Tax Court in Brief | Clary Hood, Inc. v. Comm’r | “Reasonable Compensation” and Disguised Dividend

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The Tax Court in Brief – February 28 – March 4th, 2022

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Tax Litigation:  The Week of February 28, 2022, through March 4, 2022

Clary Hood, Inc. v. Comm’r, T.C. Memo. 2022-15 | March 2, 2022 | Greaves, J. | Dkt. No. 3362-19

Short Summary: This case involves deduction of executive-level compensation. In 1980, Clary Hood and his wife founded and were the sole shareholders and members of the board of Clary Hood, Inc., a subchapter C corporation. Due to Mr. Hood’s leadership and work ethic, the company was successful, having revenue of near $44 million (net $7 million) in 2015 and $68 million (net $14 million) in 2016. Mr. Hood and his wife set Mr. Hood’s compensation. In 2014, Mr. Hood and his advisors concluded that Mr. Hood had been undercompensated in prior years. So, for 2015, Mr. Hood and his wife set his salary at $168,559 and his bonus at $5 million. Similar compensation and bonus was approved for 2016. Mr. Hood set the other four executives’ compensation, none of whom were compensated in excess of $234,000 and none had a bonus greater than $100,000. The IRS issued a notice of deficiency, claiming that the compensation for the years at issue exceeded reasonable compensation under 26 U.S.C. (“Code”) § 162(a)(1). This resulted in total deficiencies of $1,581,202 and $1,613,308 for Petitioner’s 2015 and 2016 tax years, respectively. Accuracy-related penalties under Code Section 6662 for underpayments due to substantial understatements of income tax of $316,240 and $322,662 were also assessed. Petitioner challenged the IRS’s determinations.

Issues: Was Mr. Hood’s compensation “reasonable” under Code Section 162 and related Treasury Regulations such that the amounts paid to him were deductible as an ordinary and necessary business expense of Cary Hood, Inc.?

Primary Holdings:

Key Points of Law:

Insights:  Compensating a key employee for services rendered in the past and deducting that compensation as an ordinary and necessary business expense is permitted, but the paying employer must be careful to consider the Code and Treasury Regulations and how that compensation is determined and paid to the employee. In determining whether that compensation is “reasonable” and thus deductible under Code Section 162(a)(1), the IRS and the courts will evaluate numerous factors, including, among other things, the employee’s background and qualifications; the nature, extent, and scope of the employee’s work; and the size and complexity of the employer’s business. Knowing that, a reporting taxpayer should consider doing the same.


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