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Two experts are more reasonable than one.

A closely held corporation successfully defended its compensation policy against IRS challenge in Automotive Investment Development, Inc., TC Memo 1993-298.

In this case, the Tax Court used five factors to evaluate the reasonableness of the compensation. 1. The employee's qualifications and role in the company. 2. The company's character and condition. 3. The compensation for comparable positions in similar companies. 4. The company's salary policy and the employee's salary history. 5. An independent investor standard.

Even though the shareholder's compensation was based largely on a bonus equal to a percentage of profits, the court looked to see if the formula was within industry norms and if the amount paid reflected the value of the services provided. The court listened favorably to the industry-specific testimony of one of the taxpayer's two expert witnesses. Moreover, it described as "doubtful" the value of the other experts' nonindustry-specific testimony. After considering the five factors, the Tax Court held that the taxpayer was entitled to the full deduction claimed on the returns.

During 1984 and 1985, Larry Van Tuyl was the sole shareholder and president of Automotive Investment Development, Inc. (Automotive). Automotive invested in and managed automobile dealerships and related entities, including Dennis Chevrolet, Inc. (Dennis Chevrolet) and ABC Datsun, Inc. (ABC Datsun). Van Tuyl's salary at issue consisted of a base salary of $7,000-$8,000 per month plus a bonus equal to 28% of the pretax profit of Dennis Chevrolet and ABC Datsun. The salary agreement also provided that his salary would decrease by the same percentage of any pretax losses. Based on the formula, Van Tuyl's total compensation was approximately $1.7 million for 1984 and $2.1 million for 1985. During 1984 and 1985, Automotive did not provide stock options, a pension plan or other deferred compensation to Van Tuyl. The IRS determined that the maximum reasonable compensation was $508,000 for 1984 and $872,000 for 1985. Analysis of Automotive Investment Development An employee's qualifications and role in the company: These include consideration of position, hours worked, duties performed, overall contribution to the company's success and whether the employee is irreplaceable. The Tax Court agreed that Van Tuyl was largely responsible for Automotive's success. When acquired by Automotive, Dennis Chevrolet was at or near the bottom of its market, and ABC Datsun was only marginally profitable. Under Van Tuyl's leadership, Dennis Chevrolet became a regional success and ABC Datsun became the number one Datsun dealership nationwide. Auto manufacturers recognized Van Tuyl's merchandising ability and sought him out. Van Tuyl worked 70-80 hours per week, and was involved in the entire operation of Automotive and its related dealerships. His responsibilities included personnel matters, overseeing sales and service, and dealing with manufacturers and banks.

The character and condition of the company: This factor requires consideration of the company's size, the complexity of its business, general economic conditions, and the growth, profitability, financial condition and market share of the company compared to those of similar enterprises. From 1982, when Automotive acquired Dennis Chevrolet and ABC Datsun, until 1985, gross sales increased 350% to approximately $141 million, net income after taxes increased 750% to approximately $2.6 million, total assets increased 140% to approximately $22.6 million and retained earnings increased 320% to approximately $7.8 million. Dennis Chevrolet's sales increased between 1978 and 1985, while the number of Chevrolets sold nationally dropped 69% over the same period. Chevrolet and Datsun established annual estimates, called "planning potentials," of the number of vehicles they expected a dealership to sell based on the demographics of a dealership's geographical area. Dennis Chevrolet achieved 195% and 178% of its planning potential in 1984 and 1985, respectively. ABC Datsun achieved 288% and 391 % of its planning potential for the same years, compared to the national averages for all Datsun dealers of 79 % and 95%. Compensation for comparable positions iii similar companies: Regs. Sec. 1.162-7(b)(3) recognizes the validity of company salaries paid by similar businesses to similar employees under similar circumstances. Both Automotive and the Service used expert testimony to establish comparability. One of Automotive's experts was a CPA who had provided services to approximately 75 automobile dealership clients during the 15 years he had specialized in the operations of automobile dealerships. He testified that during 1984 and 1985 automobile dealership operators were compensated by a modest base salary plus a bonus ranging from 20% to 33.3% of pretax profits. The percentages did not vary based on the success of the dealership or whether the dealership was operator-owned. Automotive's second expert used a nonindustry-specific model that evaluated three characteristics needed for job performance: "know-how," "problem solving" and "accountability." The Service's expert analyzed surveys of average (not high) salaries paid to executives of similar sized corporations in selective nonautomotive-dealership industries. The Tax Court found the CPA'S automotive-sales-industry-specific testimony "probative," while ascribing "doubtful" usefulness to the testimony of the other two witnesses. It is obvious that the decision on the taxpayer's part to have two experts look at the situation from different perspectives helped him win over the court.

The company's salary policy and the employee's salary history: In evaluating this factor, the Tax Court considered Automotive's salary policy and Van Tuyl's salary history. Following the general practice of automobile dealerships, Automotive compensated all its key employees using formulas based on profitability. Van Tuyl's base salary and bonus as a percentage of sales had remained substantially the same since 1978. Although Van Tuyl's compensation was substantially greater than that of other Automotive employees, the Tax Court found that Van Tuyl's duties and responsibilities were more complex and demanding than those of anyone else in the company.

Independent investor standard: The Tax Court paid particular attention to whether an independent investor would have agreed to the salary paid to Van Tuyl, taking into account dividends and capital growth. Van Tuyl was Automotive's sole shareholder. He set his own salary and was responsible for declaring dividends. Theoretically, an independent investor would not approve executive compensation unless there was also a reasonable return on his investment. Since incorporation in 1977, Automotive had paid only one dividend. However, the Tax Court noted that acceptable investor reasons for not paying dividends could include the need for working capital and preference for capital appreciation. The return on equity (after-tax net income over capital contributions plus retained earnings) was 85% in 1984 and 48% in 1985. Based on these returns, the Tax Court reasoned that the amounts paid to Van Tuyl were for compensable services and were not disguised dividends.

The court's decision

After analyzing the five factors, the court determined that the amounts paid to Van Tuyl for 1984 and 1985 were reasonable and allowed the salary deduction in full for both years. The court found a direct link between Van Tuyl's management and the excellent performance of the dealerships. Van Tuyl's salary formula fell within the industry norms.

Finally, Automotive showed a generous return on shareholder equity for the years in question. Also, the court made a point to warn that even if salary was computed under a formula, it could reach a point at which it would be unreasonable. Ultimately, this test will be based on facts and circumstances.
COPYRIGHT 1993 American Institute of CPA's
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Article Details
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Title Annotation:executive compensation
Author:Hogle, William
Publication:The Tax Adviser
Date:Oct 1, 1993
Words:1198
Previous Article:S corporation planning after discontinuing active trades or businesses (or penalty taxes to be wary of).
Next Article:Receipt of partnership profits interest.
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