Best Practices for Reasonableness of Employee Compensation Analysis

(Part III of III)

Part one of this three-part series presented the description of Clary Hood, Inc. (“CHI”) and the description of the tax litigation concluded in the Hood decision. Part two of this series summarized the Tax Court’s analysis and conclusions regarding the reasonableness of executive compensation issues in this matter. This third and final discussion summarizes the Tax Court’s analysis and conclusions regarding the application of the Internal Revenue Code Section 6662 penalties in this matter.

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 presented the description of Clary Hood, Inc. (“CHI”) and the description of the tax litigation concluded in the Hood decision. Part two of this series summarized the Tax Court’s analysis and conclusions regarding the reasonableness of executive compensation issues in this matter. This third and final discussion summarizes the Tax Court’s analysis and conclusions regarding the application of the Internal Revenue Code Section 6662 penalties in this matter.

The Section 6662 Penalties

According to Sections 6662(a) and (b)2, a 20 percent penalty applies to any portion of an underpayment of tax required to be reported on a tax return that is attributable to a substantial understatement of income tax (i.e., “the reported substantial understatement penalty”). According to Section 6662(d)(1)(B), for a C corporation like CHI, a substantial understatement of income tax is an understatement that exceeds the lesser of (1) 10 percent of the tax required to be reported on the tax return for the taxable year (or, if greater, $10,000) or (2) $10,000,000.

With regard to the Hood matter, the understatements for the years at issue qualified as “substantial” within the meaning of Section 6662(d)(1)(B). That is because each understatement exceeded 10 percent of the tax required to be reported on the CHI tax return for that tax year.

With Reasonable Cause and in Good Faith Exception

According to Section 6664(c)(1), the substantial understatement penalty does not apply with respect to any portion of an underpayment to which a taxpayer acted “with reasonable cause and in good faith.” According to Regulation 1.6664-4(b)(1), whether a taxpayer acted with reasonable cause and in good faith is decided on a case-by-case basis, taking into account all pertinent facts and circumstances.

A defense of reasonable cause requires that the taxpayer exercise ordinary business care and prudence as to the disputed item. Several judicial decisions have concluded that a taxpayer’s reliance on professional advice may sometimes meet this standard.

For a taxpayer to reasonably rely upon professional advice to negate a substantial understatement penalty, the taxpayer has to prove by a preponderance of the evidence that (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.

With regard to this issue, the Hood decision stated, “In cases involving corporations, we look at the efforts of a corporate taxpayer’s relevant decision makers, officers, and employees to ascertain the corporation’s proper tax liability in determining whether the taxpayer meets this standard.”

The 2015 Penalty Amount and a Competent Professional with Sufficient Expertise

CHI sought advice on the amount of Hood’s compensation and on the applicable tax consequences from Greenway and Stokes at the Elliott Davis accounting firm. Greenway was an Elliott Davis audit partner for nearly 18 years with more than 30 years of public accounting experience. As head of the Elliott Davis construction practice group, Greenway had a history of working with CHI before the years at issue, and Greenway was familiar with the comparative performance and profitability of CHI against its industry peers through his “hundreds of [other] construction clients.” Greenway testified at trial that he considered at least two construction industry executive compensation surveys in connection with the advice he provided to CHI regarding Hood’s compensation.

As an Elliott Davis tax partner with almost 20 years of public accounting experience, Stokes was similarly qualified. His relevant experience included (1) guiding at least 20 other clients on executive compensation matters and (2) acting as a personal tax adviser to both CHI and Hood.

Accordingly, the Tax Court concluded that the CHI advisers were adequately qualified to counsel the company on the issue of Hood’s compensation and its tax implications.

Did the Taxpayer Provide Necessary and Accurate Information?

Phillips initially raised the issue of Hood’s compensation with Greenway in the fall of 2014. Over the course of the next several months, Phillips performed preliminary calculations in an Excel spreadsheet. Phillips provided draft calculations to Greenway and Stokes during the May 2015 meeting. All parties agreed at that meeting that Hood deserved catch-up compensation in the form of a $5 million bonus, pending follow-up research and analysis.

As part of the follow-up due diligence, Phillips finalized his calculations on the compensation due spreadsheet. The spreadsheet included (1) certain financial information concerning CHI for each year of the review period through May 31, 2015, (2) Hood’s reported compensation for each of those years, and (3) a series of items for each year labeled “Carly Hood Calculation Compensation.”

Although the Service disagreed with the assumptions underlying the “Clary Hood Calculated Compensation” spreadsheet items, the Service did not claim that the data and the analyses provided by Phillips were incorrect or inadequate. And, the Service did not claim that any other CHI information should have been provided to Stokes or Greenway.

Did the Taxpayer Actually Rely on the Adviser’s Judgment?

Clary and Gail Hood, as the sole members of the CHI board of directors, had limited financial and accounting knowledge. They trusted Phillips to guide them as to the issue of Hood’s compensation for the years at issue. Phillips, as the company’s CFO and signer of its federal income tax returns, knew the CHI financial performance and federal tax profile better than anyone at the company. However, Phillips was also inexperienced in matters of executive compensation.

Recognizing these shortcomings and wanting to ensure that CHI arrived at a reasonable amount of compensation for Hood, Phillips went to Elliott Davis for advice beginning in 2014. And, Phillips continued to discuss the issue of Hood’s compensation with Elliott Davis throughout May 2015.

Following the May 2015 meeting, Stokes provided Phillips with research material summarizing the tax law on executive compensation. Stokes also reviewed the compensation due spreadsheet that Phillips created for the purpose of analyzing a potential bonus amount for Hood for the 2015 tax year. The spreadsheet was based on CHI data and incorporated input that Phillips previously received from Greenway.

At trial, Stokes testified that he did not scrutinize each of the components underlying the comprehensive spreadsheet. However, his existing knowledge of the CHI business did not lead him to believe that any of these assumptions were unreasonable. Greenway confirmed the same conclusion at trial.

Stokes made a few modifications to the compensation due spreadsheet before sending it back to Phillips (with a copy to Hood). In his e-mail, Stokes noted his approval of the analysis in the spreadsheet and its helpfulness in documenting the support necessary for the proposed 2015 bonus amount.

With regard to this issue, the Hood decision concluded, “We are satisfied that petitioner relied in good faith on the above advice when awarding Mr. Hood the 2015 amount and deducting the same for its 2015 tax year. The record does not show evidence of a rubber-stamp approval or a wink-and-a-smile by its advisers with respect to the 2015 amount.”

Therefore, the Tax Court concluded the following with regard to the Section 6662 penalty to 2015: “Accordingly, we decline to sustain respondent’s determination as to the accuracy-related penalty for the 2015 amount.”

The 2016 Penalty Amount and Reliance on Professional Advice

CHI claimed that it also relied on professional advice in awarding Hood the 2016 bonus amount. In contrast to the detailed record surrounding the advice given to determine the 2015 bonus amount, CHI provided almost no evidence at trial with respect to the advice it may have received to determine the 2016 bonus amount.

Phillips prepared an updated compensation due spreadsheet for the 2016 bonus amount. However, there was no evidence that the CHI board of directors considered or relied on his worksheet when deciding to award Hood the 2016 bonus amount. Phillips and Stokes each testified at trial that an analysis similar to the one performed for the 2015 bonus amount was undertaken in 2016. However, the court noted that there was no evidence presented in the record of any communication between CHI and its advisers that would credibly support a finding that advice was rendered with respect to the 2016 bonus amount.

The Tax Court particularly noted this lack of evidence when considering that (1) in awarding Hood the 2015 bonus amount, the record did not reflect that the CHI board still believed that Hood remained entitled to additional catch-up compensation for the review period and (2) in awarding Hood the 2016 bonus amount, the CHI board minutes did not attempt to address why the 2015 bonus amount was not sufficient in this regard. Specifically, on this issue, the Hood decision states, “If this changing view was based on advice petitioner received during its 2016 tax year, we would need to know what that specific advice was and who provided it.”

The Substantial Authority Defense

CHI also argued at trial that it has substantial authority to negate the imposition of the Section 6662 substantial understatement penalty with respect to the 2016 bonus amount. Section 6662(d)(2)(B)(k) negates an understatement that is attributable to the tax treatment of any item for which there is (or was) substantial authority for such treatment.

According to Regulation 1.6662-4(d)(3), the substantial authority standard is objective, and therefore it is not relevant whether the taxpayer believed that the substantial authority existed.

CHI claimed that its tax return position for each tax year at issue, including the 2016 bonus amount, was based on the independent investor test. CHI claimed that two judicial decisions by the U.S. Court of Appeals for the Seventh Circuit, Menard, Inc. v. Commissioner[2] and Exacto Spring Corp. v. Commissioner[3] “provide clear cut substantial authority” for the company’s use of this reasonableness of compensation test for the tax years at issue.

Regulation 1.6662-4(d)-(3)(iv(B) does permit a taxpayer to consider court cases outside of the taxpayer’s home jurisdiction to establish substantial authority. However, a single Court of Appeals acceptance of a test does not necessarily equate to substantial authority.

The Hood decision noted that “the Court of Appeals for the Fourth Circuit, the court to which an appeal of this case would lie, see sec. 7482(b), applies the multifactor approach without consideration of a hypothetical investor and without indication that a different formulation of this test might be more appropriate.”

Accordingly, the Tax Court concluded, “We therefore cannot accept the petitioner’s position with respect to the 2016 amount was based on substantial authority.”

Therefore, based on the above analysis, the Tax Court allowed the imposition of the Section 6662 substantial understatement penalty for the CHI 2016 tax year.

Summary and Conclusion

The U.S. Tax Court case Clary Hood, Inc. v. Commissioner involves a closely held C corporation’s dispute regarding the reasonableness of executive/shareholder compensation tax deductions. There was no dispute in this litigation that CHI was an extremely successful specialty construction company during the tax years at issue. Further, there was no dispute in this litigation that Clary Hood, the company CEO and (with his wife) shareholder, was largely responsible for the construction company’s success during the tax years at issue. The disputed issue in the litigation was whether the bonuses paid to Hood in 2015 and 2016 exceed a reasonable amount of executive compensation for the services Hood actually performed for the company.

In its memorandum decision, the Tax Court provided a fulsome discussion of the methodology and analysis it applied in addressing this reasonableness of executive/shareholder compensation issue. This judicial discussion provides meaningful practical guidance to private company owners and to their legal, accounting, and valuation advisers.

While this judicial guidance regarding reasonableness of compensation analysis is directly applicable to federal income tax matters, it may also be helpful regarding shareholder litigation, ERISA compliance, not-for-profit entity regulatory compliance, and other controversy matters involving the question of reasonableness of executive or professional compensation.

In particular, the Hood decision describes what the Tax Court liked—and disliked—about the expert testimony provided by the experts for both the taxpayer and the Service. That judicial description provides meaningful practical guidance to valuation analysts and other advisers who provide testifying expert services. That judicial assessment of expert testimony and of expert reports is directly applicable to federal income tax disputes. It may also be helpful to testifying experts—and to legal counsel and litigants—involved in other types of commercial disputes.

Finally, the Hood decision provides a comprehensive discussion of the court’s analysis regarding the application of Section 6662’s substantial understatement penalty. That discussion should be instructive to both individual and corporate taxpayers and to their tax counsel and other tax advisers.

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] Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), rev’g T.C. Memo. 2004-207.

[3] Exacto Spring Corp. v. Commissioner, 196 F.3d, 833.

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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.