Elliotts, Inc. v. Commissioner - 716 F.2d 1241 (9th Cir. 1983)

Rule:

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, as are bonuses consistently designated in amounts tracking either the percentage of the recipient's stock holdings. 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. 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.

Facts:

Petitioner corporation paid its CEO and sole shareholder a fixed salary plus a bonus and claimed a deduction for total compensation for two fiscal years. The Commissioner of Internal Revenue found these deductions to be in excess of the amounts the taxpayer properly could deduct as reasonable salary and issued it a notice of deficiency which limited deductions for the CEO's salary to $ 65,000 for each fiscal year. The Tax Court determined that $ 120,000 was reasonable compensation for the year 1975 and that $ 125,000 was reasonable for 1976 and reduced the deficiencies accordingly. Petitioner appealed the Tax Court's determination of reasonable compensation. According to the petitioner, the Tax Court erred in finding that part of the compensation paid to petitioner's chief executive and sole shareholder constituted a dividend distribution and, thus, was not deductible under 26 U.S.C.S. § 162(a)(1).

Issue:

Did the Tax Court err in its determination of reasonable compensation? 

Answer:

Yes.

Conclusion:

The court held that it would not presume an element of disguised dividend from the bare fact that a profitable corporation did not pay dividends and concluded that the Tax Court erred by limiting its analysis to the facts that its CEO was petitioner's sole shareholder and petitioner paid no dividends. The Tax Court also erred to the extent that it implied that incentive payment plans for shareholder-employees were unreasonable. The court reversed and remanded to the Tax Court for reconsideration and instructed the Tax Court to begin its analysis by looking at the reasonableness of the compensation payments and to consider the bonus payments in the context of the reasonableness of the formula used.