Ninth Circuit Reverses Findings on Reasonable Compensation

H was A Corp.’s primary shareholder. During the years at issue, H personally guaranteed multimillion dollar loans for A that were critical to its survival. Although H’s sons also provided personal guarantees, H’s guarantee was key, because she possessed greater wealth than the others, and the lender viewed her as the decisionmaker.

During the audit years, H also served as A’s president, attended extensive public relations activities to market the business, participated in weekly board meetings, worked full-time on A’s behalf (40 or more hours per week) and handled day-to-day corporate activities. For example, she reviewed and approved A’s trash-hauling contracts, filed company and historic records, reviewed bills and issued and signed checks. Although the board made decisions on a consensual basis, testimony from the other officers demonstrated that they had to discuss all major business decisions with H, persuade her that the decision was a correct one and obtain her final approval. In addition, H was a co-founder of A and devoted over 60 years of employment services to it.

Tax Court

The Tax Court found that most of the salary A paid to H constituted unreasonable compensation and, thus, was not deductible as an “ordinary and necessary” business expense under Sec. 162(a)(1). It conducted its own determination of reasonable compensation pursuant to the Ninth Circuit’s five-factor test articulated in Elliotts, Inc., 716 F2d 1241 (9th Cir. 1983). It concluded that H’s role in the corporation was equivalent to that of an outside board chair and it set reasonable compensation at roughly $100,000 for each audit year.

Appeal

The Ninth Circuit affirmed the Tax Court’s application of the Elliotts test and its determination that a portion of H’s salary should be disallowed as unreasonable compensation. However, it reversed the Tax Court’s finding that H’s role in the corporation was secondary and equivalent to that of a typical outside board chair, finding that it was equal or greater to that of the other officers. The undisputed evidence indicated that H’s functions were not those of an outside board chair, who by definition is neither an officer nor employee of the corporation; see Texas Partners, 685 F2d 1116 (9th Cir. 1982). Because the Tax Court’s finding as to H’s role in the corporation contradicted undisputed evidence, the finding was clearly erroneous.

The Ninth Circuit also reversed the Tax Court’s reasonable compensation figures for H, which were based largely on a survey of salaries paid to outside board chairs at allegedly comparable companies. As a result, H’s reasonable compensation was set at a level lower than subordinate employees. This was clearly erroneous. The reasonableness of H’s compensation should have been evaluated based on her actual role as A’s president. At the very least, H’s reasonable compensation should not have dropped below that of her sons during the audit years.

E.J. Harrison & Sons, Inc., 9th Cir., 6/7/05