Labelgraphics v. Comm'r of Internal Revenue

• Decision Date: 08 August 2000
• Docket Number: No. 99-70164,99-70164
• Parties: (9th Cir. 2000) LABELGRAPHICS, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1091

221 F.3d 1091 (9th Cir. 2000)

LABELGRAPHICS, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 99-70164

U.S. Court of Appeals for the Ninth Circuit

Argued and Submitted May 3, 2000

Filed August 8, 2000

Gersham Goldstein (argued) and Charles F. Adams, Stoel Rives, Portland, Oregon, for the petitioner-appellant.

A. Wray Muoio (argued) and Gilbert S. Rothenberg, Tax Division, U.S. Department of Justice, Washington, D.C., for the respondent-appellee.

Appeal from the United States Tax Court; Carolyn Miller Parr, Tax Court Judge, Presiding. Tax Ct. No. 13673-95

Before: Lay,¹, Tashima, and McKeown, Circuit Judges.

OPINION

McKEOWN, Circuit Judge:

This case stems from a bonus--characterized by the taxpayer itself as "unusually high"--paid to the president of a closely held, single-shareholder corporation. The taxpayer, LabelGraphics, Inc., ("LabelGraphics") appeals the Tax Court's decision that only $406,000 of the $878,913 paid to its president, Lon D. Martin ("Martin"), in fiscal year 1990, was reasonable compensation and therefore deductible as an ordinary and necessary business expense. We must determine whether the Tax Court appropriately applied the five-factor test established in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th Cir. 1983), for determining the reasonableness of employee compensation. Because the Tax Court did not commit clear error in applying the Elliotts test, we affirm.

BACKGROUND

LabelGraphics is an Oregon corporation that produces pressure-sensitive identification materials such as product labels and graphic overlays. The company specializes in sales to electronics and high-technology companies, but also offers retail typesetting services.

Martin, LabelGraphics's president, started the company as a sole proprietorship in 1978 and incorporated it in 1980. During the tax year in question (fiscal year ending June 30, 1990), Martin was the corporation's sole shareholder. Two years later Martin sold all of his shares to his son.

Despite its relatively small size, LabelGraphics has been very successful and has enjoyed a strong reputation as an innovator in the industry. During the company's first eight fiscal years (1981-88), its annual gross receipts increased significantly each year. Receipts declined slightly over the next two years, but this was expected due to market conditions. Fiscal year 1990 was the first year that the company sustained a net loss after taxes. Specifically, the company had a negative return on equity for that year (-6.19%), although its cumulative return on equity was still impressive (36.05%).

During 1989 and 1990, LabelGraphics developed its Micro Clean 100 proprietary process ("MC 100 process") for producing labels meeting the "clean room" production facility standards of its electronics industry customers. Martin played a leading role in the substantial research and development that led to the creation of the MC 100 process. With this process, LabelGraphics became the first company to produce contaminant-free labels. By June 1990, the company's directors anticipated that the MC 100 process would be highly successful and their prediction ultimately proved to be correct.

At that time, LabelGraphics employed 58 people. The board of directors consisted of Martin, Joan Martin (Martin's wife), and Jerry Crispe. Joan Martin and Crispe were also LabelGraphics's other two officers (secretary and executive vice president, respectively). Neither had substantial experience in the label and printing industry before working for LabelGraphics. Martin's son, Mike, also worked for the company.

In short, Martin was the "heart" of this company. During 1990, his duties included: (1) setting corporate policy; (2) establishing and monitoring quality control and authorizing resources to ensure compliance; (3) maintaining external relationships; (4) directing the investment of funds; (5) directing employee policies; (6) establishing mission statements; (7) coordinating relationships with competitors, suppliers, and consultants to establish corporate goals; (8) chairing all board meetings; (9) approving departmental strategy; and (10) reviewing and approving all capital expenditures. From 1988 to 1990, Martin also devoted some of his time to an unrelated printing venture in Puerto Rico.

Martin's compensation consisted of a salary and bonus. He received no stock options or royalties. In contrast to the board-adopted formulas for determining the bonuses of Crispe and Mike Martin, the company had no fixed formula for determining Martin's bonus; rather, the directors generally considered the company's performance over the past year.

For fiscal year 1990, the year the MC 100 process was developed, Martin's salary was $156,000 and he received a bonus of $722,913, a figure that was substantially higher than all previous bonuses:

                Year Salary Bonus Compensation
                1985 $154,000$150,000 $304,000
                1986 156,600 125,000 281,600      
                1987 156,600 125,000 281,600
                1988 185,000 250,000 435,000
                1989 158,200 200,000 385,200
                1990 156,000 722,913 878,913
                1991 156,000    - 156,000
                

In this regard, the board minutes reflected a [b]onus to Lon D. Martin. Once again, the corporation has enjoyed a successful and profitable fiscal year. The Directors recognize that this success continues to be due in large part to the efforts and expertise of President, Lon D. Martin. In light of this recognition and the fact that Mr. Martin's base salary has been continued at the same level for several years, the Directors unanimously agreed to pay Mr. Martin atotal bonus of $722,913.00. This bonus is to be paid by the corporation's forgiving a debt of $82,566.00 due from Mr. Martin to the corporation and by paying the balance of $640,347.00 in cash to Mr. Martin.

Also, for the first time, the board paid a bonus to Joan Martin and paid an additional bonus (in excess of the formula) to Mike Martin. LabelGraphics deducted these bonuses on its FY 1990 corporate tax return as reasonable compensation for services rendered.

The Commissioner sent a deficiency notice to LabelGraphics that, in pertinent part, disallowed $633,313 of Martin's total compensation as a deductible reasonable business expense. On appeal, the Tax Court found that the Commissioner correctly determined that the full amount was not reasonable compensation, but that the Commissioner overstated the excess. Accordingly, the court held that LabelGraphics was entitled to a $406,000 deduction ($156,000 as salary and $250,000 as a bonus) as reasonable compensation to Martin. LabelGraphics, Inc. v. Commissioner, 76 T.C.M. (CCH) 518 (1998). In concluding that Martin was entitled to a bonus greater than that suggested by the Commissioner, the court explained that the corporation's minor downswing in 1990 was expected and not attributable to Martin; that, in fact, despite the decline, "Martin still had done an excellent job in managing petitioner"; that Martin was "entitled to some bonus for his efforts in successfully developing" the MC 100 process; and that $406,000 of compensation would result in a revised return on equity (approximately 10.20%) that would satisfy an independent investor. Id. at 528-29. LabelGraphics timely appealed the Tax Court's decision.

STANDARD OF REVIEW

This case turns on the standard of review applicable to the Tax Court's decision. Although we review de novo the Tax Court's definition of the factors for determining the reasonableness of compensation, Elliotts, 716 F.2d at 1245, here the Tax Court appropriately delineated the Elliotts factors. As such, the real issue is the Tax Court's application of those factors to the case at hand, which we review for clear error. See id. ("The Tax Court's findings of fact, derived from application of the appropriate factors, must be affirmed unless clearly erroneous."); see also Pacific Grains, Inc. v. Commissioner, 399 F.2d 603, 605 (9th Cir. 1968) ("What constitutes reasonable compensation to a corporate officer is a fact question which must be determined in light of all of the evidence."). We affirm because we are not "left with the definite and firm conviction that a mistake has been committed." United States v. United States Gypsum Co., 333 U.S. 364, 395 (1948).

DISCUSSION

This case presents the classic tension between characterization of payments as employee compensation, which is deductible, and characterization of payments as a dividend,² which is not deductible. As we noted in Elliotts, [i]t is likely to be in the interests of both the corporation and the shareholder-employee to characterize any payments to the shareholder-employee as compensation rather than dividends. For this reason, a taxpayer's characterization of such payments may warrant close scrutiny to ensure that a portion of the purported compensation payments is not a disguised dividend.

716 F.2d at 1243.

The question here is whether the Tax Court clearly erred in finding that $406,000 of Martin's 1990 salary and bonus was reasonable, deductible compensation and excluding the remaining $472,913 of his bonus. We hold that the Tax Court's finding was not clearly erroneous.

Under section 162(a)(1) of the Internal Revenue Code, a corporation may deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered." I.R.C. S 162(a)(1). "When payments are made to an individual who is both a corporate employee and a principal shareholder, a two-prong test is applied to determine whether the distribution is truly compensatory. First, the amount of compensation must be reasonable; second, the payment must be purely for services, or have a purely compensatory purpose." O.S.C. & Assocs., Inc. v. Commissioner , 187 F.3d 1116, 1119-20 (9th Cir. 1999) (citing Elliotts , 716 F.2d at 1243), cert. denied, 120 S. Ct. 1831 (2000); see also Treas. Reg. S 1.162-7(a). The second prong of the inquiry is rarely invoked, see Elliotts, 716 F.2d at...