal years 1990-92.
The 90th percentile of this range of compensation is $621,500.
Accordingly, reasonable compensation for Mr. Brink in 1992 would
have been an amount not exceeding $621,500. Mr. Brink’s 1992
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compensation, excluding the Retention Payment,63 was $626,997.
Consequently, petitioner has failed to show that any portion of
the Retention Payment deducted with respect to Mr. Brink in 1992
constituted reasonable compensation for purposes of section
280G(b)(4).
(ii) Mr. Denny
Ms. Meyer identified 10 executives in her rebuttal report
that she considered comparable to Mr. Denny in 1992. We conclude
that Mr. Brann of Litton Industries, Inc., should be disregarded
because as noted we believe that company is not comparable to
petitioner. We conclude that the remaining nine executives are
comparable.64
63
Respondent concedes that the entire amount of the 1991
SRP Benefit paid to Mr. Brink and deducted by petitioner in 1992
was not contingent on a change in control under Q&A-24(c) of sec.
1.280G-1, Proposed Income Tax Regs., 54 Fed. Reg. 19399 (May 5,
1989).
64
Included among these nine is an executive from Rockwell
International Corp., a company with respect to which we
previously accepted Mr. Rosenbloom’s judgment that it was not
comparable to petitioner. However, Mr. Rosenbloom concedes that
Mr. Davis of Rockwell International Corp., who headed an
automation equipment subsidiary, is comparable to Mr. Denny, and
we accordingly accept Ms. Meyer’s use of that executive as a
comparable for Mr. Denny.
In addition, Mr. Rosenbloom raised specific objections to
Ms. Meyer’s use of certain other comparable executives for Mr.
Denny. On balance, we find these objections immaterial. If one
took the 90th percentile of the 1992 compensation of the
executives treated by Mr. Rosenbloom as comparable to Mr. Denny,
that figure would be higher than the 90th percentile of the 1992
compensation of the executives treated as comparable by Ms.
Meyer.
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For the reasons previously outlined, we use Ms. Meyer’s
computation of their 1992 compensation. However, an adjustment
for long-term incentive plan compensation, analogous to that made
for some of Mr. Brink’s comparables, is required. We accordingly
adjust the 1992 compensation of Mr. Suter of Emerson Electric Co.
and Mr. Davis of Baldor Electric Co. to include in their 1992
compensation a ratable portion of long-term incentive
compensation paid to them in 1993. The following table
summarizes the 1992 compensation of the executives determined to
be comparable to Mr. Denny.
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1992 Compensation
Executive/Title Per Ms. Meyer
Moore, Pres., Elec. $1,211,400
Div., Thomas &
Betts Corp.
1
Suter, Pres. & COO, 1,278,800
Emerson Elec. Co.
Bonsignore, EVP & 1,135,700
COO, Honeywell, Inc.
Moore, EVP & COO, 1,159,000
Honeywell, Inc.
Riley, Pres. & COO, 768,900
Cooper Indus.,Inc.
Clark, EVP, Inds., 645,700
Westinghouse Elec. Corp.
2
Davis, EVP & COO, 832,100
Rockwell Intl. Corp.
Marley, Pres. & COO, 570,300
AMP, Inc.
Qualls, Pres. & COO, 511,900
Baldor Elec. Co.
1
Added to the total compensation computed by Ms. Meyer is 20
percent (or approximately $378,800) of a long-term incentive
compensation plan payout in 1993 of $1,894,043, which the Emerson
Elec. Co. proxy materials in the record disclose was paid with
respect to a 5-year performance period that included 1992.
2
Added to the total compensation computed by Ms. Meyer is 33
percent (or approximately $135,200) of a long-term incentive
compensation plan payout in 1993 of $409,605, which the Rockwell
Intl. Corp. proxy materials in the record disclose was paid with
respect to a 3-year performance period that included 1992.
The 90th percentile of this range of compensation is $1,224,880.
Accordingly, reasonable compensation for Mr. Denny in 1992 would
have been an amount not exceeding $1,224,880. Mr. Denny’s 1992
compensation, excluding the Retention Payment and disputed 1991
SRP Benefit, was $1,822,072. Consequently, petitioner has failed
to show that any portion of the Retention Payment and disputed
1991 SRP Benefit deducted with respect to Mr. Denny in 1992
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constituted reasonable compensation for purposes of section
280G(b)(4).
(iii) Mr. Kurczewski
Ms. Meyer identified six executives in her rebuttal report
that she considered comparable to Mr. Kurczewski in 1992. We
conclude that Mr. Durmit of General Instrument Corp. should be
disregarded because as noted we believe that company is not
comparable to petitioner. We conclude that the remaining five
executives are comparable.
For the reasons previously outlined, we use Ms. Meyer’s
computation of their 1992 compensation. However, an adjustment
is required to correct Ms. Meyer’s computation of the 1992
compensation of Mr. Baisley of W.W. Grainger, Inc. Ms. Meyer
included in Mr. Baisley’s 1992 compensation the entire amount of
a long-term incentive compensation payout made in 1992, even
though the payout covered services rendered in 3 fiscal years
(1990-92). Accordingly, a ratable portion of the payout is
removed from 1992 compensation, as described in greater detail in
a footnote to the following table, which summarizes the 1992
compensation of the executives determined to be comparable to Mr.
Kurczewski.
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1992 Compensation
Executive/Title Per Ms. Meyer
1
Baisley, VP, GC, $468,100
W.W. Grainger, Inc.
Davies, GC, Secy, 292,400
Hubell, Inc.
Smith, VP, GC & Secy 270,300
General Signal Corp.
Grayson, VP, GC, 952,700
Honeywell, Inc.
2
Kennedy, VP, GC & Secy 475,900
Johnson Controls, Inc.
1
Excludes $37,800 of the total compensation computed by Ms.
Meyer, representing 67 percent of a $56,300 long-term incentive
compensation plan payout in 1992 that Ms. Meyer included in full,
since the 1992 payout, according to the W.W. Grainger, Inc., proxy
materials in the record, covered the company’s 3 fiscal years
1990-92.
2
Ms. Meyer’s figure includes a long-term incentive compensation
plan payout of $31,100 which, according to the Johnson Controls,
Inc., proxy materials in the record, is the 1992 portion of a
long-term incentive performance award covering the period 1992-94.
The 90th percentile of this range of compensation is $761,980.
Accordingly, reasonable compensation for Mr. Kurczewski in 1992
would have been an amount not exceeding $761,980. Mr.
Kurczewski’s 1992 compensation, excluding the Retention Payment
and disputed 1991 SRP Benefit, was $661,437. Because reasonable
compensation for Mr. Kurczewski in 1992 exceeded his 1992
compensation (exclusive of the Retention Payment and disputed
1991 SRP Benefit) by $100,543, this excess constitutes the amount
of Mr. Kurczewski’s Retention Payment and disputed 1991 SRP
Benefit that petitioner has shown by clear and convincing
evidence was reasonable compensation in 1992 for purposes of
section 280G(b)(4).
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(iv) Messrs. Garrett, Richardson, Thompson, and
Williams
Ms. Meyer identified 17 executives in her rebuttal report
that she considered comparable to petitioner’s heads of operating
divisions; namely, Messrs. Garrett, Richardson, Thompson, and
Williams, in 1992. We conclude that eight of those executives
should be disregarded, as follows: Mr. Rosso of Honeywell, Inc.,
and Mr. Claramunt of Danaher Corp. because the description of
those executives’ duties in 1992 in the proxy disclosure
materials in the record conflict with Ms. Meyer’s description of
their duties in 1992; Messrs. Jeney, Dundon, and Scherzi of
Magnetek, Inc., because the proxy disclosures of that company for
1992 are not comparable to the remaining companies, having been
made prior to October 1992 regulatory changes governing
disclosure formats; and Messrs. Drendel, Bunker, and Krisbergh of
General Instrument Corp., because as noted we believe that
company is not comparable to petitioner.
Moreover, Mr. Rosenbloom specifically objected to Ms.
Meyer’s use as comparables of two executive vice presidents of
Johnson Controls, Inc., on the grounds that they were responsible
for business segments with several billion dollars in annual
revenues and therefore not comparable to petitioner’s heads of
operating divisions. We are persuaded by Mr. Rosenbloom on this
point and find that Messrs. Lewis and Barth of Johnson Controls,
Inc., should be disregarded.
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We conclude that the seven remaining executives are
comparable. For the reasons previously outlined, we use Ms.
Meyer’s computation of their 1992 compensation. However, an
adjustment is required to correct Ms. Meyer’s computation of the
1992 compensation of Mr. Keyser of W.W. Grainger, Inc. Ms. Meyer
included in Mr. Keyser’s 1992 compensation the entire amount of a
long-term incentive compensation payout made in 1992, even though
the payment covered services rendered in 3 fiscal years (1990-
92). Accordingly, a ratable portion of the payout is removed
from 1992 compensation, as described in greater detail in a
footnote to the following table, which summarizes the 1992
compensation of the executives determined to be comparable to
petitioner’s heads of operating divisions.
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1992 Compensation
Executive/Title Per Ms. Meyer
Bonke, Group VP, $393,000
General Signal Corp.
Pluff, Group VP, 416,200
Hubbell, Inc.
Paquette, Div. Pres., 327,500
Thomas & Betts Corp.
Pileggi, Div. Pres., 262,600
Thomas & Betts Corp.
Chenoweth, Sr. Corp. 712,600
VP-Intl., Honeywell, Inc.
1
Keyser, EVP, W.W. 829,500
Grainger, Inc.
Hassan, VP-Global Interconn. 250,600
Sys., AMP, Inc.
1
Excludes $77,200 of the total compensation computed by Ms.
Meyer, representing 67 percent of a $115,231 long-term incentive
compensation plan payout in 1992 that Ms. Meyer included in full,
since the 1992 payout, according to the W.W. Grainger, Inc., proxy
materials in the record, covered the company’s 3 fiscal years
1990-92.
The 90th percentile of this range of compensation is $759,360.
Accordingly, reasonable compensation for petitioner’s heads of
operating divisions in 1992 would have been an amount not
exceeding $759,360.
(aa) Mr. Garrett
Mr. Garrett’s 1992 compensation, excluding the Retention
Payment and disputed 1991 SRP Benefit, was $591,893. Because
reasonable compensation for Mr. Garrett in 1992 exceeded his 1992
compensation (exclusive of the Retention Payment and disputed
1991 SRP Benefit) by $167,467, this excess constitutes the amount
of Mr. Garrett’s Retention Payment and disputed 1991 SRP Benefit
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that petitioner has shown by clear and convincing evidence was
reasonable compensation in 1992 for purposes of section
280G(b)(4).65
(bb) Mr. Richardson
Mr. Richardson’s 1992 compensation, excluding the Retention
Payment and disputed 1991 SRP Benefit, was $353,346. Because
reasonable compensation for Mr. Richardson in 1992 exceeded his
1992 compensation (exclusive of the Retention Payment and
disputed 1991 SRP Benefit) by $406,014, this excess constitutes
the amount of Mr. Richardson’s Retention Payment and disputed
1991 SRP Benefit that petitioner has shown by clear and
convincing evidence was reasonable compensation in 1992 for
purposes of section 280G(b)(4).
65
Respondent also argues that Mr. Garrett’s Retention
Payment (but not his 1991 SRP Benefit) cannot be reasonable
compensation for services because it is a severance payment
within the meaning of Q&A-44 of sec. 1.280G-1, Proposed Income
Tax Regs., 54 Fed. Reg. 19407 (May 5, 1989). We need not address
this contention, however, because the disputed 1991 SRP Benefit
received by Mr. Garrett, which respondent concedes is not a
severance payment, equaled $239,712. We conclude above that
petitioner has established that $167,467 of the (combined)
Retention Payment and 1991 SRP Benefit paid to Mr. Garrett in
1992 constituted reasonable compensation. Amounts above this
figure are not reasonable compensation for 1992 services.
Accordingly, $167,467 of the $239,712 1991 SRP Benefit is
reasonable compensation, but the remainder of the 1991 SRP
Benefit and all of the Retention Payment is not. Because Mr.
Garrett’s Retention Payment would not in any event constitute
reasonable compensation, we need not decide whether it is also
not reasonable compensation because it is a severance payment.
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(cc) Mr. Thompson
Mr. Thompson’s 1992 compensation, excluding the Retention
Payment,66 was $576,972. Because reasonable compensation for Mr.
Thompson in 1992 exceeded his 1992 compensation (exclusive of the
Retention Payment) by $182,388, this excess constitutes the
amount of Mr. Thompson’s Retention Payment that petitioner has
shown by clear and convincing evidence was reasonable
compensation in 1992 for purposes of section 280G(b)(4).
(dd) Mr. Williams
Mr. Williams’s 1992 compensation, excluding the Retention
Payment and disputed 1991 SRP Benefit, was $430,401. Because
reasonable compensation for Mr. Williams in 1992 exceeded his
1992 compensation (exclusive of the Retention Payment and
disputed 1991 SRP Benefit) by $328,959, this excess constitutes
the amount of Mr. Williams’s Retention Payment and disputed 1991
SRP Benefit that petitioner has shown by clear and convincing
evidence was reasonable compensation in 1992 for purposes of
section 280G(b)(4).
(v) Messrs. Francis, Free, Hite, and Pugh
With respect to Messrs. Francis, Free, Hite, and Pugh, Ms.
Meyer was unable to find any SEC proxy disclosures of
compensation for comparable executives; i.e., for a chief
66
Mr. Thompson did not receive a 1991 SRP Benefit.
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technology officer (Mr. Francis), treasurer (Mr. Free), director
of human resources (Mr. Hite), or sales and marketing executive
(Mr. Pugh).67 Consequently, to demonstrate the reasonableness of
the foregoing executives’ compensation, she used data from the
executive compensation surveys that we have rejected. Because we
have concluded that the survey data does not satisfy the
requirements of comparability, Ms. Meyer’s effort to show
reasonableness through this technique must fail.
Mr. Rosenbloom encountered the same problem and solved it by
using the assumption that, since SEC proxy materials generally
disclose the compensation of the five most highly compensated
officers, comparable executives to the foregoing Retained
Executives must have earned less than the lowest paid officer
disclosed in proxy materials of a comparable company.68 Ms.
Meyer criticized this approach by arguing that although the SEC
proxy rules require disclosure of the compensation paid to a
company’s chief executive and four most highly compensated
67
Although Mr. Rosenbloom treated Mr. Pugh as the head of
an operating division, Ms. Meyer contends that this
categorization was erroneous because Mr. Pugh had sales and
marketing responsibilities. Consistent with our previous
conclusion that Ms. Meyer demonstrated superior judgment in
comparing the duties and responsibilities of the Retained
Executives with those of comparable executives, we accept Ms.
Meyer’s judgment that Mr. Pugh cannot appropriately be compared
to the head of an operating division.
68
Because Mr. Rosenbloom treated Mr. Pugh as equivalent to
the head of an operating division, see supra note 67, he did not
apply this assumption to Mr. Pugh.
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“executive officers”, corporations have wide latitude in defining
their “executive officers”. See 17 C.F.R. secs. 229.402(a)(3),
240.3b-7 (2000). According to Ms. Meyer, for a variety of
internal reasons, a company’s four most highly compensated
executive officers may not in fact be that company’s four most
highly compensated employees. We find Ms. Meyer’s criticism
persuasive.
In light of (i) our conclusion that Ms. Meyer’s effort to
demonstrate the reasonableness of the compensation of Messrs.
Francis, Free, Hite, and Pugh is based on the executive
compensation surveys that are not comparable, and (ii) the fact
that the percentage increase in the pre- and postacquisition
compensation of Messrs. Francis, Free, Hite, and Pugh was 178,
367, 245, and 384 percent, respectively, we conclude that
petitioner has failed to establish clearly and convincingly that
any portion of the Retention Payments or disputed 1991 SRP
Benefits of these executives, deducted by petitioner in 1992,
constituted reasonable compensation for purposes of section
280G(b)(4)(A).
To reflect the foregoing,
Decision will be entered
under Rule 155.