Tax Court, Dismissing Both Experts Opinions, Decides Compensation Reasonable for Profitable Year, but Reduces Allowed Compensation in Loss Year

The Tax Court decided in Multi-Pak Corporation v. Commissioner, TC Memo 2010-139 that the sole shareholder of a corporation had been paid a reasonable salary in the profitable year under question, but that his salary for the following year when performance suffered was unreasonably high and reduced that salary to a level that produced a 10% return on equity.

The case involved a company involved in a packaging business.  The owner of the company had taken over the company from his father in 1972 when the company was near bankruptcy and over the years had made the company very successful.  A major customer had increasing demands for packaging, and the sole shareholder was involved in the design and renovation of a new warehouse facility in the first half of the first year under consideration.  In that year hit its all time high in revenue and paid the owner a total salary and bonus of $2,020,000.  Net income after the payment of that compensation was $140,700.

The following year sales were not as good, but the shareholder received $2,058,000 in salary and bonus.  For that year the company sustained a net loss of $474,000 after deducting the compensation to the owner.

The owner was paid a low base salary and monthly bonuses based on the company’s results for the month.  Bonuses were paid to the owner and his sons based on sales and the owner’s judgment regarding results of operations and relative contributions of each.

The Tax Court rejected the testimony of both experts that testified on the reasonableness of compensation.  The Court found that the taxpayer’s expert failed to come to a conclusion about the reasonability of the rate of return to a theoretical independent investor, a key factor in the view of the Ninth Circuit to whom an appeal of this case would be taken.  The IRS’s expert did make a conclusion on the rate of return, but the Court found this expert had not used reasonably comparable entities to compare the results to, and had failed to adjust for those differences.

Ultimately the Court found an investor would have been satisfied with return in the profitable year, allowing the owner additional compensation due to the increase in sales and the fact that he was clearly responsible for the company’s overall financial stability.  But the Court found an investor would not have been satisified with a higher level of compensation in the following year when sales dropped and the payment of the compensation produced a return on equity in the negative of over 15%.  Rather, the Court reasoned, an independent investor would have demanded reduced compensation.

The Court determined that the investor would be satisified with a 10% return, and reduced the salary deduction to $1,284,104 for the second year. The Court also found that even though the resulting deficiency for that year was high enough to trigger the substantial understatement penalty of §6662, the taxpayer had reasonably relied on the advice of its outside accountant as to the reasonability of compensation paid.  The corporation regularly consulted with the accounting firm on this matter, and the firm advised the company on the reasonability of the salary paid.

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