Metro Leasing v. Com'R, Internal Revenue, 02-73933.

• Decision Date: 23 July 2004
• Docket Number: No. 02-73933.,02-73933.
• Citation: 376 F.3d 1015
• Parties: METRO LEASING AND DEVELOPMENT CORPORATION; East Bay Chevrolet Company, A Corporation, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

376 F.3d 1015

METRO LEASING AND DEVELOPMENT CORPORATION; East Bay Chevrolet Company, A Corporation, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 02-73933.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted February 12, 2004.

Filed July 23, 2004.

Burgess J.W. Raby, Raby Law Office, Tempe, AZ, for the petitioners-appellants.

Andrea R. Tebbets, Department of Justice, Tax Division, Washington, DC, for the respondent-appellee.

Appeal from a Decision of the United States Tax Court; Tax Ct. No. 8054-99.

Before SCHROEDER, Chief Judge, TALLMAN and CALLAHAN, Circuit Judges.

TALLMAN, Circuit Judge.

This appeal involves the 1995 federal tax return filed by the Metro Leasing and Development Corporation and the East Bay Chevrolet Company (collectively "Metro Leasing"), two small, closely-held California corporations. We must decide whether the United States Tax Court properly determined the amount of a corporate officer's salary that Metro Leasing may deduct as a reasonable business expense under 26 U.S.C. § 162(a)(1). We affirm because the Tax Court did not clearly err when it adjusted the amount of this deduction. See Elliotts, Inc. v. Comm'r, 716 F.2d 1241, 1245 (9th Cir.1983).

We must also resolve when a paid, but contested, federal income tax accrues for purposes of the accumulated earnings tax penalty under 26 U.S.C. § 535(b)(1). This section provides that, when calculating the "accumulated taxable income" to which the tax is applied, a corporate taxpayer may deduct only those federal income taxes that had accrued in the taxable year in question. Here, the Tax Court did not permit Metro Leasing to deduct a contested tax liability that it paid in 2001 while its appeal in the Tax Court was pending. This presents a question of first impression in our circuit. We decline to follow the Fifth Circuit's decision in J.H. Rutter Rex Mfg. Co. v. Comm'r, 853 F.2d 1275 (5th Cir.1988), and hold that a contested tax liability that is paid before the legal contest is resolved does not accrue in the taxable year in which it was originally assessed. We affirm the Tax Court's ruling on this issue as well.

I

Mr. George Valente owned 100% of Metro Leasing's common stock and served as its director. When he fell ill in 1995, his wife Lena served as the president. Despite his illness, Mr. Valente remained actively involved in the business. The Tax Court found that he continued to make most of the business decisions, which Mrs. Valente then carried out. Mr. Valente determined his salary each year based on the profitability of the business, and he and his wife were paid an undivided amount to compensate them for their joint efforts. Metro Leasing did not issue shareholder dividends from 1985-1987 or from 1994-1996, though dividends ranging from $10,000 to $60,000 were paid to Mr. Valente, the sole shareholder, during 1988-1993. Metro Leasing's only other employee during this time was a corporate secretary who maintained the company's financial records.

Metro Leasing's business ventures included Mr. Valente's consultation to a San Francisco Bay Area automobile dealership he once owned, as well as the ownership and lease of real property, buildings, and automobiles. One key transaction in this appeal is Metro Leasing's January 1995 sale of a piece of real property in South San Francisco on an installment basis, which resulted in a mortgage receivable of $2,193,253 secured by the property itself.

In 1995, Metro Leasing paid the Valentes a salary of $240,435, which included a year-end bonus of $180,435. The company then deducted their compensation on its 1995 federal income tax return as a reasonable business expense under 26 U.S.C. § 162(a)(1).¹ Metro Leasing's 1995 return reported a total income of $898,479 from interest, rents, net capital gains, late payment fees, and net gain from the sale of real property. The company paid only $2,674 in federal taxes that year.

In general, corporations may not deduct the dividends they pay to shareholders from their federal income tax returns, and shareholders are taxed on the dividends they receive. For many small corporations in which the shareholders are also employees or officers, this creates an incentive to either retain profits or to pay them out as salary rather than as dividends. To discourage businesses from sheltering potential tax revenue in this manner, the Internal Revenue Code permits corporations to deduct only reasonable amounts for employee salaries, see id. § 162(a)(1), and taxes any unreasonable accumulation of earnings, see id. § 531. In February 1999, the Commissioner of Internal Revenue ("Commissioner") issued a statutory notice of deficiency to Metro Leasing regarding its 1995 income tax return, citing both of these concerns.

First, after examining corporate documents and comparing data about corporate officers' salary levels in similar equipment-leasing and rental/real estate businesses, the Commissioner determined that the Valentes had been paid an unreasonable or excessive salary under § 162(a)(1) and concluded that Metro Leasing should be allowed to deduct only $76,800 as a reasonable amount for officer compensation that year. In addition, the Commissioner assessed an accumulated earnings tax pursuant to § 531,² finding that Metro Leasing was a "mere holding or investment company" that had unreasonably accumulated its earnings and income for the purpose of avoiding shareholder income tax. See id. § 533(b).

Metro Leasing appealed the Commissioner's decisions to the United States Tax Court. Metro Leasing & Dev. Corp. v. Comm'r, T.C. Memo.2001-119, 81 T.C.M. (CCH) 1644 (2001) (hereinafter "Metro Leasing I"). The Tax Court agreed that the Valentes' salaries were unjustified in light of the actual work they had performed for Metro Leasing in 1995, and thus could not be completely deducted. T.C. Memo.2001-119 at 21. However, because it found that their efforts in the sale of some assets had contributed to a measurable increase in Metro Leasing's income that year, the court added $12,950 to the Commissioner's $76,800 figure (resulting in a total allowed deduction of $89,750). Id. at 22-24. The court next agreed that Metro Leasing was a "mere holding company" under § 553(b) and was thus properly subject to the § 531 accumulated earnings tax in the amount of $55,396. Id. at 27.

In August 2001, approximately three months after the Tax Court's initial decision, Metro Leasing tendered a payment of $326,932 to cover any income taxes and accumulated earnings tax it would be found to owe.³ In September 2001, following Tax Court Rule 155,⁴ Metro Leasing and the Commissioner both submitted proposed computations of Metro Leasing's accumulated income tax to the Tax Court for its review.

Not surprisingly, the parties provided different calculations of Metro Leasing's accumulated taxable income under § 535. The Commissioner permitted Metro Leasing to deduct only the taxes the company initially paid in 1995 ($2,674), while Metro Leasing sought to also deduct the $326,932 payment it had made in August 2001. See 26 U.S.C. § 535(b)(1) (permitting corporations to deduct from their accumulated taxable income any federal income taxes that had accrued during the taxable year). Because the parties disagreed about the proper calculation, the Tax Court also reviewed this dispute. See Tax Ct. R. 155(b) and (c).

In a supplemental opinion, the Tax Court rejected Metro Leasing's proposed computation. Metro Leasing & Dev. Corp. v. Comm'r, 119 T.C. 8, 2002 WL 1575753 (2002) (hereinafter "Metro Leasing II"). The court declined to follow the Fifth Circuit's decision in J.H. Rutter Rex Mfg. Co. v. Comm'r, 853 F.2d 1275 (5th Cir.1988), and did not allow Metro Leasing to deduct its paid, yet still contested, tax liability for 1995. See Metro Leasing II, 119 T.C. at 17.

Metro Leasing now appeals the Tax Court's initial decision regarding the amount of reasonable compensation for the Valentes' services that may be deducted (Metro Leasing I), and it also appeals the Tax Court's subsequent review of the proper calculation of the accumulated earnings tax under § 535(b) (Metro Leasing II). We have jurisdiction under 26 U.S.C. § 7482.

II

A

The reasonableness of an executive officer's compensation is a factual determination that we review for clear error. LabelGraphics, Inc. v. Comm'r, 221 F.3d 1091, 1094-95 (9th Cir.2000); accord Pacific Grains, Inc. v. Comm'r, 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."). Applying this very deferential standard of review, we will not reverse unless we are "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, 68 S.Ct. 525, 92 L.Ed. 746 (1948). Only the Tax Court's definition of the factors used to determine reasonableness is reviewed de novo. LabelGraphics, Inc., 221 F.3d at 1094.

B

To assess whether the Valentes' salaries were reasonable under § 162(a)(1), the Tax Court applied the five-factor analysis we established in Elliotts, Inc. v. Comm'r, 716 F.2d 1241 (9th Cir.1983), by addressing: (1) the Valentes' role in the corporation; (2) the salaries paid by similar companies for like services; (3) Metro Leasing's character and condition; (4) any conflicts of interest in which Metro Leasing may be disguising non-deductible shareholder dividends as salary; and (5) the internal consistency of the compensation plan. See Metro Leasing I, T.C. Memo.2001-119 at 10-16 (following Elliotts, Inc., 716 F.2d at 1245-48).

In addition, the Tax Court noted that in Elliotts, Inc., we recognized that "it is helpful to consider the matter from the perspective of a hypothetical independent investor[,]" by asking "whether an inactive, independent investor would be willing to compensate the employee as he was...