Tax Court finds compensation reasonable, rejects IRS attempt to modify independent-investor test.

• Author: Rand, Gary
• Position: 2016 memorandum decision in H.W. Johnson, Inc. v. Commissioner

In a May 2016 ruling in favor of the taxpayer (H. W. Johnson, Inc., T.C. Memo. 2016-95), the Tax Court held that compensation paid by a closely held corporation was reasonable and therefore deductible. A review of the details of the case and the court's analysis and findings of facts follow.

The Short Story

The corporate taxpayer, a concrete contractor, deducted as officer compensation $4 million and $7.3 million on its tax returns for fiscal years ending June 30 in 2003 and 2004, respectively. Additionally, the taxpayer deducted $500,000 as an administration fee paid to a related party. The IRS issued a notice of deficiency disallowing $2.6 million and $5.6 million of the compensation, in 2003 and 2004, respectively, and the $500,000 administration fee in its entirety, claiming that the disallowed deductions exceeded what was "reasonable." The court agreed with the taxpayer that all of the compensation and administrative fees deducted were reasonable and therefore deductible.

Background

The taxpayer is a second-generation, family-owned business, founded in 1974 by H.W. Johnson and his wife, Margaret Johnson. Their sons, Bruce and Donald, worked in the business and eventually took over daily operations in 1993. H.W. and Margaret gifted shares to Bruce and Donald, and each eventually owned 24.5% of the company, with the remaining 51% owned by Margaret. H.W. retired in 1996, and the brothers became co-vice presidents. Margaret was responsible for payroll, finances, accounts receivable, human resources, and other administrative functions.

The Growth Years

Beginning in 1993, when the brothers took control of operations, the company's revenues grew rapidly, from $4 million in 1993 to $13 million in 1994 and 1995. Annual revenue leveled off at around $17 million between 1996 and 1999 and then consistently increased each year, growing to $23.8 million in 2003 and $38 million in 2004, the years at issue.

It is well-documented that the company's growth was predominantly a result of the brothers' hard work and business acumen.

The Related Party

Beginning in 2002 and extending to the years at issue, there were concrete shortages as a result of a housing boom in Arizona, the taxpayer's market. The brothers planned to prevent a disruption in the supply of concrete by investing in a concrete supplier. Margaret, the majority shareholder, thought the investment was too risky and did not approve of the plan.

Instead, Bruce and Donald formed D.B.J...