Kennedy v. C. I. R.

• Citation: 671 F.2d 167
• Decision Date: 04 February 1982
• Docket Number: Nos. 80-1244,80-1245,s. 80-1244
• Parties: 82-1 USTC P 9186 James D. KENNEDY, Jr. and Dorothy H. Kennedy, Petitioners-Appellants, and Cherokee Warehouses, Inc., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (6th Circuit)

Page 167

671 F.2d 167

82-1 USTC P 9186

James D. KENNEDY, Jr. and Dorothy H. Kennedy, Petitioners-Appellants, and Cherokee Warehouses, Inc., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 80-1244, 80-1245.

United States Court of Appeals, Sixth Circuit.

Argued Oct. 9, 1981.

Decided Feb. 4, 1982.

William L. Taylor, Jr., Fred H. Moore, Robert G. Russell, Spears, Moore, Rebman & Williams, Chattanooga, Tenn., for petitioners-appellants.

N. Jerold Cohen, Chief Counsel, I. R. S., M. Carr Ferguson, Asst. Atty. Gen., Michael L. Paup, Gary R. Allen, George L. Hastings, Jr., Tax Div., Dept. of Justice, Washington, D. C., for respondent-appellee.

Before WEICK ^* and JONES, Circuit Judges, and PHILLIPS, Senior Circuit Judge.

WEICK, Circuit Judge.

Petitioners-Appellants have appealed from the decisions of the Tax Court finding them to be liable for deficiencies in their income tax returns for the taxable years 1973 and 1974. The Tax Court's decisions are reported at 72 T. C. 793 (1979).

In Appeal No. 80-1245, the issue before us is whether the entire amounts paid by appellant Cherokee Warehouses, Inc. to James D. Kennedy, Jr. during its fiscal years ending July 31, 1973 and July 31, 1974 are deductible as reasonable compensation under I. R. C. section 162(a)(1). The Tax Court held that they are not. We disagree.

In Appeal No. 80-1244, the issue is whether all of the compensation paid by Cherokee Warehouses to appellant James D. Kennedy, Jr. during the calendar year 1973 qualifies as earned income for maximum tax purposes under former I. R. C. section 1348. The Tax Court held that it does not. We disagree.

At issue in the appeals is the propriety of the application by the Commissioner of Internal Revenue and the Tax Court of Sections 162(a)(1) and 1348 to an Incentive Compensation Agreement entered into in 1950 by taxpayer James D. Kennedy, Jr. and his employer, Cherokee Warehouses, Inc., which was in operation and fully performed from 1951 to and including the tax years in question 1973 and 1974, with the results shown in footnotes 1 and 2, appended hereto.

Such an agreement was authorized by the Code of Federal Regulations, 26 C.F.R. § 1.162-7(b)(2)(3).

The last sentence in (3) expressly states the circumstances to be taken into consideration in determining the reasonableness of the compensation.

"The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract was questioned." In all the years the contract was in effect, it was not questioned until the tax years 1973 and 1974, over a period of about 22 years. Prior to the Incentive Compensation Agreement, the operations of the predecessor of Cherokee were not successful. It is obvious that neither the Commissioner nor the Tax Court appropriately took into consideration the admonition in the last sentence of (3). In essence, what the Tax Court did was approximately to split the difference between the Commissioner's and the taxpayer's figures. We disagree and reverse for the reasons hereinafter set forth.

I Facts

Petitioner-appellant Cherokee Warehouses, Inc. (Cherokee) is a closely held corporation in Chattanooga, Tennessee. It operates several warehouses where it stores merchandise primarily for large distributors and manufacturers for later distribution in the Chattanooga area and throughout the southeastern part of the country. Petitioner-appellant James D. Kennedy, Jr. (Kennedy, Jr.) is an officer and stockholder of Cherokee. His wife Dorothy is a party only because she signed and filed a joint return with her husband; she is not involved in her husband's company. During the years in issue, 1973 and 1974, Kennedy, Jr. was the Secretary-Treasurer and General Manager of Cherokee. Originally he owned only one share of stock and later he owned 7.84 percent of the stock in his own name, and another 6.60 percent as trustee for his sister. The balance of the stock, 85.56 percent, was owned by his father, James D. Kennedy, Sr.

Cherokee is the corporate successor of a partnership composed of Kennedy, Jr.' § brother-in-law, Samuel R. Smartt, and Kennedy, Sr. This partnership was formed in late 1947, utilizing some vacant manufacturing buildings which were owned by the elder Kennedy. The partnership was not successful. In Kennedy, Sr.'s opinion, Smartt was an excellent salesman but a poor administrator and Mr. Kennedy decided that their business relationship would have to be changed. The result of that decision was the formation of Cherokee.

At that time, 1950, Kennedy, Jr. was employed at a Chattanooga bank, where he had been assured that he had a promising future. However, he decided to give up that potential career and go into Cherokee with his father and Smartt because he wanted to run his own business.

All of the initial capital of $25,000 was contributed by Kennedy, Sr., who also owned 248 of the original 250 shares of $100 par value stock. Kennedy, Jr. and Smartt owned one share apiece. Kennedy, Sr. became President of the corporation, but it was agreed that he would not be involved in the day-to-day operation of the company. His role was limited to supplying financial backing and furnishing the buildings, which were leased to Cherokee. The operation of the business was to be handled by Smartt and Kennedy, Jr., who became Vice President and Secretary-Treasurer, respectively. These three were Cherokee's only employees in its fledgling days, although by 1973 it had grown to employ some 200 people.

A key aspect of Cherokee's formation, and one which is central to the decision in this case, was the incentive compensation plan which was developed for Smartt and Kennedy, Jr. Kennedy, Sr. did not want to burden the new corporation with large fixed salaries for the two officers, since the whole venture was a risky undertaking at the time. Moreover, from his business experience over the years he had come to believe in the value of incentive compensation in order to motivate employees. Accordingly, the parties negotiated and entered into an incentive compensation agreement in 1950 whereby Kennedy, Jr. and Smartt each received a small fixed salary of $400 per month, with the bulk of their compensation contingent upon profits. In addition to the monthly salary, each was to receive a monthly bonus of 20 percent of the excess of gross receipts over 11/9 times the monthly operating expenses, and an annual bonus of 10 percent of the excess of gross receipts over 11/9 times the annual operating expenses. ¹ The salaries were included in the operating expenses in determining the monthly bonuses, and salaries and monthly bonuses were both counted as expenses in determining the annual bonus. The net result of this agreement was that Smartt and Kennedy, Jr. each would receive 26 percent of the net profits of Cherokee, while Cherokee received the remaining 48 percent. Kennedy, Sr. received the same basic salary, increased to $750 per month in 1954, but no incentive compensation.

Gradually, Kennedy, Jr. and Smartt built the corporation up into a going concern. During the early years, they put in long hours and worked in all phases of the business, from manual labor to management. Since Cherokee was a new company facing well-established competition, much of their time was spent soliciting customers. By the mid-fifties the business had begun to take off; new buildings were constructed, and additions were made to existing buildings. Kennedy, Jr. acted as general contractor for this construction in order to reduce expenses.

Sam Smartt died in 1964, and Kennedy, Jr. took over the duties as General Manager. To compensate for the added responsibility, the incentive compensation agreement was modified in August of that year. Kennedy's monthly salary was set at $1000 per month (increased to $1100 per month on August 1, 1973). The monthly incentive compensation was raised from 20 percent to 25 percent of net profits, and the annual bonus was increased from 10 percent to 121/2 percent of net profits. The result of this adjustment was that Kennedy, Jr.'s share of the profits increased from 26 percent to 34.375 percent, and Cherokee's share increased from 48 percent to 65.625 percent.

Cherokee is an authorized dealer for Allis-Chalmers forklift trucks. This line of business constitutes the Material Handling Division of Cherokee. The managers of this division are also compensated on an incentive basis consisting of a salary plus 20 percent of the profits of the division.

In 1964, when Kennedy, Jr. took over as General Manager, Cherokee had only 38 employees. By 1973-74, this number had grown to 200 employees. During the years in issue, Kennedy, Jr. was a full-time employee of Cherokee, usually working 40-50 hours per week. His responsibilities included solicitation of new accounts and maintenance of relations with existing customers pricing and negotiation of rates; recruiting, hiring, and training of key employees; supervision of daily warehouse activity; management of receivables, payables, and major purchases; and formulation of corporate growth strategy. More detailed matters, such as daily warehouse operations, building maintenance, bookkeeping, and material handling, were controlled by five supervisors who reported directly to him.

The principal thrust of Cherokee's business has been the servicing of large accounts requiring large commitments of space. Although some of the supervisors assisted Kennedy, Jr. in soliciting new accounts, that has always been primarily his responsibility, and he has been quite successful at it. Over the years he has obtained for Cherokee the business of such companies as DuPont, Monsanto, UniRoyal, Goodyear, Union Carbide, Carnation, General Mills, Pillsbury, and Winn-Dixie.

Since 1964, Kennedy, Jr. has devoted a considerable amount of time to warehouse trade association activities and publications. He...