Clary Hood, Inc. v. Comm'r of Internal Revenue
Decision Date | 02 March 2022 |
Docket Number | 3362-19 |
Court | U.S. Tax Court |
Parties | CLARY HOOD, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
William C. Elliott, Jr., Raboteau Terrell Wilder, Jr., and Stanton P. Geller, for petitioner.
Joseph D. Stewart-Pirone, Randall S. Trebat, and Creshenole N Opata, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined deficiencies in, and section 6662[1] accuracy-related penalties with respect to, Clary Hood, Inc.'s (petitioner or company) Federal income tax for its tax years ending May 31, 2015 and 2016 (collectively, years at issue), [2] as follows:
Year
Deficiency
2015
$1, 581, 202
$316, 240
2016
1, 613, 308
Following trial, the issues for decision are: (1) the amount petitioner may deduct under section 162(a)(1) as reasonable compensation paid to its chief executive officer (CEO) and shareholder Clary L. Hood (Mr. Hood) during the years at issue, and (2) whether petitioner is liable for the substantial understatement accuracy-related penalties under section 6662(a) and (b)(2) for the years at issue. For the reasons explained below, we hold that petitioner is entitled to deduct no more than $3, 681, 269 and $1, 362, 831 for the 2015 and 2016 tax years, respectively, and that petitioner is liable for the section 6662 penalty for the 2016 tax year.
The parties filed a stipulation of facts with accompanying exhibits that are incorporated by this reference. Petitioner had its principal place of business in South Carolina when the petition was filed.
To understand Clary Hood, Inc., one must first know Mr. Hood. Mr. Hood has dedicated his entire career to the construction profession, specializing in the field of land grading and excavation. He first learned the craft as a boy from his father, J.E. Hood, who operated his own land grading business. After school and during summer breaks, J.E. Hood spent time teaching his son how to operate and repair heavy grading equipment, such as tractors and bulldozers. Upon graduation from high school in 1967, Mr. Hood joined his father's company to acquire further experience in the land grading trade.
In 1980 Mr. Hood determined it was time to make his own mark and founded Clary Hood, Inc., with his wife.[3] Together they served as petitioner's sole shareholders and members of the board of directors. Mr. Hood held ultimate decisional control over all of petitioner's operations from its founding through the years at issue. The company focused on land grading and excavation services for construction projects in the South Carolina region, generally acting as a subcontractor. Petitioner started with only two employees and a hodgepodge of used equipment valued at no more than $60, 000 before growing into a 150-person company with nearly $70 million in revenue by the end of its 2016 tax year. Success was not immediate or easy as petitioner faced external pressures and undertook significant risks along the way.
From 2000 to 2010 growth was modest and profits irregular, with petitioner realizing less than $1 million in net income after taxes most years. Like other construction businesses in the late 2000s, petitioner found itself in a particularly troubled financial position during the "Great Recession" and sustained three years of operating losses for its tax years ending May 31, 2009 to 2011. Unlike many of its competitors who folded during this period, petitioner survived on its reputation and the following key decisions in which Mr. Hood played an instrumental, if not exclusive, role: (1) conserving cash outlays by maintaining a low debt profile and not declaring dividends; (2) temporarily reducing employee pay; (3) withholding Mr. Hood's salary, when necessary, to ensure that sufficient funds were available to cover petitioner's payroll needs; and (4) selling $800, 000 of equipment to offset losses and supplement its cash reserves.
As if the challenge of surviving the Great Recession was not enough, petitioner faced yet another existential threat in 2012, this time of its own making. Petitioner abruptly shifted away from one of its largest and most consistent sources of revenue: site grading work for Walmart shopping centers (Walmart projects). Between 1999 and 2011 revenue from Walmart projects generally accounted for more than 20% of petitioner's annual revenue. While petitioner initially welcomed this steady stream of income, the Walmart projects slowly grew into a constant sore for petitioner. Petitioner encountered significant job bidding and pricing pressures from its Walmart projects, which led to weakened operating margins. The Walmart projects also placed significant constraints on petitioner's resources for timely completion, further reducing its ability to pursue other high-paying jobs. It became apparent to Mr. Hood that petitioner needed to shift away from Walmart projects lest it become complacent with these increasingly competitive projects and dwindling profit margins. In summer 2011 Mr. Hood, without seeking input from any of petitioner's other executives, notified the Walmart developer's representative that petitioner would not engage in any future Walmart projects. At the time, petitioner's other executives were caught off guard by the sudden decision, with many questioning whether petitioner would survive without this reliable source of revenue. This risky decision would handsomely reward petitioner.
True to Mr. Hood's promise, petitioner started winding down its existing work on Walmart projects in July 2011[4] and began diversifying its customer base by transitioning from retail-related work to the commercial and industrial market sectors. Through Mr. Hood's personal efforts, petitioner quickly landed on the bid list for a sizable prospective project with a zinc recycling plant in North Carolina. Petitioner won that project bid, which over the next several years evolved into the largest and most profitable job in petitioner's history, bringing in over $30 million of revenue and a gross profit margin above 40%. Also in 2011, one of Mr. Hood's industry contacts enabled petitioner to land another large grading project with one of Bridgestone's plants in Aiken, South Carolina. That project accounted for nearly $9.5 million of petitioner's revenue over the next few years, with petitioner realizing an overall gross profit margin of 41%. Around 2014 Mr. Hood's efforts again secured one of petitioner's largest grading jobs, a project for the Tryon Equestrian Center that by the end of the 2016 tax year had generated over $23 million in revenue and $5.4 million in gross profit for petitioner.
Petitioner's revenue growth and financial performance skyrocketed following its transition away from the Walmart projects, as reflected in the following financial statements for petitioner's tax years ending May 31, 2000 to 2016 (review period):
Year end
Revenue
Gross income (Loss)
Net income (Loss) before taxes1
Shareholders equity
Cash and cash equivalents
2016
$68, 834, 166
$22, 090, 576
$14, 537, 867
$31, 262, 166
$15, 481, 871
2015
44, 111, 646
13, 879, 822
7, 088, 529
21, 742, 422
10, 059, 619
2014
34, 074, 836
10, 008, 003
8, 271, 261
17, 419, 060
9, 434, 712
2013
42, 830, 999
11, 755, 042
7, 427, 560
11, 965, 811
5, 024, 051
2012
23, 680, 476
3, 738, 212
2, 308, 710
7, 112, 009
1, 172, 793
2011
15, 575, 546
1, 072, 062
(120, 530)
5, 478, 422
1, 234, 290
2010
20, 605, 072
130, 997
(589, 730)
5, 550, 877
1, 342, 332
2009
27, 757, 113
1, 023, 856
(390, 922)
5, 910, 615
923, 853
2008
38, 439, 625
5, 116, 648
2, 864, 533
6, 186, 310
1, 170, 632
2007
25, 898, 118
3, 099, 005
1, 294, 923
4, 366, 759
647, 649
2006
14, 936, 476
1, 615, 374
125, 617
3, 554, 653
657, 222
2005
22, 150, 933
2, 157, 518
981, 456
3, 476, 981
140, 955
2004
13, 243, 547
1, 826, 002
874, 588
2, 858, 337
293, 333
2003
9, 332, 724
(97, 393)
(773, 222)
2, 330, 395
137, 797
2002
17, 590, 697
250, 363
(876, 490)
2, 822, 055
120, 078
2001
25, 347, 752
1, 531, 231
(123, 607)
3, 378, 880
342, 416
2000
16, 366, 605
2, 235, 929
833, 116
3, 454, 137
1 These totals represent amounts after reduction for Mr. Hood's total purported compensation in the given year. We also note that the total amount of "General and Administrative" expenses for salaries, wages, and bonuses for petitioner's employees as reported in petitioner's audited annual financial statements during the review period does not always align with the total amount of annual purported compensation paid to petitioner's employees as reported in the Stipulation of Facts but find such discrepancies immaterial in deciding this case.
Even after its tremendous financial success, petitioner never declared or paid a cash dividend to its shareholders, i.e., Mr. and Mrs. Hood, at any time during the review period.
Mr Hood held various titles with petitioner during the review period, but his duties remained relatively constant: (1) oversight of petitioner's fleet of equipment (procurement, use, maintenance, and disposition); (2) hiring, training, and supervision of mechanics; (3) supervision and inspection of jobsites; (4) preparation, review, and approval of job estimates and budgets; (5) submission and negotiation of job bids; (6) setting of employee salaries and bonuses; and (7) acquisition of bonding for projects. He rarely took vacations and typically worked 60-70 hours per week (including weekends).[5] While Mr. Hood's leadership and work ethic contributed to petitioner's exponential growth, petitioner's success would have been fleeting...
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