BASIS OF REASONABLENESS DETERMINATION: COMPENSATION

Section 162(a)(1) provides that a taxpayer may deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” 26 U.S.C. § 162(a)(1). That Elliott actually rendered services as an employee of Taxpayer is not disputed. At issue is whether the payments made to Elliott are attributable to that employment relationship or to his role as Taxpayer’s sole shareholder. Our inquiry focuses on whether the Tax Court, in finding that a part of the payments made to Elliott could not be attributed to his employment status, correctly defined and applied the factors that determine what is “reasonable compensation” under section 162(a)(1).

Although we accord deference to the Tax Court’s special expertise, definition of the appropriate factors is reviewable by this court as a question of law. See Keller Street Development Co. v. Commissioner, 688 F.2d 675, 678 (9th Cir.1982); Sibla v. Commissioner, 611 F.2d 1260, 1262-63 (9th Cir.1980). The Tax Court’s findings of fact, derived from application of the appropriate factors, must be affirmed unless clearly erroneous. Keller Street, 688 F.2d at 678; Estate of Skaggs v. Commissioner, 672 F.2d 756, 757 (9th Cir.1982), cert. denied, 459 U.S. 1037, 103 S.Ct. 448, 74 L.Ed.2d 603 (1982).

Our cases have defined a number of factors that are relevant to this attribution determination, “with no single factor being decisive of the question.” Pacific Grains, 399 F.2d at 606. For analytical purposes, these factors may be divided into five broad categories.

A. Role in Company
The first category of factors concerns the employee’s role in the taxpaying company. Relevant considerations include the position held by the employee, hours worked, and duties performed, American Foundry v. Commissioner, 536 F.2d 289, 291-92 (9th Cir.1976), as well as the general importance of the employee to the success of the company, American Foundry, 536 F.2d at 291-92. If the employee has received a large salary increase, comparing past duties and salary with current responsibilities and compensation also may provide significant insights into the reasonableness of the compensation scheme. Pacific Grains, 399 F.2d at 605, 607.

The Tax Court found that Elliott worked 80 hours per week, performed the functions of general manager, sales manager, and credit manager, and made all policy decisions concerning the parts and service department. Elliotts, Inc. v. Commissioner, 40 T.C.M. (CCH) 802, 804 (1980). These are *1246 all appropriate considerations. The Tax Court also considered Elliott’s qualifications and found that although he was a “capable executive” he had no “special expertise.” Id. at 813. The Tax Court did not seem, however, to consider Elliott’s extreme personal dedication and devotion to his work. See id. at 811. To the extent that this benefited the corporation, it is surely something for which an independent shareholder would have been willing to compensate Elliott. Because we reverse and remand on other grounds, we point this out so that the Tax Court may consider it on remand.

B. External Comparison
The second set of relevant factors is a comparison of the employee’s salary with those paid by similar companies for similar services. See Hoffman Radio Corp. v. Commissioner, 177 F.2d 264, 266 (9th Cir.1949); E. Wagner & Son v. Commissioner, 93 F.2d 816, 819 (9th Cir.1937).

The Tax Court did compare Elliott’s compensation to that of managers at other John Deere dealers. 40 T.C.M. at 813. In making these comparisons, it appears that the Tax Court considered that Elliott was performing the functions that two or three people performed at other dealers. This was correct. Such comparisons should be made on the basis of services performed. See E. Wagner, 93 F.2d at 818; Treas.Reg. § 1.162-7(b)(3). If Elliott was performing the work of three people, the relevant comparison would be the combined salaries of those three people at another dealer.

C. Character and Condition of Company
The third general category of factors concerns the character and condition of the company. The focus under this category may be on the company’s size as indicated by its sales, net income, or capital value. See E. Wagner, 93 F.2d at 819; General Water Heater Corp. v. Commissioner, 42 F.2d 419, 420 (9th Cir.1930). Also relevant are the complexities of the business and general economic conditions. To the extent that they are relevant to this case, the Tax Court did adequately consider these factors.

D. Conflict of Interest
The fourth category focuses on those factors that may indicate a conflict of interest. The primary issue within this category is whether some relationship exists between the taxpaying company and its employee which might permit the company to disguise nondeductible corporate distributions of income as salary expenditures deductible under section 162(a)(1).4 Such a potentially exploitable relationship may exist where, as in this case, the employee is the taxpaying company’s sole or controlling shareholder, see Nor-Cal, 503 F.2d at 361; Pacific Grains, 399 F.2d at 607; E. Wagner, 93 F.2d at 817, 819, or where the existence of a family relationship indicates that the terms of the compensation plan may not have been the result of a free bargain, Harolds Club v. Commissioner, 340 F.2d 861, 865 (9th Cir.1965). Other factors also may point toward an attempt to distribute income through “compensation,” including the existence of a bonus system that distributes all or nearly all of the company’s pre-tax earnings, Nor-Cal, 503 F.2d at 362; Klamath Medical, 261 F.2d at 846; Sunset Scavenger Co. v. Commissioner, 84 F.2d 453, 455 (9th Cir.1936), that amounts to a disproportionately large percentage of gross income when combined with salary, Pacific Grains, 399 F.2d at 607; General Water Heater, 42 F.2d at 420, or that provides large bonuses to owner-executives, but none to non-owner management, Nor-Cal, 503 F.2d at 361.

In this case, where Elliott was the sole shareholder, the sort of relationship existed that warrants scrutiny. The mere existence of such a relationship, however, when coupled with an absence of dividend payments, does not necessarily lead to the conclusion that the amount of compensation is unreasonably high. Further exploration of the situation is necessary.

*1247 In such a situation, as discussed earlier, it is appropriate to evaluate the compensation payments from the perspective of a hypothetical independent shareholder. If the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement. If, however, that is not the case and the company’s earnings on equity remain at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary.

During the fiscal year ending February 28, 1975, Taxpayer reported equity of $415,133 and net profits (profits less taxes and compensation paid Elliott) of $88,969-a return of 21%. For fiscal year 1976, Taxpayer reported equity of $513,429 and net profits of $98,297-a return of 19%. 40 T.C.M. at 804. Thus, the average rate of return on equity during these years was 20%. The Tax Court failed to consider the significance of this data. It seems clear, however, that this rate of return on equity would satisfy an independent investor and would indicate that Taxpayer and Elliott were not exploiting their relationship.6

The Tax Court erred by limiting its analysis in this area to the facts that Elliott was Taxpayer’s sole shareholder and Taxpayer paid no dividends. These are relevant factors, but they cannot be viewed in isolation. Taxpayer’s no-dividend policy does not by itself demonstrate that the relationship between Taxpayer and Elliott was being exploited.

E. Internal Consistency
Finally, evidence of an internal inconsistency in a company’s treatment of payments to employees may indicate that the payments go beyond reasonable compensation. Bonuses that have not been awarded under a structured, formal, consistently applied program generally are suspect, see Nor-Cal, 503 F.2d at 362, as are bonuses consistently designated in amounts tracking either the percentage of the recipient’s stock holdings, id.; General Water Heater, 42 F.2d at 420, or some type of tax benefit, Pacific Grains, 399 F.2d at 607 (bonus adjusted according to available surtax exemption). Similarly, salaries paid to controlling shareholders are open to question if, when compared to salaries paid non-owner management, they indicate that the level of compensation is a function of ownership, not corporate management responsibility. Sunset Scavenger Co., 84 F.2d at 456. On the other hand, evidence of a reasonable, longstanding, consistently applied compensation plan is evidence that the compensation paid in the years in question was reasonable.

There was evidence in this case of a longstanding, consistently applied compensation plan. Since Taxpayer’s incorporation, it had paid to Elliott an annual bonus equal to 50% of its net profits. Taxpayer contended before the Tax Court that because the yearly bonuses paid Elliott were derived from a predetermined formula that had been in use for over 20 years, it could be inferred that the bonuses constituted compensation for services rather than a dividend distribution. *1248 It noted that under the bonus formula Elliott’s salary in some prior years had been too low to compensate him for the services he had rendered to Taxpayer, so that the higher salaries in the years in issue “resulted in average reasonable compensation during the 10-year period ... 1968 through 1978.” 40 T.C.M. at 809-10.

In considering the significance of this longstanding bonus formula, the Tax Court erred in several respects.

The Tax Court failed to consider the reasonableness of the contingent formula itself; it concentrated instead on the amounts paid under the formula in two particular years. Such a formula may overcompensate in good years and undercompensate in bad years. This feature, however, does not necessarily make the formula unreasonable. It is permissible to pay and deduct compensation for services performed in prior years. Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119, 50 S.Ct. 273, 274, 74 L.Ed. 733 (1930).

Whether payments under such a formula are reasonable will depend on whether the formula is reasonable. The reasonableness of a longstanding formula should not be determined on the basis of just one or two years. Taxpayer persuasively argues that, accepting the Tax Court’s determination of reasonable compensation for 1974 and 1975, Elliott was severely undercompensated in terms of constant dollars in six of the seven preceding years.

Also relevant to the reasonableness of the formula used in this case is the return on equity an independent investor would have achieved. A formula which would not allow a reasonable return on equity is likely to be unreasonable. In this case, however, as discussed earlier, the return on equity in the years at issue was about 20%.

Over the long run, such a formula should reasonably compensate for the work done, the performance achieved, the responsibility assumed, and the experience and dedication of the employee. At the same time, it should not stand in the way of a satisfactory return on equity.

The Tax Court also discounted the significance of the bonus formula on the ground that “[n]o special incentive is necessary to insure [Elliott’s] best efforts since he would ‘receive the fruits of success through his status as the majority shareholder.’ ” 40 T.C.M. at 811, quoting Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 153 (8th Cir.1974), cert. denied, 420 U.S. 908, 95 S.Ct. 826, 42 L.Ed.2d 837 (1975). To the extent that this implied that incentive payment plans for shareholder-employees are unreasonable, it was error.

Incentive payment plans are designed to encourage and compensate that extra effort and dedication which can be so valuable to a corporation. There is no reason a shareholder-employee should not also be entitled to such compensation if his dedication and efforts are instrumental to the corporation’s success. In this case, there is no doubt that Elliott’s extreme dedication and hard work were valuable to Taxpayer. If an outside investor would approve of such a compensation plan, that plan is probably reasonable. The fact that the recipient is a shareholder-employee does not make the plan unreasonable.

Word Document version.