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Recent Court Decisions Related To The Reasonableness Of Executive Compensation


     By Willamette Management Associates Business Valuations, Economic Analysis, Financial Advisory & Expert Witness Services

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In litigation controversies related to the income tax deduction of shareholder/executive compensation as a business expense, the courts generally apply a multi-factor test to determine if the compensation is reasonable. The courts apply this test with an emphasis on the perspective of a hypothetical independent investor. In this analysis, the extent to which the courts accept and rely on compensation data from published compensation surveys and/or from comparable company analyses varies.

In litigation controversies related to the income tax deduction of shareholder/executive compensation as a business expense, the courts generally apply a multi-factor test to determine if the compensation is reasonable. Nonetheless, the courts apply this multi-factor test with an emphasis on the perspective of a hypothetical independent investor. In this reasonableness of compensation analysis, the extent to which the courts accept and rely on compensation data from published compensation surveys and/or from comparable company analyses varies. The courts often rely on expert witnesses to provide valuable guidance with regard to the reasonableness of shareholder/executive compensation. However, the courts only rely on expert witnesses if they provide thorough qualitative and quantitative economic analyses.





INTRODUCTION

Internal Revenue Code Section 162(a)(1) allows a business to deduct ordinary and necessary business expenses including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” The Internal Revenue Service (the “Service”) may disallow deductions related to executive compensation paid to shareholder/employees by closely held C corporations if such compensation is considered to be excessive. The excessive (or unreasonable) amounts of shareholder/employee compensation are often reclassified as dividend payments, which are not deductible to the corporation.

The Service is typically less concerned with the reasonableness of executive compensation paid by publicly traded companies because the executive offices of these companies, unlike shareholder/employees of closely held C corporations, cannot set their own compensation. Rather, they are ultimately responsible to the board of directors who, in turn, are responsible to the shareholders. In addition, Internal Revenue Code Section 162(m)(1) limits the deduction for compensation to $1 million in a taxable year for any employee of a publicly held corporation.

For S corporations, the Service is not concerned with the deductibility of compensation expenses but may question unreasonably low levels of compensation resulting in underpayment of FICA, Medicare, FUTA, SUTA, and other compensation-related employment taxes. For not-for-profit organizations, the Service may conclude that excessive compensation to not-for-profit executives results in the private inurement of the organization’s funds.

This discussion will summarize several recent judicial decisions with regard to the reasonableness of closely held C corporation shareholder/executive compensation conclusions. In addition, to the extent relevant to the decision, this discussion will summarize any judicial commentary related to the expert witness testimony.



BEINER, INC. V. COMMISSIONER OF INTERNAL REVENUE

Overview

In Beiner, Inc. v. C.I.R., T.C. Memo 2004-219, the Tax Court considered five factors from the perspective of a hypothetical (but passive) independent investor. This independent investor test was first set out in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir.1983). In the Beiner, Inc. case, the Tax Court reached a conclusion with respect to the reasonableness of the shareholder/executive compensation paid to Robert Beiner in 1999 and 2000.

In determining the amount of executive compensation that was reasonable and, therefore, deductible as a business expense, the Tax Court relied on the opinion of the taxpayer’s expert. That expert testimony was based on compensation data extracted from 34 publicly held companies in similar industries.



Facts of the Case

Robert Beiner was a founder of Beiner, Inc., a wholesale distributor of motor control parts manufactured by Allen-Bradley. During 1999 and 2000, he was the sole shareholder and served as the chief executive office, chief financial officer, president, secretary, and treasurer of the company.

The total compensation paid to Robert Beiner by Beiner, Inc., including salary and bonus, was $1,087,000 in 1999 and $1,350,000 in 2000. The bonus paid to Mr. Beiner was generally based on a formula. That bonus formula took into account the company sales and profit for the year. The company had never paid a dividend and there was no formal compensation plan or written employment agreement with Mr. Beiner.

The Service determined in a notice of deficiency that only $303,020 and $157,982 of compensation were deductible in 1999 and 2000, respectively. The Service also determined that the taxpayer corporation was liable for an accuracy-related penalty for each year.



Opinion

In the Beiner, Inc. decision, the five factors considered by the Tax Court were: (1) the employee’s role in the company, (2) a comparison of the compensation paid to the employee with the compensation paid to similarly situated employees in similar companies (external comparison), (3) the character and condition of the company, (4) whether a conflict of interest existed that might have permitted the company to disguise dividend payments as deductible compensation, and (5) whether the company’s payments of compensation to all of its employees were internally consistent (internal consistency).

These factors were evaluated by the Tax Court from the perspective of a hypothetical (inactive) independent investor. That hypothetical independent investor would consider each factor favorably or unfavorably in deciding whether payment of the disputed compensation to Mr. Beiner was required to retain his services.



Employee’s Role in the Company

While Mr. Beiner played an important role in the company, the Service asserted that: (1) his services were nonspecialized, (2) he spent little time in the company’s business, (3) he spent a significant amount of time working for California Controls, Inc., and (4) his brother was the primary income-producing factor in the business. The Service concluded that Mr. Beiner’s services did not justify the amount of compensation that the taxpayer corporation paid to him.

The Tax Court disagreed with the assertions and conclusion of the Service. The Tax Court concluded that the most important element of the business, the purchase of parts at prices less than those paid by authorized distributors, was directly attributable to the efforts of Mr. Beiner.

The Tax Court also concluded that, without the services of Mr. Beiner, the company would not have operated as profitably as it did. The Tax Court found that Mr. Beiner spent 38 hours per week working for Beiner, Inc., and approximately 19 hours per week at California Controls, a wholesale distributor for parts manufactured by other vendors that he owned with his brother.

The Tax Court also concluded (1) that Mr. Beiner’s brother had not participated in the Beiner, Inc., business after the company limited its business to Allen-Bradley parts in 1992 and (2) that Robert Beiner was the company’s most valuable employee.

The Tax Court concluded that a hypothetical independent investor would consider this factor favorably.



External Comparison

The expert for the taxpayer corporation performed an economic analysis to estimate reasonable compensation for Mr. Beiner in each of the years in dispute. He selected 34 publicly traded companies with standard industrial classification (SIC) codes of 5063 and 5065 for inclusion in his analysis. His analysis correlated (1) salary payments with sales and (2) incentive payments with sales and profitability. He then constructed formulas to estimate a reasonable salary and a reasonable incentive.

The taxpayer’s expert estimated (1) a reasonable salary consistent with the size and nature of the taxpayer and amounts paid at the 90th percentile of the 34 comparable companies and (2) reasonable incentive consistent with prevailing executive incentive practices and based on the sales and profitability of the taxpayer corporation. To these two figures, he added an amount equal to the taxpayer’s gross profit less the gross profit the taxpayer would have realized if it had performed at the ratio of gross profit to sales corresponding to the 90th percentile of the 34 comparable companies (the “excess gross profits”).

The reasonable compensation amounts concluded by the taxpayer’s expert for 1999 and 2000 were $906,740 and $1,533,093, respectively.

The Service did not offer any expert testimony with respect to this factor. Instead, the Service argued that the excess gross profit portion of the economic analysis should be ignored. However, the Tax Court agreed with the taxpayer’s expert that the taxpayer corporation was entitled to pay these excess profits to Mr. Beiner. This was because his services were directly related to the realization of these profits.

The Tax Court concluded that a hypothetical independent investor would consider this factor favorably.



Character and Condition of the Company

The Tax Court acknowledged that the company was extremely well-managed and profitable, with extraordinary growth in sales and shareholder equity. During the years in dispute, the company had a strong character and a strong financial condition.

The Service argued that the taxpayer corporation was a simple business requiring few personal skills. The Tax Court again disagreed. The Tax Court noted that the sales and gross profits were attributable to the personal skills of Mr. Beiner in obtaining the Allen-Bradley parts at prices below those paid by authorized distributors.

The Tax Court concluded that a hypothetical independent investor would consider this factor favorably.



Conflict of Interest

This factor addresses the possibility of a relationship between the taxpayer company and an employee that could result in disguising dividend payments as deductible compensation. The Tax Court considered that if the company’s return on equity would satisfy a hypothetical independent investor, there is a strong indication that profits are not being “siphoned out of the company disguised as salary.”

The Service asserted that the compensation payments to Mr. Beiner, as a percent of gross receipts or net income, were too high. The Tax Court held that payment of compensation to a valuable employee in an amount exceeding a certain percentage does not necessarily mean that some of all of the compensation is unreasonable. Rather, reasonable compensation is a question of fact based on all credible evidence.

The Tax Court concluded that Mr. Beiner was “vital and indispensable” to the company’s success and that the returns (on equity) to a hypothetical inactive independent investor were meaningful.

The Tax Court concluded that a hypothetical independent investor would consider this factor favorably.



Internal Comparison

This factor relates to the inconsistency among payments to employees as an indication of unreasonable compensation. The Service argued that a comparison of Mr. Beiner’s compensation to that of a nonowner officer and other employees shows that his compensation is unreasonable.

The Tax Court disagreed. The Tax Court concluded (1) that the taxpayer’s profits were almost exclusively due to Mr. Beiner’s efforts and (2) that the other employees had limited roles in the profitability of the taxpayer company.

The Tax Court concluded that a hypothetical independent investor would consider this factor favorably.



Additional Factor

The Service asked that the Tax Court consider an additional factor: the taxpayer’s intent in making the payments to Mr. Beiner. The Service argued that the payments were not made with compensatory intent. The Service argued that the payments were paid to avoid the Section 531 accumulated earnings tax.

The Tax Court declined to decide the taxpayer’s intent in making the payments. The Tax Court noted that this was not a case with evidence that an otherwise reasonable compensation payment contained a disguised dividend.



Conclusion

The Tax Court concluded that, with respect to four of the five factors, a hypothetical independent investor would pay the disputed amounts to Mr. Beiner as compensation to retain his executive services. With respect to the fifth factor, the external comparison, the Tax Court found that a hypothetical inactive independent investor would limit Mr. Beiner’s compensation to the amounts concluded by the Taxpayer’s expert: $906,740 in 1999 and $1,533,093 in 2000.

The Tax Court, therefore, concluded that $180,260 ($1,087,000 minus $960,740) of Mr. Beiner’s 1999 compensation was not deductible by the taxpayer corporation as an ordinary business expense. The Tax Court also held that the taxpayer corporation was not liable for an accuracy-related penalty



BREWER QUALITY HOMES, INC. V. COMMISSIONER OF INTERNAL REVENUE

Overview

In Brewer Quality Homes, Inc. v. C.I.R. (T.C. Memo 2003-200), the Tax Court considered the multi-factor tests set out in Owensby & Kritikos v. Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987), aff’g. T.C. Memo 1985-267. The concluded reasonable shareholder/executive compensation amounts were based on: (1) the rebuttal expert witness report of the expert for the Service for 1995 and (2) ratio data (i.e., executive compensation as a percent of sales) published by The Risk Management Association (formerly Robert Morris Associates (RMA)) for 1996.

On appeal, the Fifth Circuit affirmed the decision of the Tax Court.



Facts of the Case

Brewer Quality Homes, Inc. was a retail seller of mobile homes. Jack Brewer and his wife, Mary Brewer, each owned 50 percent of the stock of the taxpayer company. Mr. Brewer served as president, chief financial officer, chief executive officer, general manager, sales manager, loan officer, credit manager, purchasing officer, personnel manager, advertising manager, insurance agent, real estate manager, and corporate legal affairs liaison.

Jack Brewer worked approximately 60 hours per week during the years in question, 1995 and 1996. In 1995, his salary was $62,186 and his bonus was $700,000. His 1996 salary and bonus were $63,559 and $800,000, respectively.

There was no mention in the corporate minutes that these payments were intended to make up for undercompensation in prior years. Dividends of (1) $116,100 were distributed in 1993 and (2) $320,949 were distributed in 1994.

The Service allowed as deductible as reasonable compensation $423,245 in 1995 and $465,800 in a notice of deficiency. The expert witness for the Service, in his rebuttal report, concluded reasonable compensation of $599,117 in 1995 and $485,966 in 1995. This expert conclusion was based primarily on a fair return to investor analysis. The Service conceded that these amounts, plus an additional $5,000 in compensation in 1995 (as additional compensation for the personal guarantee on a line of credit), were tax deductible.

Related to the reasonableness of Mr. Brewer’s compensation, the taxpayer corporation offered testimony by two experts. The first expert, a CPA, merely opined that Mr. Brewer’s compensation was reasonable and did not estimate a maximum reasonable compensation amount for Mr. Brewer’s services. The second expert concluded that an investor in an arm’s-length transaction would have thought Mr. Brewer’s compensation to be reasonable. This expert did not conclude a maximum reasonable compensation amount, but she did present data from RMA to support her expert conclusion.



Opinion

The Tax Court did not find any of the expert witness conclusions particularly helpful. Instead, the Tax Court used some of their analyses and data in reaching its own reasonableness of shareholder/executive compensation decision.

The Tax Court first considered the RMA data provided by the expert for the taxpayer. Based on the performance of the taxpayer company, the Tax Court concluded that Mr. Brewer’s compensation, as a percentage of sales, should be compared to companies in the 90th percentile (as estimated by the taxpayer’s expert). This analysis led to a preliminary conclusion of reasonable compensation of $520,000 in 1995 and $600,000 in 1996.

The Tax Court then (1) added $5,000 to the 1995 figure to compensate Mr. Brewer for the personal guarantee of a line of credit and (2) added approximately 5 percent to each year’s figure to compensate Mr. Brewer for retirement benefits that he did not receive. This analysis resulted in a reasonable compensation amount of $550,000 in 1995 and $630,000 in 1996.

However, since the Service was willing to allow what their expert had concluded as reasonable compensation in 1995, the Tax Court revised its conclusion—after correcting mathematical errors (and the addition of $5,000 related to the loan guarantee) and rounding—to $610,000 for 1995.



The Appeal

Brewer Quality Homes, Inc., appealed the Tax Court decision. The taxpayer corporation claimed that the Tax Court properly identified the nine-factor test but it failed to provide an analysis and applications of the factors. These nine factors are: 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; the salary policy of the taxpayer as to all employees; and the amount of compensation paid to the employee in previous years.

The taxpayer corporation contended that the Tax Court considered ten “indicia” of reasonable compensation—with half in favor of the Service and half in favor of the taxpayer—but that these could only be roughly related to the nine factors.

The Fifth Circuit held that the nine factors could be considered without a detailed written analysis. The Fifth Circuit was satisfied that the nine factors were considered by the Tax Court. The Tax Court considered these factors as evidenced by the extensive findings of fact and the repeated references to Owensby & Kritikos in the opinion. The decision of the Tax Court was affirmed.



HIGHLIGHTS OF ADDITIONAL CASES

Miller & Sons Drywall, Inc. v. Commissioner of Internal Revenue

In this case (T.C. Memo. 2005-114), the Service disallowed tax deductions for the tax years ending June 30, 1998, to June 30, 2000, related to the compensation of three brothers. The three brothers were the sole shareholders of the taxpayer company, a drywall construction business. Expert witness testimony on behalf of both the Service and the taxpayer was offered at trial.

The Tax Court considered each of the nine factors (and an additional profit margin factor) and found more of the factors favorable to the taxpayer. The Tax Court examined the taxpayer corporation return on equity from the perspective of an independent investor (without relying entirely on either expert’s economic analysis).

It is interesting that the Tax Court rejected much of the quantitative analysis performed by both experts. In particular, the Tax Court rejected most of the experts’ analyses with respect to prevailing rates of compensation for comparable positions in comparable concerns. The Court’s reasons for rejection included (1) the use of an incorrect Standard Industrial Classification (SIC) code, (2) the fact that the survey data do not consider the number of hours worked, (3) the lack of comparability of companies included in survey data, and (4) a lack of data for the appropriate percentile.

The Tax Court ruled in favor of the taxpayer corporation. The Court’s decision stated that a preponderance of the evidence showed that the brothers were reasonably compensated in each year.



Wechsler & Co., Inc. v. Commissioner of Internal Revenue

In this case (T.C. Memo. 2006-173), the Service disallowed a portion of the tax deductions for the compensation paid by the taxpayer to (1) Norman Wechsler, the majority shareholder, over eight fiscal years ending May 31, 1999, and (2) his wife, Sharon Wechsler for fiscal year 1999.

The Service also disallowed all of the compensation paid to Norman Wechsler’s brother, Gilbert Wechsler, as a consultant for fiscal years 1992 and 1993. The taxpayer corporation was a market maker, broker-dealer, and investor specializing in convertible bonds.

The Tax Court considered the five factors listed previously in the description of the Beiner, Inc., case, from the perspective of an independent investor. With respect to the compensation of Norman Wechsler, the Service offered testimony from one expert, and the taxpayer offered testimony from two experts.

The Tax Court concluded a reasonable compensation amount for Sharon Wechsler—using its “best judgment”—of $253,154, computed as actual salary paid of $178,154 plus a bonus of $75,000. This amount was above the $150,000 allowed by the Service and below the $483,154 amount of total compensation paid.

The Tax Court ruled that none of the compensation paid to Gilbert Wechsler was tax deductible. This was because the taxpayer corporation failed to establish that he performed any services of value during the years in question.

In determining the amount of reasonable compensation for Norman Wechsler, the Tax Court was not persuaded by the economic analyses of either of the taxpayer’s experts.

Little weight was given to the economic analysis performed by the first expert. In part, this was because the taxpayer’s other expert testified that his conclusions based on the analysis of 27 broker-dealers were unreliable. His criticism was that the companies analyzed were substantially larger than the taxpayer. The taxpayer’s second expert based his conclusion that Norman Wechsler’s compensation was reasonable on a number of factors. However, these factors were given no weight. And, that expert did not provide a method that an independent investor could use to determine if the subject executive compensation was reasonable in any given year.

The Tax Court used the method presented by the expert for the Service to determine a reasonable level of compensation for Norman Wechsler. This expert opined that (1) the base salaries paid to Norman Wechsler were reasonable, (2) that an independent investor would have received a reasonable return on investment if incentive compensation for all bonus-paid employees was limited to 20 percent of profits, and (3) that Mr. Wechsler was entitled to 40 percent of such incentive compensation.

The Tax Court concluded that reasonable compensation for Mr. Wechsler would include (1) the actual annual salaries paid, (2) an adjustment in one year to reflect interest he should have earned on a securities loan to the company, and (3) an annual bonus equal to a full 20 percent of adjusted earnings before federal income tax (adjusted to reflect the nondeductible payments to Sharon and Gilbert Wechsler and before the payment of any bonus to Norman Wechsler). Using this methodology, the Tax Court concluded that the total amount of reasonable compensation for Norman Wechsler for the fiscal years 1992 through 1999 was $16,050,820. This amount is higher than (1) the $17,748,338 allowed by the Service and (2) the $9,088,620 concluded by the expert for the Service—but lower than the $37,991,771 amount actually paid to Mr. Wechsler over that period.



SUMMARY AND CONCLUSION

There are several lessons that can be learned from a review of these recent judicial decisions. An expert witness in a reasonableness of shareholder/executive compensation case should:



1. consider all relevant factors when estimating the reasonableness of compensation and not simply rely on quantitative economic analyses,

2. conclude an estimate of reasonable compensation (or a reasonable range of compensation or a maximum amount of reasonable compensation) and not just opine that the actual compensation paid was (or was not) reasonable, and

3. fully describe all methods used to estimate the reasonable compensation amount as well as the rationale for the methods—and selection of related compensation variables—used in the economic analysis.



The courts look to the financial adviser experts to provide relevant facts, data, and economic analyses to guide them in their reasonableness of shareholder/executive compensation decisions. While a judge may (1) reject a particular method or data source or (2) change certain variables, a comprehensive expert opinion report should provide a valuable resource to the court.

ABOUT THE AUTHOR: Pamela J. Garland

Pamela Garland is a senior manager in our Chicago office. 

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

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