Tax Court in Brief | Clary Hood, Inc. v. Comm’r | “Reasonable remuneration” and disguised dividend | law of the free man

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Tax litigation: The week of February 28, 2022 to March 4, 2022

Clary Hood, Inc. v. Comm’r, TC Memo. 2022-15 | March 2, 2022 | Greaves, J. | Dekt. No. 3362-19


Short summary: This case involves the deduction of executive compensation. In 1980, Clary Hood and his wife founded and were the sole shareholders and board members of Clary Hood, Inc., a Subchapter C corporation. Through the leadership and work ethic of Mr. Hood, the business has been successful, with revenues of nearly $44 million ($7 million net) in 2015 and $68 million ($14 million net) in 2016. Mr. Hood and his wife set Mr. Hood’s compensation. . In 2014, Mr. Hood and his advisers concluded that Mr. Hood had been underpaid in previous 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 compensation for the other four executives, none of whom were paid more than $234,000 and none received a bonus of more than $100,000. $. The IRS issued a notice of deficiency, saying the compensation for the years at issue exceeded the compensation reasonable under 26 USC (“Code”) § ​​162(a)(1). This resulted in total deficits of $1,581,202 and $1,613,308 for the Applicant’s 2015 and 2016 taxation years, respectively. Accuracy penalties under Code Section 6662 for underpayments due to materially understating income tax of $316,240 and $322,662 were also imposed. The petitioner challenged the decisions of the IRS.

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

Main holdings:

  • The petitioner cannot deduct more than $3,681,269 and $1,362,831 for the 2015 and 2016 tax years, and the petitioner is subject to the penalty of section 6662 for the 2016 tax year.
  • The Claimant has failed to adequately establish how the amounts paid to Mr. Hood were both reasonable and paid solely as compensation for his services. Although certain factors favor the Applicant, factors relating to comparable compensation by comparable companies, the Applicant’s shareholder distribution history, the manner in which Mr. Hood’s compensation is determined and Mr. Hood’s involvement in Applicant’s cases were the most relevant and compelling factors for the Court.
  • “There is no doubt that Mr. Hood is the epitome of the American success story; his efforts directly contributed to the prosperity of the petitioner during the relevant period. . . . [H]However, we are considering the extent to which this compensation can be deducted for federal income tax purposes because, as even the petitioner acknowledges, there are limits to what can reasonably be deducted as compensation.

Main points of law:

  • A subchapter C corporation is subject to federal income tax on its taxable income, which is its gross income less any deductions allowed, including under section 162(a)(1) of the Code.
  • For deductions, “[t]here may be included among ordinary and necessary expenses paid or incurred in the exercise of a trade or business a reasonable allowance for wages or other compensation for personal services actually rendered. The test for deductibility in the case of damages is whether they are reasonable and are in fact payments purely for services. » 26 CFR § 1.162-7(a); 26 USC § 162(a)(1); to see 26 CFR § 1.162-7(b)(2) (regarding compensation based on conditional or future service).
  • An employer may deduct remuneration paid to an employee in a year, although the employee may have rendered the services in a before year. The employer must demonstrate that the employee was not sufficiently compensated in the previous year and that the current year’s compensation was in fact intended to compensate for this underpayment. Different factors are taken into account.
  • An “ostensible salary” paid by a closely held company to one of its few shareholders is likely to constitute a disguised dividend when the amount is “greater than those usually paid for similar services and the excessive payments correspond or have a close relationship with the holdings of managers or employees”. 26 CFR § 1.162-7(b)(1).
  • Some courts use a “multi-factor” approach to determining reasonable compensation, taking into account, for example, the qualifications of the employee; the nature, extent and scope of the employee’s work; the size and complexity of the business; and several other factors. Other jurisdictions use an “arm’s length investor” test, which essentially asks whether an inactive arm’s length investor would be willing to compensate the employee as compensated.
  • A 20% penalty applies to any portion of a tax underpayment that must be reported on a return that is attributable to a substantial understatement of income tax. 26 USC § 6662(a), (b)(2). For a subchapter C company, a substantial understatement of income tax is an understatement that exceeds the lesser of 10% of the tax required to be reported on the return for the tax year (or, if greater, $10,000) or $10,000,000.
  • The substantial understatement penalty does not apply to any part of an understatement in respect of 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 determined on a case-by-case basis, taking into account all relevant facts and circumstances.
  • In order for a taxpayer to reasonably rely on professional advice to reverse a substantial understatement penalty, the taxpayer must prove by a preponderance of evidence that: (1) the adviser was a competent professional who had sufficient expertise to justify trust; (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.

Knowledge: It is permissible to compensate a key employee for past service and deduct that compensation as an ordinary and necessary business expense, but the paying employer must be careful to consider the Code and Treasury regulations and the manner in which this remuneration is determined and paid to the employee. In determining whether this compensation is “reasonable” and therefore deductible under Section 162(a)(1) of the Code, the IRS and the courts will weigh many factors, including, but not limited to, background and qualifications. of the employee; the nature, extent and scope of the employee’s work; and the size and complexity of the employer’s business. Knowing this, a filing taxpayer should consider doing the same.

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