Best Practices for Reasonableness of Employee Compensation Analysis

(Part II of III)

Part one of this three-part series summarized the facts regarding Clary Hood, Inc. (“CHI”) and the basis for the litigation. This second article focuses on the Tax Court’s analysis of the reasonableness of compensation issue in the Hood decision.

Introduction

The U.S. Tax Court decision in Clary Hood, Inc. v. Commissioner[1] provides important practical guidance to private companies and to private company owners—and to their legal, accounting, and valuation analysts—regarding the reasonableness of executive/shareholder compensation income tax deductions. In this decision, the Tax Court provides a fulsome discussion of its application of the so-called multifactor approach to reasonableness of compensation executive analysis. This judicial decision also provides important practical guidance to valuation analysts and other professionals who provide testifying expert services in reasonableness of compensation (and in other) federal taxation disputes.

Part one of this three-part series summarized the facts regarding Clary Hood, Inc. (“CHI”) and the basis for the litigation. This discussion focuses on the Tax Court’s analysis of the reasonableness of compensation issue in the Hood decision.

Reasonableness of Executive/Shareholder Compensation Tax Deductions

Tax Deduction Requirements under Section 162(a)

CHI, a C corporation, is subject to federal income tax on its taxable income, which is its gross income less allowable deductions. Under Section 162, a corporation may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses include a reasonable allowance for salaries or other compensation; for example, bonuses for personal services actually rendered. Whether the compensation payments are reasonable and purely for services is a question of fact to be determined based on all the facts and circumstances of each case. In its discussion of the facts and circumstances criteria, the memorandum decision cited Martens v. Commissioner[2] and American Savings Bank v. Commissioner.[3]

Since it was an issue in the Hood matter, it is noteworthy that an employer may deduct compensation paid to an employee in a year although the employee may have performed the services in a prior year. To support this proposition, the Hood decision cited Lucas v. Ox Fibre Brush Co.[4] and R.J. Nicoll Co. v. Commissioner.[5] However, the employer has to show that (1) the employee was not sufficiently compensated in the prior year and (2) the current year’s compensation was in fact paid to compensate for that underpayment. To support this proposition, the Hood decision cited Estate of Wallace v. Commissioner.[6]

The Hood decision specifically stated:

Another consideration is whether the employee was also a shareholder of the corporation. Where officer-shareholders are in control of a closely held corporation and set their own compensation, careful scrutiny is required to determine whether the alleged deductible compensation is in fact a nondeductible dividend.

In this regard, the Hood decision cited Richlands Medical Association v. Commissioner[7] and Estate of Wallace v. Commissioner.[8]

The Multifactor Approach to Assessing the Reasonableness of Compensation

The Tax Court recognized that the U.S. Court of Appeals for the Fourth Circuit, the appeals court to which an appeal of the Hood matter would be made, requires consideration of multiple factors in determining reasonable compensation (the so-called multifactor approach). These multiple factors include the following: the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; and the salary policy of the taxpayer as to all employees. In its discussion of this multifactor approach, the Hood decision cited Richlands Medical Association v. Commissioner.[9]

In the context of a private corporation with a limited number of officers, additional reasonableness of compensation factors to consider may include (1) the amount of compensation paid to the employee in the previous years (as considered in Mayson Manufacturing Company v. Commissioner[10]) and (2) any personal guaranties of debts or other obligations of the corporation (as considered in E.J. Harrison & Sons, Inc. v. Commissioner[11]).

In the application of the multifactor approach, no single factor is considered to be decisive. Instead, the trial court may consider and weigh the totality of the factors and circumstances when making its decision (as in Martens v. Commissioner[12]). In doing so, the trial court may find certain factors less relevant or helpful than other factors when considering the factors necessary to reach a reasonableness of compensation conclusion (as in Medina v. Commissioner[13]).

The Independent Investor Test

Some federal courts have applied the so-called independent investor test to analyze the reasonableness of private company executive/shareholder compensation. Some of the judicial decisions that applied the independent investor test include (1) Metro Leasing & Development Corporation v. Commissioner[14] (noting that the independent investor test is one of several factors that may be considered in analyzing the reasonableness of executive/shareholder compensation); (2) Haffner’s Service Stations, Inc. v. Commissioner[15] (rejecting the independent investor test as the only test and instead applying a multifactor approach with consideration of the taxpayer company’s profit and return on equity); and (3) Exacto Spring Corp. v. Commissioner[16] (relying primarily on the independent investors test).

Under this independent investor test of reasonable executive/shareholder compensation, the court typically considers, “whether an inactive, independent investor would be willing to compensate the employee as he was compensated” (see Elliotts, Inc. v. Commissioner[17]).

In the Hood matter, CHI asked the Tax Court to follow the independent investor test in determining whether the compensation paid to Hood in the tax years at issue was reasonable. At least one Court of Appeals has accepted the independent investor test in a reasonableness of compensation dispute. However, the Hood decision noted that the U.S. Court of Appeals for the Fourth Circuit has not adopted any version of the independent investor test.

In addition, the Hood decision noted that the Tax Court generally applies the multifactor approach unless a case is appealable to a Court of Appeals that has expressly applied the independent investor test. See, for example, (1) Pepsi-Cola Bottling Co. of Salina v. Commissioner[18] (noting that it is “well settled” that the Tax Court should consider the multifactor approach in reasonable compensation cases); (2) Beiner, Inc. v. Commissioner[19] (refusing to apply the independent investor test exclusively by finding comparative industry salaries the most relevant factor in that case; and (3) Metro Leasing & Development Corporation v. Commissioner[20] (concluding that it was not “appropriate to rely solely on the independent investor test to reach our findings and/or holding”).

Therefore, in the Hood matter, the Tax Court concluded that it should apply the multifactor approach to determine the reasonableness of the CHI compensation paid to Hood based on the precedent of the Tax Court and, more importantly, based on the precedent of the Court of Appeals for the Fourth Circuit (see Golsen v. Commissioner[21]).

The Tax Court Analysis of Hood’s Compensation

In the judicial decision, Judge Greaves specifically mentioned “There is no doubt that Mr. Hood is the epitome of the American success story.” In the Hood matter, the parties did not dispute that Hood was entitled to some degree of additional compensation for the prior services he rendered as a CHI employee during portions of the review period.

It is not the responsibility of either the Tax Court or the Service to substitute its business judgment for that of the CHI board as to the setting of the appropriate amount of an employee’s compensation. However, it is the responsibility of the Tax Court to examine the extent to which that compensation may be deducted from federal income tax purposes. That is because, as even CHI management recognized, limits do exist as to what may be reasonably deducted as compensation expense.

From a federal income tax perspective, the Service challenged whether the increase in Hood’s compensation in the 2015 and 2016 CHI fiscal years constituted (1) deductible employee compensation or (2) a means of draining corporate profits through a disguised dividend. For the reasons concluded from each of the factors described below, the Tax Court held that CHI could not deduct the full amount of compensation paid to Hood. Based on the court’s assessment, CHI failed to adequately establish how the entire amount was both reasonable and paid solely as compensation for Hood’s services to CHI during the review period.

Hood’s Background and Qualifications

An employee’s superior qualifications for his or her position may justify high compensation. With over 50 years of relevant work experience, Hood had substantial knowledge and experience in both managing and performance grading and excavation work. In addition, Hood had developed an excellent reputation in his market. The court recognized that Hood’s reputation allowed CHI to compete for, and win, subcontracting jobs.

The Nature, Extent, and Scope of Hood’s Work

An employee’s position, duties performed, hours worked, and general importance to the private corporation’s success may justify high compensation. The court recognized that Hood was the key employee and driving force since the company’s inception. Hood managed and built up the business, solicited and obtained grading jobs, and supervised all work performed.

In addition, Hood made the executive decisions (1) to sever business dealings with Walmart and (2) to transition to the commercial and industrial market sectors, a decision which led to the CHI financial success.

The Size and Complexity of the CHI Business Operations

Courts may consider the size and complexity of a taxpayer’s business when deciding the reasonableness of compensation paid to its executive/shareholders.

During the review period, CHI experienced exceptional growth in terms of both employees and revenue. The CHI workforce increased from approximately 80 to 150 employees. The CHI annual revenue increased from as low as $9 million in 2003 to over $68 million by 2016. The Hood decision noted, “Even if we were to assume that land excavation and grading does not require substantial scientific or technical knowledge, petitioner’s work is more complex than that of a general construction company.”

CHI specialized in the land grading and excavation sectors of the construction industry. This industry sector requires performance of the following services at exacting specifications: earth excavation, site clearing and grading, storm drainage, installation of water systems, installation of curbs and gutters, landscaping, and irrigation services.

As a result of Hood’s contributions, CHI created a niche in that specialty segment by (1) competing in a cost-effective manner and (2) developing an excellent reputation in its market.

Comparison of Hood’s Compensation to the CHI Income

It is often helpful for analysts to measure executive/shareholder compensation as a percentage of both gross receipts and net income. However, the net income analysis is typically considered to be more important. This is because the net income analysis more accurately gauges whether a private company is disguising the distribution of dividends as compensation. A taxpayer’s pattern of attempting to distribute a significant portion of its pretax net income as deductible executive/shareholder compensation may indicate that the private company is disguising dividends as compensation. That said, no particular ratio between executive/shareholder compensation expense and gross or net table income is a prerequisite for a determination of reasonableness.

In the instant case, CHI paid approximately 42 percent and 26 percent of its pretax income to Hood as compensation in its 2015 and 2016 fiscal years, respectively. In the Hood matter, the Tax Court did not find those percentages to indicate an egregious pattern of disguised dividends.

The Prevailing Economic Conditions

The prevailing economic conditions may help to determine whether the success of a business is attributable to the efforts and business acumen of the executive/shareholder, as opposed to being attributable to general trends in the economy. Adverse economic conditions, for example, tend to indicate that an executive/shareholder’s skill was important to a private company that increased in size during bad economic years.

In the instant case, the CHI annual revenue increased from approximately $16 million to over $68 million during the review period. Greenway, a CPA with extensive experience in the construction industry, offered testimony at the Hood trial that the CHI success, at least in the post-Walmart era, was due to factors other than general economic conditions.

At trial, Greenway testified that CHI was his most profitable construction client between 2013 and 2016. Even the Service’s testifying expert offered confirmation of this view. The Service’s testifying expert placed the CHI performance in the upper quartile of its industry peers for the post-Walmart era. During that time period, CHI attained its most profitable jobs through Hood’s direct involvement.

At trial, Hood testified that the CHI poorest performance years were predominantly attributable to years of national economic contractions. Hood also testified that many of the CHI competitors went out of business during these economic downturns. Hood, on the other hand, took active measures as CEO to ensure the CHI survival during such economic downturn periods. Those measures included (1) selling equipment; (2) reducing employee compensation, including Hood’s own compensation; and (3) conserving financial resources.

Comparison of Hood’s Compensation with Distributions to Stockholders

It is not a legal requirement for a private corporation to pay dividends. Private company shareholders are often content to enjoy the appreciation in the value of their stock that arises through the retention of company earnings. However, a complete absence of dividends to shareholders may result in an inference that some of the compensation paid to an executive/shareholder represents a distribution of profits.

CHI was profitable during the review period, especially in the tax years at issue. However, CHI never declared or paid a cash dividend.

With regard to this dividend distribution factor, the Hood decision states, “Some of petitioner’s claimed reasons for not doing so, e.g., to meet working capital needs during the Great Recession and maintain a competitive edge through strong balance sheets, are certainly persuasive when considering tax years such as 2010 in which business was slow and capital needs were high. These reasons, however, can be carried only so far before they start to lose their appeal after taking into account (1) Mr. Hood’s decision, as controlling shareholder of petitioner, to defer monetary recognition through a dividend for his investment of the entire 16-year review period and (2) petitioner’s decision to not recognize those deferrals through a dividend but instead reward Mr. Hood exclusively through a purported bonus after it had acquired sufficient capital and cash in the years at issue to do so.”

Prevailing Compensation Rates for Comparable Positions at Comparable Concerns

In deciding whether compensation paid to an executive/shareholder is reasonable, analysts often compare it to compensation paid to persons holding comparable positions in comparable companies. Federal courts frequently place great emphasis on this comparative analysis factor.

In assessing this factor in the Hood matter, the Tax Court considered the testimony of the parties’ testifying experts. In its decision, the Tax Court noted this principle: “As trier of fact, we are not bound by the opinion of any expert witness and will accept or reject expert testimony, in whole or in part, in the exercise of sound judgment.”

The Samuel Kursh Expert Testimony

CHI offered the expert testimony of Samuel Kursh of BLDS, LLC (“BLDS”), an economic consulting firm. Kursh is an economist and BLDS principal whose experience includes corporate finance and market database analysis, as well as return on equity calculations.

The Kursh expert report (“the BLDS report”) indicated that Kursh wrote the report in conjunction with his colleague Dr. Brett Margolin.

The Hood decision concluded that “Mr. Kursh’s knowledge as to the report’s content, supporting data, and calculations was materially lacking.” At trial, Kursh admitted that Margolin would be better suited to answer basic questions regarding the BLDS report despite the fact that Margolin was not presented as a witness at the trial.

Regarding this expert’s report, the Tax Court also concluded, “The BLDS report also lacked necessary supporting calculations and did not include all underlying data, leaving us unable to verify the veracity of its findings and conclusions.”

In addition, the Tax Court commented that “The BLDS report additionally rested on numerous dubious assumptions. Perhaps most egregious, the BLDS report crudely compared the performance of petitioner, a private regional specialty construction firm, to that of dissimilar public companies such as the multinational conglomerate Caterpillar, Inc., with little attempt at adjusting for the obvious and stark differences between such companies.”

Finally, with regard to the Kursh analysis, the Tax Court concluded that “the BLDS report focused on the independent investor test, which we do not find to be controlling.”

The Theodore Sharp Expert Testimony

At trial, CHI also offered the expert testimony of Theodore Sharp, a senior partner at the management consulting firm Korn Ferry. Sharp is a member of the Korn Ferry Executive Pay and Governance group and specializes in compensation-relation issues, including executive compensation benchmarking. At trial, Sharp testified that he reviewed and agreed with his written expert report (“the Korn Ferry report”), but Sharp acknowledged that he had not written it.

The Korn Ferry report consisted of approximately one dozen PowerPoint slides in bullet-point format.

The Tax Court had the following observation regarding this expert’s work: “As with the BLDS report, supporting calculations used to reach key findings and conclusions were conspicuously absent from the report and underlying data sources were not adequately disclosed.”

The Tax Court also expressed serious concerns about the soundness of the assumptions in the Korn Ferry report. For example, the Korn Ferry report relied on compensation survey data for companies with up to $500 million in annual revenue. The expert report attempted to offset the disparity with the CHI revenue size by applying a 20 percent “discount” to the data. The Korn Ferry report explained (and Sharp confirmed at trial) that this percentage was not supported by any empirical data but was selected “based on our experience working with similarly sized companies.”

The Tax Court also commented that, “The external compensation survey data relied upon in the Korn Ferry report was materially lacking in completeness as well.”

Finally, with regard to this taxpayer expert witness, the Tax Court concluded, “We therefore afford Mr. Sharp’s testimony little to no weight.”

The David Fuller Expert Testimony

At trial, the Service offered the expert testimony of David Fuller. Fuller is the founder of Value, Inc. In his role at Value, Inc, Fuller provides financial and valuation consulting services to corporate clients in various industries, including the construction industry. His practice areas include valuation opinions for financial and tax reporting purposes. And, he routinely renders advice to companies on the issue of executive compensation.

Fuller’s expert report (“the Fuller report”) accounted for all known amounts of compensation paid to Hood during the review period. The Fuller report contained detailed disclosures of the data sources relied upon, the methodologies applied, and the supporting calculations. The data that Fuller analyzed included the entire 17-year review period. Fuller compared the CHI performance against data supplied by the Risk Management Association (“RMA”) survey service for site preparation contractors, using the CHI annual asset size and revenue size.

The Fuller report placed CHI in annual quartiles in a given year based on the company’s performance against the RMA data. Then, the Fuller report examined officer compensation as a percentage of revenue within the respective annual performance quartile. As part of his analysis, Fuller observed compensation data for executive/shareholders in the construction industry from the survey service PAS. Fuller also applied the multifactor approach.

In terms of financial metrics, Fuller concluded that CHI was a lower quartile performing business from 2000 through 2011, a median performing business in 2012, and an upper quartile performing business from 2013 through 2016. Fuller assigned lower quartile wages for a board chairman to Hood for 2000 to 2011, average wages for a board chairman to Hood for 2012, and the highest level of compensation (i.e., the 99th percentile) for a board chairman to Hood for 2013 through 2016. Fuller also concluded that elective undercompensation by a company owner is not dissimilar to a loan to the company. Therefore, Fuller calculated interest each year on Hood’s calculated undercompensation.

The Fuller report contained two opinions. In the first opinion (“the primary opinion”), Fuller concluded reasonable compensation for Hood to be $3,681,269 for the 2015 tax year and $1,362,831 for the 2016 tax year. As part of this determination, Fuller included compensation to Hood for the surety bond guaranties.

The second opinion (“the alternative opinion”) excluded compensation for the surety bond guaranties. This is because Fuller noted that the PAS survey may have already included such guaranties in the construction industry data for a company board chairman. The alternative opinion ultimately concluded reasonable compensation for Hood to be $2,202,063 for the 2015 tax year and $1,314,500 for the 2016 tax year.

CHI disagreed with Fuller’s opinion and asked the Tax Court to reject Fuller’s report in its entirety. One of the principal reasons that CHI presented to justify its request is the allegation that the Fuller report was “statistically invalid.” This allegation was because Fuller used data from the RMA and PAS survey services.

The Tax Court noted that the CHI expert witness Sharp admitted there is no such thing as “perfect data” when it comes to executive compensation. The Tax Court did not find these data services to be intrinsically defective or inappropriate for the purposes at hand. The court noted that the CHI other expert witness, Kursh, also relied on RMA data in the BLDS report. And, the CHI independent accountant, Greenway, used PAS survey data, which the CHI CFO had found to be “helpful.”

Accordingly, the Tax Court concluded, “Therefore, while such benchmark data may not be as statistically exacting as petitioner would like, petitioner did not provide satisfactory countervailing evidence through its expert witness that would credibly support a greater allowable amount. In this absence, we are left looking to Mr. Fuller’s report as the most credible and complete source of data, analyses, and conclusions in the record regarding what similar companies might be willing to pay Mr. Hood on petitioner’s facts.”

Did Hood Provide Extraordinary or Unique Services?

At trial, CHI claimed that Hood’s role in the company’s growth and success should be seen as extraordinary or unique such that the Tax Court should place less reliance on industry comparisons.

In response to this taxpayer position, the Tax Court concluded, “We agree with petitioner that Mr. Hood is extraordinarily talented in his industry and that perhaps few other individuals could have achieved similar results for petitioner during the later years of the review period. However, petitioner fails to appreciate that these considerations were taken into account in the expert witnesses’ reports. Mr. Fuller’s report specifically placed petitioner’s performance in the highest tier group of its comparable industry peers for years 2013 to 2016. Accordingly, we see no reason to discount reports that already sufficiently factor in Mr. Hood’s extraordinary contributions to petitioner.”

The Salary Policy as to Other CHI Employees

Certain federal courts have considered salaries paid to other employees of a private company in deciding whether executive/shareholder compensation is reasonable. In the Hood matter, the Tax Court also looked to this factor to determine whether Hood was compensated differently from the other CHI employees solely because of his status as a shareholder.

CHI had no structured system in place for the setting of its nonshareholder employee compensation. Hood personally set the salary and the bonus amounts of other employees and officers. At trial, Hood testified that he based these decisions on his own subjective belief as to the individual’s “work records,” “ability to get along with people,” and “pride in the company.”

Hood’s salary and bonus in the tax years at issue represented almost 90 percent of the total amount of compensation that CHI paid to its officers, despite the fact that nonshareholder officers such as Painter and Addley worked nearly the same number of hours as Hood and shared many of Hood’s responsibilities.

CHI had no agreement in place with Hood regarding his compensation. Instead, Hood’s compensation during the review period was set by him along with his wife in their roles as the CHI board of directors. Therefore, the court examined the specific circumstances surround the setting of Hood’s compensation in the tax years at issue.

The 2015 Compensation Amount

The 2015 bonus amount was initially proposed at the May 2015 meeting by Phillips, Hood, and the CHI external advisers at Elliott Davis in which the meeting participants tentatively agreed on a bonus amount of $5 million for Hood. In arriving at this bonus amount, CHI and its advisers had the advantage of knowing its anticipated year-end profits for the 2015 tax year. The 2015 tax year was expected to be the most successful year in its corporate history. Despite the fact that CHI never paid Hood a dividend, the company continued with its plan to award Hood a lump sum bonus.

CHI also used its own performance as a proxy for Hood’s performance with the board minutes citing only overarching contributions by Hood to the company during the review period. That is, there was no attempt in the board minutes to value or quantify the specific services rendered by Hood during the review period (other than his debt guaranties).

In the Hood decision, the Tax Court concluded, “Such a comparison may make sense for a one-man enterprise; however, petitioner employed dozens of hardworking employees during the review period and conceded that the company’s growth during this time could not be tied exclusively to Mr. Hood’s efforts.”

CHI did not provide evidence at trial to support what portion of the company’s growth should reasonably be attached to each of the various services, including possible values thereof, rendered by Hood during the review period. In addition, CHI did not provide evidence at trial to distinguish between the services provided by Hood during the review period and to the services provided by the company’s other officers and employees.

In addition, the Tax Court provided the following observation in the Hood decision with respect to the 2015 bonus amount:

Finally, and perhaps most telling, there was Mr. Hood’s testimony during trial. When asked why he considered it acceptable to take a significant amount of money out of the company starting in the 2015 tax year despite his reluctance to do so in the past, Mr. Hood admitted that he was aware that he needed to start making necessary preparations from an “income tax” perspective in “getting money out of” the company in anticipation of “a changing of the guard”.

The 2016 Compensation Amount

In awarding Hood the 2016 bonus amount, CHI acted under the awareness that, on the basis of its preliminary financial statements, its 2016 fiscal year was to be even more profitable than its 2015 fiscal year. Nevertheless, the CHI board again chose not to declare a dividend. Instead, the CHI board rewarded Hood exclusively through another $5 million bonus, reciting the same underlying rationale it provided for the 2015 amount. In addition, CHI made no attempt to explain why the 2015 bonus amount had been insufficient catch-up compensation for Hood’s prior services during the review period.

The Tax Court noted that the trial record did not indicate that (1) when it awarded Hood the 2015 bonus amount, the CHI board believed that Hood remained undercompensated or (2) additional catch-up compensation may be warranted in the future for these prior services.

In the Hood decision, the Tax Court noted that, “Petitioner nevertheless attempts to distinguish its legal effect by asking us to apply section 1.162-7(b)(2), Income Tax Regs., to a portion of the 2016 amount. This regulation provides that if contingent compensation is paid under a free bargain between an employer and employee before the services are rendered, then the purported compensation amount should be allowed as a deduction even though it may be greater than what may ordinarily be paid.”

In the Hood decision, the Tax Court also noted that, “There is little to no evidence that a bargain as envisioned under this regulation existed between petitioner and Mr. Hood with respect to any portion of the 2016 amount.” That is, no written management services agreement outlining an understanding between CHI and Hood existed regarding Hood’s potential total compensation for the 2016 tax year. And, CHI did not establish that its board of directors considered any part of the 2016 bonus amount at the May 2015 meeting, that is, before the commencement of Hood’s 2016 performance.

Analysis of Hood’s Prior Compensation Amounts

Where a large salary increase is an issue (as in the Hood matter), it may be helpful for the analyst to compare past and present duties and salary payments. Such a comparison may help the analyst determine whether and to what extent the current payments represent compensation for services performed in prior years that can be currently deductible.

Hood’s total compensation increased over 300 percent in the CHI 2015 fiscal year, its most profitable year to date. Nonetheless, there was no corresponding increase in Hood’s duties or responsibilities in that year. According to the CHI corporate minutes, the stated justification for this increase is that Hood was undercompensated in prior years. In the Hood decision, the Tax Court addressed this issue as follows: “While we do not disagree that Mr. Hood was undercompensated in certain years of the review period, this does not entitle petitioner to carte blanche in deducting Mr. Hood’s backpay bonus amount.”

In addition, the Tax Court expressed concern that CHI did not sufficiently demonstrate through reliable means how the full amount of each of the 2015 and the 2016 bonus amounts was proportionate in value to each of the past services allegedly rendered by Hood.

Hood’s Personal Guaranty of the CHI Debts and Bonding Obligations

The CHI justification for Hood’s higher compensation for the tax years at issue included Hood’s debt guaranties and surety bond guaranties during the review period. Guaranty fees may qualify as a deductible business expense under Section 162(a).

In various judicial decisions, the Tax Court has considered some of the following factors when deciding the deductibility of such fees paid to a private company executive/shareholder: (1) whether the fees were reasonable in amount given the financial risks, (2) whether companies of the same type and size as the taxpayer customarily pay such fees to shareholders, (3) whether the executive/shareholder demanded compensation for the guaranty, (4) whether the taxpayer had sufficient profits to pay a dividend but failed to do so, and (5) whether the purported guaranty fees were proportional to the executive/shareholder’s stock ownership.

The Tax Court noted that (1) it is customary for the owners of construction companies to guarantee debts and bonds and (2) compensation for these guaranties is appropriate. Further, the Service’s expert witness, Fuller, testified the compensation that CHI paid to Hood for surety bond guaranties in the tax years at issue was reasonable.

Regardless of this issue, the Tax Court concluded, “We recognize that Mr. Hood historically did not seek compensation for the guaranties and petitioner had sufficient profits to pay a dividend during the years at issue; however, we place more weight on the customary nature and reasonableness of the fees.”

The Hood Decision Reasonable Compensation Conclusion

Considering the totality of the factors discussed above, the Tax Court concluded that CHI did not adequately establish how the total compensation amounts paid to Hood during the tax years at issue were both (1) reasonable and (2) paid solely as compensation for his services to the company during the review period. While certain factors favored the taxpayer CHI, the court did not simply sum which party had the most factors in reaching its conclusion. In the court’s analysis, all factors were not afforded equal weight.

In reaching its final conclusion, the Tax Court described that the factors addressing comparable pay by comparable companies, the CHI shareholder distribution history, the setting of Hood’s compensation in the tax years at issue, and Hood’s involvement in the CHI business were the most relevant and persuasive factors.

In concluding the appropriate reasonable compensation amount, the Tax Court found Fuller’s expert testimony to be most helpful. The Service’s expert Fuller considered the multifactor approach, included compensation for the surety bond guaranties. And, Fuller offered a well-reasoned comparison of CHI and Hood’s salary against industry standards. According, the Tax Court allowed a reasonable compensation tax deduction for amounts paid to Clary Hood of $3,681,269 for tax year 2015 and $1,362,831 for tax year 2016.

The Tax Court’s discussion of the Section 6662 penalties in the Hood decision will be summarized in the third and final installment of this three-part discussion series.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

[1] Clary Hood, Inc. v. Commissioner of Internal Revenue, Tax Court decision in T.C. Memo 2022-15 (“the Hood decision”).

[2] Martens v. Commissioner, 934 F.2d 319, 1991 WL 87160, at *8 (4th Cir. 1991), aff’g per curiam T.C. Memo. 1990-42.

[3] Am. Sav. Bank v. Commissioner, 56 T.C. 828, 843 (197).

[4] Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930), aff’g Ox Fibre Brush Co. v. Blair, 32 F.2d 42 (4th Cir. 1929, rev’g 8 B.T.A.. 422 (1927).

[5] R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50 (1972).

[6] Estate of Wallace v. Commissioner, 95 T.C. 525, 553-554, aff’d 965 F.2 1038 (11th Cir. 1992).

[7] Richlands Med. Ass’n v. Commissioner, 953 F.2d 639, 1992 WL 14603, at *2 (4th Cir. 1992), aff’g per curiam T.C. Memo. 1990-660.

[8] Estate of Wallace v. Commissioner, 95 T.C. at 556.

[9] Richlands Med. Ass’n v. Commissioner, 1992 WL 14603, at *2.

[10] Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949), rev’g and remanding a Tax Court Memorandum Opinion dated November 16, 1948).

[11] E.J. Harrison & Sons, Inc. v. Commissioner, T.C. Memo. 2003-239, 2003 WL 21921049, at *14-*16, aff’d in part, rev’d in part, and remanded on another issue, 138 F. App’x 994 (9th Cir. 2005).

[12] Martens v. Commissioner, 1991 WL 87160, at *9.

[13] Medina v. Commissioner, T.C. Memo. 1983-253.

[14] Metro Leasing & Dev. Corp. v. Commissioner, 326 F.3d 1, 3-4 (1st Cir. 2003), aff’g T.C. Memo. 2001-119, 2001 WL 530694 and 119 T.C. 8 (2002).

[15] Haffner’s Serv. Stations, Inc. v. Commissioner, 326 F.3D, 1-3 (1st Cir. 2003), aff’g T.C. Memo. 2002-38.

[16] Exacto Spring Corp. v. Commissioner, 196 F.3d 833,838 (7th Cir. 1999).

[17] Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th Cir. 1983), rev’g T.C. Memo. 1980-282.

[18] Pepsi-Cola Bottling Co. of Salina v. Commissioner, 61 T.C. 564, 567 (1974), aff’d, 528 F.2d 176, 179 (10th Cir. 1975).

[19] Beiner, Inc. v. Commissioner, T.C. Memo. 2004-219, 2004 WL 2164888.

[20] Metro Leasing & Dev. Corp. v. Commissioner, 2001 WL 530694.

[21] Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d 445 F.2d 985 (10th Cir. 1971).

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.