2001 Tax Ct. Memo LEXIS 146 | Tax Ct. | 2001
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="1" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*146 Decisions will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, JUDGE: In these consolidated cases, respondent determined the following deficiencies and penalties in petitioners' 1 1995 and 1996 taxable years:
Deficiencies
_________________________
Penalty
Income Accumulated _______
Year tax earnings tax
____ __________ ____________ ____________
19952001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="2" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*147 $ 307,699 $ 108,714 $ 61,540
1996 142,559 --- 28,512
The parties have reached agreement with respect to several issues, and the following issues remain for our consideration: (1) Whether for its 1995 or 1996 tax year petitioner is entitled to deduct officer's compensation in any amount exceeding $ 76,800, the amount determined by respondent; (2) whether for its 1995 tax year petitioner permitted its earnings to accumulate beyond the reasonable needs of the business so as to be subject to the accumulated earnings tax; and (3) whether petitioner is liable for an accuracy-related penalty under
FINDINGS OF FACT
Metro Leasing and Development Corp., petitioner, had its principal place of business in El Macero, 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="3" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*148 California, at the time the petitions were filed in these cases. During the years in issue, George Valente, who was approximately 70 years old, was director and owned 100 percent of the common stock of petitioner. Mr. Valente became ill in 1992 and suffered from prostate cancer during 1995 and 1996. Mr. Valente was somewhat disabled by and concerned about his condition, so he appointed his wife, Lena Valente, to be petitioner's president during the years under consideration. During 1995 and 1996, Mrs. Valente was 66 and 67 years of age, respectively. Even though he was ill, Mr. Valente remained active in petitioner's business by means of a cooperative effort with Mrs. Valente. Under that arrangement, Mr. Valente was the decision-maker, and Mrs. Valente executed his decisions. Mr. Valente determined the amount of compensation to be paid to officers based on the profitability of the business. Because of their joint efforts, Mr. and Mrs. Valente's compensation was treated as an undivided amount for their combined efforts. Mrs. Valente became ill during 1996, retiring at the end of that year, and she died during 1998.
Mr. Valente became involved in the automobile business in 1959 and2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="4" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*149 at one point owned seven automobile dealerships and an automobile leasing company. Mr. Valente sold the last of his automobile dealerships, Green Valley Ford, in 1990. In connection with the last sale, Mr. Valente agreed to provide business consultation to the new owners and to "run" the profit-sharing plan. The new owners agreed to provide the Valentes with a new car each year. In 1991, Mr. Valente received $ 20,444 of compensation from Green Valley Ford and for 1992, 1993, 1995, and 1996 he received $ 1,690, $ 2,851, $ 3,289, and $ 2,049, respectively. For 1995 and 1996, Mr. Valente received distributions of $ 55,307 and $ 76,076, respectively, from Green Valley Ford's profit-sharing plan.
During the years in issue, petitioner had three employees, Mr. and Mrs. Valente and Jo Ann Michaels, who was the corporate secretary and bookkeeper. As bookkeeper, Ms. Michaels deposited receipts, prepared checks, reconciled bank statements and maintained the books of account, including the general ledger and the cash receipts and disbursement journals. Petitioner's place of business was in the Valentes' residence.
Petitioner's business during 1995 and 1996 included the ownership of land and2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="5" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*150 buildings leased to Green Valley Ford, under which the lessee paid the expenses associated with the property. Petitioner was also engaged in the business of leasing automobiles and the purchase and sale of real property. Petitioner had approximately 10 automobile leases during the years in question, all of which had been entered into prior to 1995. Petitioner's assets included land and a building in El Cerrito, and mortgages receivable in excess of $ 2.5 million, secured by real property located on Airport Boulevard, South San Francisco. Petitioner had sold this property, on the installment basis, on January 19, 1995.
Mr. Valente was qualified to be involved in any aspect of the automobile business, including petitioner's activities of leasing realty to an automobile dealer and leasing automobiles. Mr. Valente was, in general, successful and experienced in business operations. For the 12-year period 1985 through 1996, his highest annual wages exceeded $ 1 million, and his average wages for that period exceeded one-half million dollars. After 1990 and before 1995, however, Mr. Valente's reported wages did not exceed $ 320,000 and were as low as $ 151,690 and averaged $ 209,462. Mr. 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="6" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*151 Valente consulted for and was compensated by Green Valley Ford. He also consulted with the dealership executives in connection with petitioner's business operations. Mr. Valente spent as much as 15 hours per week consulting. His expertise was also used in connection with the South San Francisco property, which also involved an automobile dealership. He consulted with that dealership's executives to help ensure their continued ability to make mortgage payments on petitioner's self- financed sale of the property to the new dealer. Mr. Valente also spent a limited amount of time working on petitioner's accounts collectible.
For 1995, petitioner deducted $ 240,435 as compensation to officers, which included a yearend bonus of $ 180,435. For 1996, petitioner deducted $ 460,000 as compensation to officers, including yearend bonuses of $ 150,000 to Mrs. Valente and $ 250,000 to Mr. Valente. For years prior to 1995, the Valentes reported wages as follows:
Year Amount
____ ______
1985 $ 498,647
1986 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="7" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*152 493,485
1987 1,053,801
1988 1,075,075
1989 941,407
1990 1,072,362
1991 320,000
1992 151,690
1993 152,851
1994 213,305
For 1995 and 1996, petitioner's gross receipts consisted of the following amounts:
Type of income 1995 1996
______________ ____ ____
Interest income $ 259,652 $ 240,427
Gross rents 353,376 388,676
Net capital gains 35,884 267,657
Form 4797 gain 246,346 8,141
Late fees 2,931 1,170
________ ________
Total income 898,189 906,071
Petitioner's total income before2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="8" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*153 expenses, officer's compensation, and ratio of compensation to total income for 1987 through 1996 were as follows:
Compensation as
Total Officer percentage of
Year income compensation total income
____ ______ ____________ _______________
1987 $ 626,991 $ 425,000 67.8
1988 583,949 310,000 53.1
1989 503,859 260,000 51.6
1990 569,530 260,000 45.7
1991 946,396 360,000 38.0
1992 604,344 150,000 24.8
1993 633,688 150,000 23.7
1994 640,602 210,000 32.8
1995 898,479 240,435 26.7
1996 806,071 460,000 57.1
Petitioner acquired and sold shares of stock as follows:
Company name 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="9" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*154 Date acquired Date sold
____________ _____________ _________
Data Med 9/20/88 5/9/95
Mylex Corp. pre-'95 ---
Cyrix Corp. '95 & '96 '96
Focus Enhancement 5/23/96 12/9/96
IMP, Inc. 12/16/94 5/9/96
Interactive Medical
Tech. 6/30/95 10/21/96
Oryx '96 ---
Respondent determined the amount of petitioner's allowable deductions for reasonable compensation by use of statistics reflecting compensation for corporate officers in the equipment- leasing and real estate-rental business. Based on those statistics, respondent determined that petitioner was entitled to a deduction of $ 76,800 for each of the years 1995 and 1996 as reasonable compensation for the Valentes' services to petitioner.
The following schedule reflects respondent's comparison between petitioner's taxable income; adjusted taxable income (adjusted to not include net operating loss deductions, special deductions, and deductions for officer's2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="10" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*155 compensation); officer's compensation; and the percentage of adjusted taxable income represented by officer compensation:
Adjusted
Taxable taxable
Year income income Compensation Percentage
____ _______ ________ ____________ __________
1987 ($ 171,253) $ 285,636 $ 425,000 1 100.0
1988 33,406 343,406 310,000 90.3
1989 (19,237) 240,763 260,000
1990 (5,402) 273,871 260,000 94.9
1991 327,543 692,945 360,000 52.0
1992 244,323 394,376 150,000 38.0
1993 26,348 176,348 150,000 85.1
1994 (36,327) 173,673 210,000
1995 17,825 294,587 240,435 81.6
1996 58,755 518,755 460,000 88.7
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="11" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*156 The following schedule reflects the dividends received by the Valentes from petitioner:
Year Amount
____ ______
1985 -0-
1986 -0-
1987 -0-
1988 $ 17,600
1989 10,560
1990 11,241
1991 60,000
1992 10,000
1993 10,800
1994 -0-
1995 -0-
1996 -0-
Petitioner owned property in El Cerrito, which had been used as a parking lot, and Mr. Valente envisioned future development of the property. Although Mr. Valente envisioned future development at a cost ranging from $ 7 million to $ 10 million, as of the years in question, no plans had been2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="12" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*157 made for development nor action commenced to initiate a formal plan to develop the property. Petitioner, through its bookkeeper and the Valentes, provided all relevant information to their accountant and relied upon his expertise and judgment in the preparation and reporting of Federal income.
OPINION
The parties disagree about the methodology to be used for measuring or determining the amount of reasonable compensation. They also rely on differing facts in applying the standards.
Respondent, emphasizing case law from opinions of the Court of Appeals for the Ninth Circuit, 3 argues that when payments are made to a corporate employee who is also a principal shareholder, the compensation must be reasonable in amount and have a purely compensatory purpose. See
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="13" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*158 Respondent also points out that the Court of Appeals for the Ninth Circuit traditionally has looked to five factors, none of which is decisive, to evaluate whether compensation is reasonable, to wit: (1) The employee's role in the company; (2) an external comparison of the employee's salary with salaries paid by similar companies for similar services; (3) the character and condition of the company; (4) the conflict of interest between the company and the employee; and (5) the internal consistency in the company's treatment of payments to employees. See, e.g.,
Petitioner, in a similar fashion, points out that there are five traditional factors that the courts have used to decide whether compensation is reasonable, to wit: (1) The type of services and their extent; (2) the scarcity of qualified employees; (3) qualifications and prior earning capacity; (4) the net earnings of the corporate taxpayer; and (5) the peculiar characteristics of the taxpayer's business. Petitioner's suggested traditional factors are, in essence, the same ones the Court of Appeals for2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="14" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*159 the Ninth Circuit has utilized.
Each party reviews the facts of these cases under the traditional factors and concludes that their position is fully supported--i.e., respondent contends that his determination is correct, and petitioner contends that its compensation claims are reasonable. Petitioner, however, contends that the traditional tests are not adequate in the circumstances of these cases. Petitioner urges us to use exclusively the "independent investor test" in the same manner as used by the Court of Appeals for the Seventh Circuit in
We begin our reasonable compensation analysis by evaluating the facts of these cases in the context of the traditional factors, in the format used by the Court of Appeals for the Ninth Circuit.
We consider the Valentes as a single unit in the setting of this case because Mr. Valente was ill, and, although he was able to make decisions, it was Mrs. Valente who executed his decisions. Although a large portion of the compensation was paid to Mrs. Valente, the2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="15" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*160 total compensation was based on the Valentes' joint efforts or performance, and we refer to that performance collectively and in the singular. The Valentes (initially Mr. Valente and then Mrs. Valente) were taken ill and became unable to fully function in petitioner's business. Petitioner's sources of income are of a passive or investment nature, in that income was generally received from established capital investment rather than from personal services. Prior to the years under consideration, Mr. Valente sold his active operating interests in automobile dealerships and a leasing operation. Thereafter, operating out of the Valentes' home, petitioner's sources of income were mainly from investment type activity -- collection of rent and interest and the purchase and sale of securities and realty. Except for the ownership of a couple of parcels of land and some stock, petitioner's source of income was from the remnants of Mr. Valente's former ownership of automobile dealerships. Until the beginning of 1995, they owned realty that was leased to two different Ford dealerships. In the beginning of 1995, they sold one of the properties to the lessee and their income therefrom became income2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="16" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*161 from seller-financing rather than from rental.
Due to their age and physical condition, the Valentes were essentially semiretired. During 1995 and 1996, Mr. Valente was recuperating from surgery necessitated by prostrate cancer, so that his ability to participate in petitioner's business activity was more limited than it had been in prior years. For the 4 years immediately prior to 1995 and 1996, the Valentes' wages or salary, including amounts received other than from petitioner, averaged just over $ 200,000. For 1995 and 1996, the years under consideration, petitioner compensated the Valentes in the amounts of $ 240,435 and $ 460,000, respectively. We note that for 1995 and 1996, the Valentes were more hindered by health and age than in prior years and unable to devote their full efforts to the business.
Mr. Valente's consultation to automobile dealerships which either leased from petitioner or for whom petitioner was mortgagor is thought by petitioner to be critical to the success of the automobile companies. We are not able to find that Mr. Valente's role was critical, especially because the financial condition of the dealerships was not made a part of the record. There is no2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="17" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*162 indication that the dealerships that leased or purchased from petitioner were in financial difficulty or that petitioner's income stream was in jeopardy. Mr. Valente did, in any event, play a role in obtaining and maintaining the source of rental and interest income. We must note, however, that Mr. Valente received each year the use of a new automobile, monetary compensation, and relatively large profit- sharing distributions from the Green Valley Ford dealership.
For the years 1995 and 1996, approximately 68 percent and 78 percent, respectively, of petitioner's income was from interest and rents derived from sources that were established prior to or at the beginning of the 1995 year. The majority of the remainder of petitioner's income was derived from the sale of property, both real and personal. Other than the Valentes, petitioner had only one employee, who was a clerical/bookkeeper. Accordingly, petitioner's financial success and the job of ensuring a continued income stream fell upon the Valentes. Although it was not shown that the automobile dealerships to whom land had been sold on installment contract or leased were in financial difficulty, petitioner has shown that, to some2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="18" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*163 extent, Mr. Valente's efforts helped to ensure or maintain the income stream. Those same efforts also enhanced the capital structure of petitioner. In these circumstances, it is difficult to decide whether the Valentes' efforts were designed to generate income and/or to protect Mr. Valente's capital investment.
B. AN EXTERNAL COMPARISON OF THE EMPLOYEE'S SALARY WITH SALARIES
PAID BY SIMILAR COMPANIES FOR SIMILAR SERVICES
On this point, respondent contends that Mrs. Valente would not be entitled to earn the amount petitioner paid her during 1995 and 1996. Conversely, petitioner argues that the compensation paid to Mr. and/or Mrs. Valente was for their joint effort. Admittedly, Mrs. Valente acted in the nature of an amanuensis for Mr. Valente; however, petitioner has shown that its payments were to the Valentes for their joint efforts. Our focus here is not on the question of who should report the income but on the amount deductible as reasonable compensation for the efforts of the operative officers of petitioner. See, e.g.,
Respondent characterizes petitioner as a small business with activities that are not complex. As noted, petitioner's income during the years in issue was from passive sources (rents, interest, and dividends), and respondent emphasizes that those sources did not require much effort by the Valentes. Respondent, however, acknowledges that the increases to petitioner's 1995 and 1996 income were attributable to gain on the sale of real property and stocks. Those increases, compared to the average of the prior 3 years, amounted to $ 25,922 and $ 171,719 for 1995 and 1996, respectively. 4 Considered as a percentage increase over the 3 years prior to 1995, the increases were 4 percent and 27 percent, respectively.
Petitioner2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="20" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*165 contends that its assets were "interwoven with the retail automobile business" and that it was Mr. Valente's knowledge, expertise, and involvement that made petitioner financially successful. Petitioner acknowledges that the Valentes did not devote their full time to petitioner but argues that petitioner's success was nevertheless dependent upon the Valentes.
The question posed here is whether the Valentes used their control of petitioner to pay deductible salary, as opposed to nondeductible dividends. As contended by respondent, substantially all of petitioner's income was paid out in the form of compensation to the Valentes. In that regard, respondent references
general problem [in] * * * distinguishing between dividends and
compensation for services received by a shareholder-employee of
a closely held corporation. What makes this situation
troublesome is that the shareholder-employee and the corporation
are not dealing with each other at arm's length. It is likely to
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="21" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*166 be in the interests of both the corporation and the shareholder-
employee to characterize any payments to the shareholder-
employee as compensation rather than dividends. For this reason,
a taxpayer's characterization of such payments may warrant close
scrutiny to ensure that a portion of the purported compensation
payments is not a disguised dividend. See
In that regard, respondent points out that petitioner paid out 26.7 percent and 57.1 percent of its gross income as compensation for 1995 and 1996, respectively. In addition, petitioner paid out in compensation to the Valentes' 81.6 percent and 88.7 percent of its taxable income before considering the compensation deduction for 1995 and 1996, respectively.
E. THE INTERNAL CONSISTENCY IN THE COMPANY'S TREATMENT OF
PAYMENTS TO EMPLOYEES
Under this test, a company's formal compensation program is considered, and a comparative analysis is made of compensation to shareholder/employees in relation to compensation of nonshareholder employees. Petitioner had no such formal program; instead, Mr. 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="22" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*167 Valente would decide the amount of compensation on a year-by-year basis. Moreover, the only other employee of petitioner was a bookkeeper who did not have comparable qualifications, responsibilities, etc.
In addition to and in conjunction with the above- considered traditional tests, the Court of Appeals for the Ninth Circuit has also used an independent investor test. In
A relevant inquiry is whether an inactive, independent investor
would be willing to compensate the employee as he was
compensated. The nature and quality of the services should be
considered, as well as the effect of those services on the
return the investor is seeing on his investment. The
corporation's rate of return on equity would be relevant to the
independent investor in assessing the reasonableness of
compensation in a small corporation where excessive compensation
would noticeably decrease the rate of return.
The Court of Appeals for the Ninth Circuit has employed the independent investor test in conjunction with2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="23" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*168 the other above- discussed tests as another means of measuring the reasonableness of officer compensation.
Petitioner contends that we should disregard the traditional tests and focus solely upon the independent investor test, in the same manner as the Court of Appeals for the Seventh Circuit did in
Respondent, based on petitioner's tax returns, contends that, after subtracting the compensation deducted by petitioner, the return on petitioner's equity is as follows:
Pretax After-tax Return on
Year income income Equity 1 equity (%)
____ ______ _________ _________ __________
1995 2 $ 17,825 $ 15,151 $ 2,013,692 .75
1996 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="24" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*169 58,755 49,066 2,028,715 2.42
Petitioner does not dispute the returns on equity computed by respondent based upon the information reported in petitioner's income tax returns. Petitioner contends that we should focus on the return on equity in the form of appreciation of petitioner's assets. Based on petitioner's calculation of the increases (appreciation) in the value of realty and securities, its return on equity for 1995 and 1996 would have been 34.5 percent and 36.5 percent, respectively. Petitioner, on the same basis, contends that it had a 29-percent average return on equity for the years 1993 through 1996.
Respondent2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="25" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*170 argues that petitioner's approach to measuring the return on equity is speculative and overstated and does not match the amount shown on petitioner's tax returns. In other words, respondent contends that the return on equity should be measured based on realized income and not on unrealized appreciation of the business assets. Respondent points out that petitioner's percentage return is due to unrealized appreciation on marketable securities and estimated average appreciation on the leased Green Valley Ford property. In addition, respondent notes that petitioner did not factually establish that the real property had appreciated to the extent claimed. Significantly, there has been no showing that any portion of the claimed asset appreciation was due to the Valentes' efforts rather than general market conditions.
We cannot accept the inherent premise of petitioner's approach; i.e., that an independent investor would be satisfied with little or no return on petitioner's current income stream that was being generated with little effort on the part of petitioner's officers. Petitioner's approach also assumes that an independent investor would forgo an established stream of income cash-flow2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="26" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*171 return on equity for the possibility that unrealized asset appreciation will be available in the future. To some extent, an independent investor might invest in an entity for the possibility of asset appreciation. That investor, however, would not, without some compelling reason, forgo the income stream from those assets. That is especially true where, as here, the Valentes' efforts were, in great part, directed at the maintenance, as opposed to the creation of the income stream. In fact, there is no evidence that the income stream (rental income and mortgage installment payments) was in jeopardy. While it is clear that the Valentes played some role in producing the 1995 and 1996 income increases over prior years, the increases were limited to the acquisition and sale of realty and marketable securities.
During 1995 and 1996, petitioner's adjusted taxable income (pretax and without considering net operating loss deductions from other years) was $ 294,587 and $ 518,755, respectively. Assuming an independent investor would have been satisfied with a 20-percent return, then as much as $ 235,670 and $ 415,004, for 1995 and 1996, respectively, would have been available for compensation2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="27" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*172 of petitioner's officers. However, reasonable compensation cannot be based solely on allowing an amount that represented what was left after computing what was thought to be a fair return for an investor. Under any measure of reasonable compensation, the amount must be for "personal services actually rendered".
The facts in these cases reflect that a majority of petitioner's income stream would have existed regardless of the Valentes' services or efforts during 1995 and 1996. The passive portion of petitioner's income was well established and would continue with a minimum amount of effort. We also note that Mr. Valente had been well compensated in prior years, reflecting that he had already been compensated for petitioner's financial success prior to 1995. Significantly, the Valentes were physically less able to devote their time and efforts to petitioner's business during 1995 and 1996, yet petitioner seeks to justify substantial increases in the Valentes' compensation over the average of the prior 3 years. The increases over the $ 209,462 average2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="28" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*173 for the 4 prior years was approximately $ 30,000 in 1995 and $ 250,000 for 1996. Although, as discussed infra, there appears to be some justification for compensation in excess of the amount determined by respondent, the amounts sought by petitioner are unreasonable and unjustified on this record. The profit from the acquisition and sale of realty and securities, on the other hand, was more directly attributable to the Valentes' efforts.
The compensation paid to the Valentes represented 81.6 percent and 88.7 percent, respectively, of petitioner's 1995 and 1996 adjusted 5 taxable income. That would leave an independent investor with less than 20 percent and 10 percent of petitioner's income for 1995 and 1996, respectively. An independent investor might or might not be willing to accept a division of "operating" profits that is not based on the extent to which the efforts, talents, or services of the officers were necessary for the generation of the profit. Those are the same aspects that we have considered to decide the amount of compensation that is reasonable. Accordingly, petitioner must show here that the Valentes were compensated for services and that the compensation was reasonable; 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="29" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*174 i.e., that the officers in these cases were responsible for 81.6 percent and 88.7 percent of the profit.
Petitioner has not shown that the Valentes' efforts in the collection of petitioner's established stream of income would warrant any amount in excess of the annual $ 76,800 in compensation that respondent determined was reasonable. Petitioner, however, has shown that the increases to its income for 1995 and 1996 due to the sale of assets during the 1995 and 1996 years were attributable to the Valentes' efforts. Those efforts produced additional income in the amounts of $ 25,922 and $ 171,719 for 1995 and 1996, respectively. 6 Unfortunately the parties did not provide the Court with appropriate expert testimony or some methodology by which to decide the quantum of compensation (bonus) to be attributed to the results obtained by the Valentes' efforts. 2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="30" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*175 Starting with respondent's $ 76,800 determination as a base amount attributable to the Valentes' collection of petitioner's established income, we have approximated an additional amount of compensation attributable to the increase in income generated by the Valentes during 1995 and 1996. We conclude and hold that reasonable compensation for the Valentes' services for 1995 and 1996 is $ 89,750 and $ 162,650, respectively. We calculated those amounts by dividing the increased amount of income earned by the Valentes' efforts between the officer/employee and equity holder, which when added to respondent's $ 76,800 determination resulted in an annual reasonable compensation of $ 89,750 and $ 162,650 for 1995 and 1996, respectively. 7
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="31" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*176 Petitioner argues that the independent investor test should be the sole method of deciding whether the officer compensation claimed by petitioner was reasonable. Respondent counters that the independent investor test should be only one of the factors considered, citing the Court of Appeals for the Ninth Circuit opinion in
Respondent points out that the compensated officer of Exacto Spring Corp. (Exacto), a fine wire and spring manufacturer, was a technical expert who was integrally involved in development of the automated machinery that was one of the reasons for Exacto's financial success. In addition, the compensated officer in Exacto was responsible for the solicitation of 60 percent to 70 percent of Exacto's sales. By contrast, the Valentes' services to petitioner were, with the exception of the purchase and sale of assets during the years under consideration, essentially to maintain and collect petitioner's established and passive2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="32" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*177 sources of revenue. Considering the fact that venue for any appeal of this case would be the Court of Appeals for the Ninth Circuit, see
II. WHETHER PETITIONER PERMITTED ITS 1995 EARNINGS TO ACCUMULATE
BEYOND THE REASONABLE NEEDS OF THE BUSINESS --
The controversy here focuses on two questions: (1) Whether petitioner was a "mere holding or investment company" so as to not be entitled to accumulate income for reasonable needs beyond $ 250,000, and, if not, (2) whether petitioner accumulated income beyond its reasonable needs. Respondent argues that petitioner meets the definition of a holding company as set forth in the statute and the regulations. A corporation is a "holding company" if it has "practically no activities except holding property and collecting the income therefrom or investing therein".
Petitioner held real property and stocks and received income from rent, interest, and the sale of stocks and realty. Although some of the income was from rent, the leases were net leases, and petitioner was not involved2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="34" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*179 in operating or managing the rental properties. Petitioner's situation here is not, in any distinguishable aspect, different from that in
Petitioner argues that its circumstances are more similar to those of the taxpayer in
(1) Locating an undeveloped parcel of real estate for a shopping
center; (2) negotiating and paying the purchase price of such
undeveloped land; (3) securing leases for occupancy of the
buildings to be situated2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="35" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*180 in the shopping center; (4) arranging
for a loan for construction of the shopping center; (5) various
management functions with respect to the center; and (6)
maintaining and repairing various portions of the center. The
taxpayer also actively managed other properties.
We do not find petitioner's activities to approach those that this Court found sufficient to distinguish between a corporation that is primarily a "holding company" and one that is a "mere holding company" in
2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="36" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*181 III. WHETHER PETITIONER IS LIABLE FOR ACCURACY-RELATED PENALTIES
UNDER
Respondent, focusing on the reasonable compensation question, contends that the Valentes did little or nothing to earn the $ 240,435 and $ 460,000 salaries they were paid. Although we have concluded that the value of their services was less than the amounts paid, we have found that the Valentes did play a meaningful role in the success of petitioner. That is in contrast to respondent's contention that the Valentes performed no services and/or2001 Tax Ct. Memo LEXIS 146" label="2001 Tax Ct. Memo LEXIS 146" no-link"="" number="37" pagescheme="<span class=">2001 Tax Ct. Memo LEXIS 146">*182 did not play a meaningful role in the financial success of petitioner.
Petitioner contends that no penalty should apply here because of its full disclosure to and reliance upon a competent professional. See
To reflect the foregoing and the agreement of the parties,
Decisions will be entered under Rule 155.
Footnotes
1. Petitioner, Metro Leasing and Development Corp. is a successor in interest to petitioner, East Bay Chevrolet Co., a corporation. Accordingly, there is no need to distinguish between them for purposes of this opinion, and petitioners will be collectively referred to as petitioner.↩
2. All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.↩
1. Greater than 100 percent.↩
3. Barring a stipulation to the contrary, any appeal from this Court's decision would be to the Court of Appeals for the Ninth Circuit. See sec. 7482(b).↩
4. For computation of these increases see infra note 6.↩
1. The amount of equity reflected consists of the total of the
yearend balances in the capital stock, paid-in surplus, and retained
earning accounts.↩
2. The $ 17,825 amount is after a deduction for a net operating
loss carryforward from another year. Without considering the net
operating loss deduction, the return on equity would be 1.67 percent
for 1995.↩
5. The income was adjusted so as not to include net operating loss deductions from other years, special deductions, and the deductions for officers' salaries.↩
6. The total income for 1992, 1993, and 1994 was $ 604,344, $ 633,688, and $ 640,602 for an average total income of $ 626,211 ($ 1,878,634 w 3). The total income for 1995 and 1996 was $ 898,479 and $ 806,071 for increases of $ 272,268 and $ 179,860, respectively. The $ 272,268 for 1995, however, includes $ 246,346 of income from recapture of depreciation, so that the increase in earned income was actually $ 25,922 ($ 272,268 - $ 246,346). The 1996 income figure contained recapture of $ 8,141 so that the adjusted income was $ 171,719.↩
7. The amount of compensation in excess of the $ 76,800, the amount determined by respondent, was calculated by dividing in half the 1995 and 1996 increases in income over the average of the 3 prior years, $ 25,922 and $ 171,719 and arriving at bonuses of $ 12,950 and $ 85,850.↩
8. We note that the burden of proof is on petitioner and has not been shifted to respondent under sec. 534(c). See also Rule 142(e). Although it is unnecessary for us to consider whether petitioner had reasonable needs of its business in excess of $ 250,000, we must note that under traditional standards petitioner has not shown that its needs exceeded the $ 250,000 amount. Petitioner's needs were based on the speculation that Mr. Valente's future inability to provide such consultation to the auto dealerships could result in defaults on obligations to petitioner and that there would be a need for capital. The financial status of the automobile dealerships, however, is not available in this record, nor is there any indication that such event was a need, without even considering whether it was "reasonable". Petitioner also anticipated the death of the Valentes and the possibility of stock redemption to pay estate taxes. To this respondent aptly points out that there would likely be no estate tax burden when the first of the Valentes died. Finally, although no formal plans had been made or action taken, Mr. Valente described a desire to develop a parcel of property which had been held by petitioner for an extended amount of time. Although Mr. Valente testified about some of these matters, no steps had been taken or evidence presented that corroborated these matters as established or reasonable needs.↩
