Kennedy v. Comm'r of Internal Revenue
| Decision Date | 07 August 1979 |
| Docket Number | Docket Nos. 9849-77 9850-77. |
| Citation | 72 T.C. 793 |
| Parties | JAMES D. KENNEDY, JR., and DOROTHY H. KENNEDY, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENTCHEROKEE WAREHOUSES, INC., PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Cherokee, a closely held warehousing corporation, had paid its general manager, James, under an incentive compensation arrangement since its incorporation in 1951. James, a trust for his sister's benefit, and his father held all of Cherokee's stock in the respective portions of 8 percent, 7 percent, and 85 percent. From 1951 to 1964, James received approximately 26 percent of Cherokee's net profits. During the years after the only revision in the compensation arrangement in 1964, including the years in issue, James received approximately 34 percent of Cherokee's net profits. While Cherokee has grown as a successful corporation since 1951, the total number of executives and other employees has also grown from 2 to over 200. Held, a reasonable allowance for compensation is determined. Held, further, the amounts paid in excess of the reasonable allowance for compensation are not earned income for purposes of the maximum tax provisions of section 1348, I.R.C. 1954. Held, further, petitioners abandoned the issue of deducting the expense of supplying James an automobile for the years in issue. William L. Taylor, Jr., and Robert G. Russell, for the petitioners.
Wesley J. Lynes, for the respondent.
Respondent, in two statutory notices dated June 30, 1977, determined deficiencies in the Federal income taxes of the petitioners as follows:
Due to concessions by both petitioners and respondent,1 the only issues remaining for our decision are (1) whether payments by petitioner Cherokee Warehouses, Inc. (hereinafter Cherokee), to petitioner James D. Kennedy, Jr. (hereinafter James), were unreasonable compensation in excess of respondent's determination and thus not deductible under section 162(a)(1)2 by Cherokee in either fiscal year ending (FYE) July 31, 1973, or FYE July 31, 1974; (2) whether such compensation, if found to be nondeductible as unreasonable, nevertheless qualifies under section 1348 as earned income to James in 1973; and (3) whether the expense of supplying James an automobile is deductible by Cherokee in both FYE July 31, 1973, and FYE July 31, 1974.
Some of the facts have been stipulated and are so found. The stipulation of facts, and the exhibits attached thereto, are incorporated herein by this reference.
Petitioners James and Dorothy H. Kennedy resided at Lookout Mountain, Tenn., during all times pertinent to this case. They timely filed joint Federal income tax returns for both 1972 and 1973 with the Internal Revenue Service Center, Memphis, Tenn. Dorothy is a party only by virtue of having filed the joint returns with James.
Petitioner Cherokee is a corporate continuation of a partnership composed of James' brother-in-law, Samuel R. Smartt (Sam) and James' father, James D. Kennedy, Sr. (J.D.), who founded the sole proprietorship from which the partnership evolved. Cherokee timely filed its corporate income tax returns for FYE July 31, 1973, and FYE July 31, 1974, on an accrual basis with the Internal Revenue Service Center, Memphis, Tenn. Located both then and now in Chattanooga, Tenn., Cherokee operates several warehouses in which it stores merchandise primarily for large distributors and manufacturers and acts as the local and southeastern United States distribution center of these customers. Cherokee also derives a portion of its income from being an authorized dealer for the Allis-Chalmers Lift-Truck Division.
During the years in issue, stock in Cherokee was held as follows:
+----------------------------------------------------------+
¦ ¦Percent¦
+--------------------------------------------------+-------¦
¦ ¦ ¦
+--------------------------------------------------+-------¦
¦J.D ¦85.56 ¦
+--------------------------------------------------+-------¦
¦James ¦7.84 ¦
+--------------------------------------------------+-------¦
¦James, as trustee for Mary K. Dunkerly, his sister¦6.60 ¦
+--------------------------------------------------+-------¦
¦Total ¦100.00 ¦
+----------------------------------------------------------+
J.D., president of Cherokee since its formation, was in the manufacturing business until 1942. In that year, he sold the business but retained ownership in the related buildings, which he then rented to his successor. Using these same buildings, in 1947, J.D. and Sam entered a warehouse business partnership in which Sam would operate the business and J.D. would maintain the buildings. Income would be split evenly. However, losses sustained in 1950 were impairing the return J.D. received from his investment in the buildings.
In 1950, Cherokee was incorporated under the laws of Tennessee. Initial capitalization was a contribution of $25,000 from J.D., with the 250 shares of $100 par stock distributed 248 to J.D. and 1 each to James and Sam. At the beginning, these same three individuals were the officers and the only full-time employees of Cherokee.
Key to the incorporation of Cherokee was the implementation of an incentive compensation plan which would promote J.D.‘s financial investment in Cherokee while rewarding those individuals operating the business without burdening the new corporation with large fixed salaries.3 Under the original agreement, James, with Cherokee for the first time, and Sam were each to receive, in addition to a monthly salary of $400,4 a monthly bonus of 20 percent of the excess of gross receipts over 1 1/9 times the monthly operating expenses,5 and an annual bonus of 10 percent of the excess of gross receipts over 1 1/9 times the annual operating expenses. The operating expenses included the salaries for determining the monthly bonuses and included the salaries and monthly bonuses for determining the annual bonus. The net effect of this compensation agreement was that Sam and James each would receive 26 percent of the net profits of Cherokee, while Cherokee received the remaining 48 percent.
After incorporation, Cherokee entered into a lease with J.D. for the use of the buildings which had been used in the partnership. Under this lease, Cherokee would pay J.D. $700 per month plus 10 percent of the gross storage and rental revenues and would pay all taxes, insurance, and maintenance for the buildings, as well. These buildings, many of which were built before 1920, were not particularly suited for the warehouse business and required major repairs during the first year of operation. A large part of Cherokee's initial capitalization was used for these repairs.
While J.D., whose interest was strictly financial, was not active in the daily operations of Cherokee, James and Sam worked long hours, 6 days per week at the start, performing all of the necessary tasks of the business. Much of their time was spent soliciting warehouse business. When business was slow, they would try to sell merchandise to make a profit for Cherokee.
From the time he learned he had lung cancer in the spring of 1963 until his death in June 1964, Sam curtailed his activities in the business. James assumed the total responsibility for the operation of Cherokee during Sam's illness and was appointed general manager after Sam's death. To compensate James for the added responsibility, J.D. proposed a new incentive compensation plan, which James accepted. Instituted in August 1964, the new plan provided for James, in addition to a monthly salary of $1,000,6 a monthly bonus of 25 percent of net operating income for the month exclusive of capital gains, charitable contributions and expenses such as interest, and an annual bonus of 12 1/2 percent of net operating income for the fiscal year, less prior monthly bonuses and adjusted as the monthly bonus base figures were. The subsequent agreement increased James' receipts from 26 percent to 34.375 percent of earnings and Cherokee's share from 48 percent to 65.625 percent of earnings.
During the years in issue, James participated in many tasks at Cherokee, such as: solicitation of new accounts; maintenance of existing customer relationships; pricing and negotiation of rates; recruiting, hiring, and training of key employees; daily warehouse activity supervision; management of receivables, payables, and major purchases; and formulation of corporate growth strategy. James' primary responsibility, however, was soliciting new business. Other areas, such as daily warehouse operations, building maintenance, bookkeeping and materials handling were controlled by five supervisors who reported directly to James. Some of the supervisors assisted James when he was soliciting business for their respective divisions of Cherokee. One supervisor also performed the duties of office manager and superintendent.
The principal thrust of Cherokee's business...
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