Rutter v. C.I.R.
| Decision Date | 07 September 1988 |
| Docket Number | No. 87-4599,87-4599 |
| Citation | 853 F.2d 1267 |
| Parties | -5594, 88-2 USTC P 9500 James H. RUTTER and Marie R. Rutter, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. |
| Court | U.S. Court of Appeals — Fifth Circuit |
Edward B. Benjamin, Jr., Jones, Walker, Waechter, Poitevent, Carrere & Denegre, Robert W. Nuzum, Deutsch, Kerrigan & Stiles, New Orleans, La., for petitioners-appellants.
Michael L. Paup, Chief, Appellate Section, Michael C. Durney, Acting Atty. Gen., Williams S. Rose, Ann Belanger Durney, Reviewer, William A. Whitledge, Atty., Gary R. Allen, Acting Chief, Washington, D.C., for respondent-appellee.
Appeal from the Decision of the United States Tax Court.
Before THORNBERRY, WILLIAMS and SMITH, Circuit Judges.
Appellants challenge the Tax Court's holding that amounts paid as compensation in 1976, 1977, 1978, and 1979 by the J.H. Rutter Rex Manufacturing Company, Inc. to James H. Rutter in part exceeded reasonable compensation for services actually rendered during those taxable years. The Tax Court held that the excessive amounts of compensation constituted payments of dividends and therefore were subject to a higher tax rate. The Tax Court assessed against appellants, James Rutter and his wife Marie, deficiencies of $28,640.28 for taxable year 1977 and $12,302.13 for taxable year 1979. The 1977 and 1979 deficiencies against James and Marie Rutter are the only deficiency orders before us in this case. We affirm.
James H. Rutter was born in 1904 and has been in the clothing manufacturing business his entire adult life. In 1930, Rutter and two other individuals formed the Rex Shirt Company. Rutter was the most active of the three owners of the company and was responsible for managing and overseeing all aspects of the business. Under his management, the company's sales volume increased from $37,968 in 1931 to $1,525,161 in 1941. In 1941, Rutter bought out the other two owners of the company, and changed the name of the company to the J.H. Rutter Rex Manufacturing Company, Inc. ("Rutter Rex"). Since 1941 James Rutter has owned 99.908% of the stock in Rutter Rex, and his wife Marie has owned the remaining 0.092%. Rutter Rex is a Louisiana corporation that currently manufactures various types of work pants and shirts, jeans, and casual pants and shirts. The company primarily manufactures clothing items for such retailers as Sears, J.C. Penney, and Montgomery Ward, and for the U.S. military. The company does not have any retail facilities of its own.
Beginning in the early 1950's, the company was run by James Rutter, his son, Eugene, and his son-in-law, A.H. Denis. These three individuals managed and supervised all aspects of a business whose sales volume increased to over $20 million by 1976. In 1960, Eugene Rutter became chief operating officer of the company and Denis became vice president. James Rutter has always been chairman of the board of directors and the company's chief executive officer. Denis left the company in 1969, and his duties were taken over by the two Rutters. During the years at issue, 1976-1979, James and Eugene Rutter made the final decisions with respect to all aspects of Rutter Rex's business. James was in Rutter Rex's offices on a regular basis. When he was not at the office, he was visiting one of the company's factories or travelling to call on customers. He took no vacations during this period.
Rutter Rex deducted the following amounts as compensation paid and accrued to James Rutter during the years 1976-1979: 1
Salary Bonus Total Compensation
1976 $200,000 $225,000 $425,000
1977 200,000 337,500 537,500
1978 200,000 337,500 537,500
1979 200,000 318,125 518,125
These compensation amounts were determined by James Rutter, who set or had final approval as to the compensation of all Rutter Rex employees. Rutter Rex did not provide either pension or profit-sharing benefits to any of its employees or officers, including James and Eugene. Nor did the company provide any stock option benefits to any of its employees or officers.
Beginning in March 1979, the IRS audited Rutter Rex's 1976-1979 federal income tax returns and determined that the company had paid compensation to James and Eugene Rutter that exceeded reasonable compensation for the services rendered during those years. The IRS adjusted Rutter Rex's 1976-1979 federal income tax returns accordingly by disallowing the deductions under 26 I.R.C. Sec. 162(a)(1) for these excessive amounts of compensation. 2 The IRS also determined that Rutter Rex had retained earnings and profits over and above the reasonable needs of its business in 1977 and 1978 and therefore was subject to the tax on accumulated earnings. 3
The IRS also audited and adjusted appellants' 4 federal income tax returns and determined that the excessive amounts paid to James Rutter as compensation during these years were dividend payments subject to a maximum tax rate of 70% rather than earned income subject to a maximum 50% tax rate. 5 The Commissioner issued a notice of deficiency on March 25, 1981.
Appellants disputed the Commissioner's adjustments and filed a petition with the United States Tax Court on June 26, 1981. Rutter Rex disputed its adjustments and filed a petition on March 17, 1982. The two cases were consolidated for trial by the Tax Court on December 15, 1982, upon appellants' and Rutter Rex's motion. At trial, appellants presented the reports and testimony of two expert witnesses, Ted S. Decker and Donald R. Simpson. Both these experts asserted that the entire amounts of compensation paid to James and Eugene Rutter during 1976-1979 were reasonable. The Tax Court did not give Decker's testimony much weight, since Decker analyzed James and Eugene Rutter's compensation as a percentage of sales although he also testified that there was no direct relationship in the clothing manufacturing industry between sales and compensation.
Utilizing the "Hay System" to develop his compensation analysis, witness Simpson determined the maximum comparable salaries for comparable positions in comparable companies. Simpson then increased these figures by over 200% for bonuses and "long-term incentives" to conclude that the compensation amounts paid to James and Eugene were reasonable. The Commissioner also presented two expert witnesses on reasonable compensation, Ernest Gruenfeld and Emmet James Brennan, III. Not surprisingly, they testified that James and Eugene had been excessively compensated.
After trial, the Tax Court found that part of the compensation paid to James and Eugene Rutter during 1976-1979 exceeded reasonable compensation for the services actually rendered during those years. The court determined the following amounts constituted reasonable compensation to James and Eugene under 26 I.R.C. Sec. 162(a)(1):
James Eugene
1976 $286,375 $220,625
1977 312,000 229,750
1978 375,125 270,125
1979 431,500 306,375
These figures were based primarily on the upper limit of reasonable compensation testified to by Mr. Simpson, one of appellants' experts, plus a 25% addition to compensate for Rutter Rex's lack of a pension or profit-sharing plan. The court held that the excessive compensation amounts paid to James Rutter constituted payments of dividends and were thus subject to the higher maximum tax rate of 70%. The court assessed deficiencies in federal income taxes against appellants in the amount of $28,640.28 for 1977 and $12,302.13 for 1979. 6 The court also disallowed Rutter Rex's deductions under 26 I.R.C. Sec. 162(a)(1) for compensation paid to James and Eugene to the extent these amounts exceeded the court's reasonable compensation determinations. In a further holding, the court found Rutter Rex liable for the accumulated earnings tax for 1977 and 1978. James and Marie Rutter and Rutter Rex appeal. The determinative issue before us is the reasonable compensation issue.
26 I.R.C. Sec. 162(a)(1) permits a corporation to deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered." Treas.Reg. 1.162-7(a) states:
There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.
In order for compensation payments to be deductible under Sec. 162(a)(1), the payments therefore must, first, be for "services actually rendered" and, second, be "reasonable." There is no doubt that James and Eugene Rutter rendered extensive services to Rutter Rex during the years at issue. The focus, therefore, must be upon the reasonableness factor.
The inquiry into the reasonableness of compensation is especially critical in the case of a closely held corporation having few shareholders, practically all of whom draw a salary. In such a closely held corporation, like Rutter Rex, it obviously is in the tax interest of all parties to characterize the amounts distributed to shareholder/officers as compensation rather than as dividends. Corporations can deduct salaries and bonuses under Sec. 162(a)(1) but obviously not dividend payments because they are profits, not business expenses. The concern is to prevent the distribution of corporate profits through the payment of unreasonably large salaries and bonuses to controlling shareholder/officers. Distribution of profits through compensation payments to shareholder/officers avoids the double tax on corporate profits which are distributed to shareholders as dividends. In addition as mentioned earlier, during the years at issue in this case individuals were taxed at a maximum rate of 50% for earned income but...
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