Executive Compensation Amounts and Arrangements Held Amply Reasonable

• Date: 01 July 2016
• Published date: 01 July 2016
• DOI: http://doi.org/10.1002/npc.30214

Bruce R. Hopkins’ NONPROFIT COUNSEL

July 20166THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

is only a minimum age requirement. Again, it does not

provide formal instruction. Individualized training is

available only if a parent or another racer is willing to

share knowledge with the beginner. The participants

are not required to have a certain level of talent and

achievement to receive support. The organization does

not provide intensive daily training to prepare its partici-

pants for national or international competition. [4.3(a),

11.2, 20.12(a)] ◆

EXECUTIVE COMPENSATION

AMOUNTS AND

ARRANGEMENTS HELD

AMPLY REASONABLE

In an opinion of significance to public charities and

other types of tax-exempt organizations, the US Tax

Court ruled, on May 11, that compensation paid to two

company executives, who are working hard and other-

wise are integral to the success of the entity, is amply

reasonable (H.W. Johnson, Inc. v. Commissioner).

Facts

The business corporation involved operates a con-

crete contracting business. It was started by a married

couple, who operated it out of their home. Their two

sons, following college, assumed daily running of the

business. During the two years at issue, this business

became one of the largest of its type in the state, with

more than 200 employees and annual revenues of $24

and $38 million.

Revenues for this business grew rapidly after the sons

assumed control. At the time they did, annual revenue

was about $4 million. Revenues climbed steadily over the

ensuing years. During the issue years, gross profit margins

for the company (before payment of officer bonuses)

were 38.3 and 38.2 percent. The sons personally guar-

anteed loans, the proceeds of which were used by the

company to purchase materials and supplies.

The company was divided into divisions, each man-

aged by a son. They worked 10 to 12 hours a day, five to

six days a week, engaging in contract bidding and nego-

tiation, project scheduling and management, equipment

purchase and modification, personnel management,

and customer relations. The court wrote that the broth-

ers “were readily available if problems at a jobsite arose

and were known in the local industry for their responsive

and hands-on management style.” They supervised and

often designed the concrete work, mostly at residential

sites. Because of the company’s “excellent reputation,”

it was “routinely awarded contracts even where it was

not the lowest bidder.”

A reliable supply of concrete is crucial to this business.

Yet it did not produce concrete, relying on suppliers. Due

to shortages of and other disruptions in the supply of con-

crete, the sons formed a concrete supplier company, with

investors; they invested substantial sums in and guaran-

teed the indebtedness of this company. The sons saw to

it, by means of this company, that the concrete contract-

ing business had ample amounts of concrete even though

other contractors could not and were forced to temporar-

ily suspend operations. This company also provided the

other with bulk discounts. For its services, the supplier

company was paid $500,000 by the contracting business.

During the years at issue, the sons were paid a total

of about $4 million and $7 million in salaries, bonuses,

and directors’ fees. The bonuses were paid pursuant to a

formula associated with the company’s annual contract

revenue and paid out of a bonus pool. Modest dividends

were paid to shareholders.

Law

A for-profit company is allowed a business expense

deduction for payment of salaries and other compensa-

tion for personal services rendered (IRC § 162(a)(1)). This

rule is comparable to the rule in the nonprofit context

that reasonable compensation is not a form of private

inurement or (nearly always) private benefit.

The court applied the test of reasonableness articu-

lated in Elliotts, Inc. v. Commissioner (1983) (sum-

marized in the October 2000 issue), which entails five

factors, not one of which is determinative. These factors

are the employee’s role in the company, a comparison

of compensation paid by similar companies for similar

services, the character and condition of the company,

potential conflicts of interest, and the internal consist-

ency of compensation arrangements. Factor four is irrel-

evant in the nonprofit setting, inasmuch as it focuses on

whether payments are disguised dividends.

Analysis

Not surprisingly, on these facts, the IRS totally lost

this case. As to the first factor, the sons were held to

be “integral” to the success of the company during

the years at issue, due to the quality of their work,

dedication, and personal guarantees. The second factor

entailed a home run for the company in that its “per-

formance so exceeded that of any of the companies

identified by the parties’ experts as comparable that

compensation comparisons are not meaningful.” The

third factor weighed in the company’s favor, due to

the “remarkable revenue, profit margins (before officer

compensation), and asset growth” experienced by the

company in the issue years. As to factor five, the court

held that bonuses were paid pursuant to a “structured,

formal, and consistently applied program.” [20.4(b)]

Commentary: This opinion serves the tax-exempt com-

munity well, demonstrating that salaries and bonuses