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

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

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

Opinion

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:

  • Petitioner may deduct no more than $3,681,269 and $1,362,831 for the 2015 and 2016 tax years, and Petitioner is liable for the section 6662 penalty for the 2016 tax year.
  • Petitioner did not adequately establish how the amounts paid to Mr. Hood were both reasonable and paid solely as compensation for his services. While certain factors favor Petitioner, the factors addressing comparable pay by comparable concerns, Petitioner’s shareholder distribution history, the manner of setting Mr. Hood’s compensation, and Mr. Hood’s involvement in Petitioner’s business were the most relevant and persuasive factors for the Court.
  • “There is no doubt that Mr. Hood is the epitome of the American success story; his efforts directly contributed to petitioner’s prosperity during the review period. . . . [H]owever, we do examine the extent to which that compensation may be deducted for Federal income tax purposes because, as even petitioner recognizes, limits do exist for what may be reasonably deducted as compensation.”

Key Points of Law:

  • A subchapter C corporation is subject to federal income tax on its taxable income, which is its gross income less allowable deductions, including under Code Section 162(a)(1).
  • For deductions, “[t]here may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.” 26 C.F.R. § 1.162-7(a); 26 U.S.C. § 162(a)(1); see 26 C.F.R. § 1.162-7(b)(2) (addressing compensation based on contingent or future services).
  • An employer may deduct compensation paid to an employee in a year although the employee may have performed the services in a prior year. The employer must show that the employee was not sufficiently compensated in the prior year and that the current year’s compensation was in fact to compensate for that underpayment. Various factors are considered.
  • An “ostensible salary” paid by a closely held corporation to one of its few shareholders is likely to constitute a disguised dividend where the amount is “in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees”. 26 C.F.R. § 1.162-7(b)(1).
  • Some courts use a “multi-factor” approach to determine reasonable compensation, taking into consideration, for example, the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; and several other factors. Other jurisdictions use an “independent investor” test, which basically asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated.
  • A 20% penalty applies to any portion of an underpayment of tax required to be shown on a return which is attributable to a substantial understatement of income tax. 26 U.S.C. § 6662(a), (b)(2). For a subchapter C corporation, a substantial understatement of income tax is an understatement that exceeds the lesser of 10% of the tax required to be shown on the return for the taxable year (or, if greater, $10,000) or $10,000,000.
  • The substantial understatement penalty does not apply with respect to any portion of an underpayment as to which the taxpayer acted with reasonable cause and in good faith. at § 6664(c)(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.
  • For a taxpayer to reasonably rely upon professional advice to negate a substantial understatement penalty, the taxpayer must 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.

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.