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CASE NO. 17-01
IN THE
Supreme Court of the United States _________
COMMISSIONER, INTERNAL REVENUE COMMISSION, Petitioner,
v.
STUMP INCORPORATION, Respondent.
_________
On Writ of Certiorari to the United States Court of Appeals
for the Second Circuit
_________
BRIEF FOR THE PETITIONERS
TEAM 3:
PETITIONER
CASE NO. 17-01
IN THE
Supreme Court of the United States _________
COMMISSIONER, INTERNAL REVENUE COMMISSION, Petitioner,
v.
STUMP INCORPORATION, Respondent.
_________
On Writ of Certiorari to the United States Court of Appeals
for the Second Circuit
_________
BRIEF FOR THE PETITIONERS
TEAM 3
i
QUESTIONS PRESENTED
I. Whether the Commissioner rightfully disallows a deduction for shareholder
employee compensation under § 162(a)(1), when the independent investor test fails
to consider extraneous factors that the compensation is unreasonable, and the
deduction taken exceeds the corporate net income by 100% and the corporate gross
receipts by 80%?
II. Whether Taxpayer sufficiently overcame the presumption of correctness afforded to
the Commissioner on its disallowance of an improperly claimed deduction for
business entertainment expenses, which was not in accordance with the “ordinary
and necessary” or “directly related” standards, under § 271(a).
PARTIES TO THE PROCEEDING Petitioner is the Commissioner of the Internal revenue commission. The
respondents are, Stump Incorporation; J. Ronald Stump founder and president of Stump
Incorporation; Oak Stump Vice President of Stump Incorporation; Maple Stump
Corporate Treasurer of Stump Incorporation; and Willow Stump Corporate Secretary of
Stump Incorporation.
ii
TABLE OF CONTENTS
QUESTIONS PRESENTED ................................................................................................ i PARTIES TO THE PROCEEDING .................................................................................... i TABLE OF CONTENTS .................................................................................................... ii TABLE OF AUTHORITIES ............................................................................................. iv STATEMENT OF JURISDICTION................................................................................... 1 OPINIONS BELOW ........................................................................................................... 1 STAUTORY PROVISIONS INVOLVED ......................................................................... 1 STATEMENT OF THE CASE ........................................................................................... 2 SUMMARY OF THE ARGUMENT ................................................................................. 4 ARGUMENT ...................................................................................................................... 6
I. The Appeals Court erred in reversing the Tax Court’s decision which properly disallowed Stump Inc.’s claimed deduction for shareholder employee compensation under §162(a)(1). .................................................................................. 6
A. The Independent Investor test should not be construed as a substantial presumption when extraneous facts suggests the ROE is an inaccurate measure for determining whether shareholder employee compensation is reasonable. ................. 8
B. Stump Inc.’s deduction for shareholder employee salary exceeds even the most liberal compensation benchmarks. ............................................................................ 16
II. The Appeals Court erred in reversing the Tax Court’s agreement with the determination of the Commissioner which properly disallowed Respondent’s claimed deduction of hockey tickets as a business entertainment expense under Internal Revenue Code §§ 162 and 274(a)(1)). ......................................................... 19
A. The court below failed to thoroughly examine the threshold issue of establishing the expenses as both “necessary” and “ordinary,” as required by § 162 and interpreted by this Court’s jurisprudence. .......................................................... 21
iii
B. Taxpayer failed to properly and sufficiently establish that the hockey games, for which the tickets were purchased, qualify as “directly related to” or “associated with” the active conduct of the taxpayer’s trade or business. ................................... 22
C. Taxpayer failed to properly establish that the hockey games, for which the tickets were purchased, qualify as a “clear business setting.” .................................. 24
CONCLUSION ................................................................................................................. 27
iv
TABLE OF AUTHORITIES
Cases Berkley Machine Works and Foundry Co. v. C.I.R., 623 F.2d 898 (4th Cir. 1980) ......... 20 Botany Worsted Mills v. United States, 278 U.S. 282 (1929) ............................................. 4 Commissioner v. Heininger, 320 U.S. 467 (1943) ............................................................ 17 D. A. Foster Trenching Co., v. United States, 473 F.2d 1398 (Ct.Cl. 1973) .................... 17 Danville Plywood Corp. v. United States, 899 F.2d 3 (Fed. Cir. 1990) ........................... 17 Dexsil Corp. v. C.I.R., 147 F.3d 96 (2d Cir. 1998) ......................................................... 5, 8 Eberl’s Claim Service Inc. v. C.I.R., 259 F.3d 994 (10th Cir. 2001) .......................... 11, 12 Elliots, Inc. v. C.I.R., 716 F.2d 1241 (9th Cir. 1983) .......................................... 6, 8, 11, 12 Exacto Spring Corp. v. C.I.R., 196 F.3d 833 (7th Cir. 1999) ......................................... 6, 8 Good Chevrolet v. C.I.R., 36 T.C.M. (CCH) 1157 (1977) ......................................... 14, 15 Handelman v. C.I.R., 509 F.2d 1067 (2d Cir. 1975) ......................................................... 21 Lilly v. C.I.R., 343 U.S. 90 (1952) .................................................................................... 17 Mayson Mfg. Co. v. C.I.R., 178 F.2d 115 (6th Cir. 1949) ................................................... 5 Moore v. United States, 943 F. Supp. 603 (E.D. Va. 1996) .............................................. 22 Mulcahy, Pauritsch, Salvador & Co., Ltd., v. C.I.R., 680, F.3d 867 (7th Cir. 2012) 6, 9, 11 Owensby & Kritikos, Inc. v. C.I.R., 819 F.2d 1315 (5th Cir. 1987) ........................... passim Pepsi-Cola Bottling Company of Salina v. C.I.R., 528 F.2d 176, 179 (10th Cir. 1975) ..... 4 Rutter v. C.I.R., 52 T.C.M. (CCH) 326 (1986) ................................................................. 11 Schneider & Co. v. Commissioner, 500 F.2d 148, (8th Cir. 1974) ...................................... 5 Hippodrome Oldsmobile, Inc. v. United States, 474 F.2d 959 (6th Cir. 1973) ................ 17 St. Petersburg Bank & Trust Co. v. United States, 362 F. Supp 674 (1973) .................... 20
v
Transupport, Incorporated v. Commissioner of Internal Revenue, 2016 WL 6900913 * 8 (T.C. 2016) .......................................................................................................................... 6 United States v. United States Gypsum Co., 333 U.S. 364 (1948) ..................................... 2 Welch v. Helvering, 290 U.S. 111 (1933) ......................................................................... 17
Statutes 26 U.S.C. 13 (2008) ............................................................................................................ 3 26 U.S.C.§ 162(a)(1) (2014) ...................................................................................... passim 26 U.S.C. § 274(a)(1) (2014) .............................................................................................. 1 Other Authorities Blacks Law Dictionary (10th ed. 2014) ............................................................................. 13 CCH Tax Research Consultant, COMPEN: 9,1114, Independent Inactive Investor Analysis to Evaluate Reasonableness of Compensation ..................................................... 5
Regulations Treas. Reg. § 1.162-7(a) (1960) .......................................................................................... 4 Treas. Reg. § 1.274-2(c)(4) ............................................................................................... 23 Treas. Reg. § 1-274-2(c)(3)(i) ........................................................................................... 21 Treas. Reg. § 1.162-7(a) (1960) .......................................................................................... 4
1
STATEMENT OF JURISDICTION1
A Formal Statement of Jurisdiction has been omitted in accordance with the
University of Buffalo Law School 2017 Albert R. Mugel National Tax Court
Competition.
OPINIONS BELOW
The decision of the court of appeals reversing the tax court’s decision is reported
at 123 F.4th 1(2016). The tax court’s decision holding the deduction for the
compensation and tickets improper is unreported.
STAUTORY PROVISIONS INVOLVED
This case involves two provisions of the United States Tax Code 26 U.S.C.§
162(a)(1) (2014) and 26 U.S.C. § 274(a)(1)(A) (2014). First, §162(a)(1) states, “There
shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business, including a reasonable
allowance for salaries or other compensation for personal services actually rendered. In
conjunction, this case involves compensation to shareholder-employees that was
deducted in 2013.
Further, 26 U.S.C. § 274(a)(1) states, “No deduction otherwise allowable under
this chapter shall be allowed for any item—With respect to an activity which is of a type
generally considered to constitute entertainment, amusement, or recreation, unless the
taxpayer establishes that the item was directly related to, or, in the case of an item
directly preceding or following a substantial and bona fide business discussion (including 1 References to the Official Record appear as “R##”
2
business meetings at a convention or otherwise), that such item was associated with, the
active conduct of the taxpayer’s trade or business. This case involves a deduction of
hockey tickets as a business entertainment expense.
STATEMENT OF THE CASE
I. STATEMENT OF FACTS
This case involves a Notice of Deficiency served on Stump Incorporation
(“Taxpayer” or “Stump Inc.”) for the 2013 taxable year. R. at 5. Stump Inc. is a closely
held corporation in Buffalo, New York. R. at 2. Its founder, president and CEO, J.
Ronald Stump owns approximately 97% of Stump Inc.’s corporate stock, while Stump’s
older children, Oak Stump, the Vice President of Stump Inc., Maple Stump, Treasurer,
and Willow Stump, Stump Inc.’s corporate secretary, each own 1% of Stump Inc.’s
corporate shares. Id. Stump Inc. is known throughout New York, for its expertise in real
estate development, including the development of a Western New York casino and
waterfront. R. at 2. Stump Inc.’s success in the real estate development business has
created a “buzz” throughout most of the New York area and as a result, the Stump name
now appears on restaurants, spa’s, gentlemen club’s, and golf courses. Id. However,
aside from Stump Gardens, a property Stump Inc. purchased with borrowed funds in
2010 for $25,000,000, Stump Inc. nor its shareholder employees own any of the listed
properties or real estate assets. Id. Instead, the Stump enterprise success has resulted
mainly from the licensing of the Stump name to real estate properties and other luxury
goods. Id. at 4.
In fact, the Stump name has become so popular throughout the region, in 2013
alone Stump Inc. grossed nearly $5,000,000 in revenue from its licensing deals. R. at 4.
3
Testimony at trial indicated that the Stump brand’s popularity has thus far accounted for
the financial success of a number of firms. As a result, Stump Inc. paid each of its
shareholder employees $1,000,000 in compensation for services rendered to build the
Stump brand. Id. At the time of the notice of deficiency, Stump Inc. had not distributed
dividends to its shareholder employees but deducted $4,000,0000 on its 2013 tax return
for the shareholder employee compensation. Stump Inc. also deducted $100,000 for four
season tickets to the Buffalo Sabres as necessary business expenses. R. at 5. In
conclusion, Stump Inc. paid $0.00 in taxes for the 2013 taxable year after grossing
$5,000,000 in revenue, distributing $4,000,000 in compensation, and deducting an
additional $100,000 for business expenses. Id.
II. NATURE OF PROCEEDINGS
Following Stump Inc.’s 2013 deductions, the Commissioner served a Notice of
Deficiency on Stump Inc. The Commissioner claimed that the $4,000,000 deduction for
shareholder employee compensation and the $100,000 deduction for hockey tickets were
improper and unreasonable under the tax code. R. at 5. At the Tax Court, both parties
introduced evidence in support of its respective theory. However, after considering
considering Stump Inc.’s grossed revenue, outstanding debts, and structure of the closely
held Corporation, the Tax Court agreed with the Commissioner and upheld the 2013
deficiency as improper or excessive. Id. Stump Inc. appealed and the Second Circuit
Court of Appeals reversed the Tax Court’s decision, finding that Stump Inc.’s 2013
deductions for shareholder employee compensation was reasonable under §162(a)(1) and
the expenses for the Sabres tickets was reasonable under § 274(a)(1).
4
SUMMARY OF THE ARGUMENT
The Second Circuit, as are all of United States Appellate Courts, is a court of
limited jurisdiction. In the proceeding below, the Second Circuit should have affirmed
the Tax Court’s decision unless clearly erroneous. This Court has established that “a
finding is clearly erroneous when although there is evidence to support it, the reviewing
court on the entire evidence is 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)
(emphasis added). Accordingly, the Second Circuit reversal of the Tax Court’s decision,
which concluded that Stump Inc.’s 2013 deductions for shareholder employee
compensation and business entertainment expenses were improperly claimed and
unreasonable, should be reversed because when viewed holistically the compensation and
business expenses were unreasonable.
Specifically, 26 U.S.C. §162(a)(1) authorizes reasonable deductions for ordinary
and necessary expenses paid or incurred during the taxable year. In the current case, the
$4,000,000 deduction for shareholder employee compensation was improper,
unreasonable, and not clearly erroneous because §162(a)(1) disallows deductions for
compensation when the compensation is not reasonable or distributed purely for services
rendered. Courts have outlined a nine factor test to determine whether shareholder
employee compensation is reasonable but some courts have redefined the nine factor test
into a five factor categorization. The courts are divided over how to treat the nine factor
test and the five factor categorization when determining whether compensation paid to
shareholder employees is reasonable. However, the Appellate Court’s decision should be
reversed because the Tax Court’s finding that Stump Inc.’s 2013 $4,000,000 deduction
5
fails the independent investor rebuttable presumption and exceeds even the most liberal
corporate gross and net income threshold.
In addition, the court below erred in its reversal of the Tax Court’s decision to
uphold the determination of the Commissioner as to its disallowance of the improperly
claimed deduction of sporting tickets as a business entertainment expense. While
governed by § 162 of the Internal Revenue Code, business entertainment expenses must
also satisfy the more rigorous requirements of § 274(a), as well as the substantiation
requirements of § 274(d). Berkley Machine Works and Foundry Co. v. Commissioner of
Internal Revenue, 623 F.2d 898, 901 (4th Cir. 1980). The “directly related” requirements
of the statute follow the intent of Congress to avoid abuse and to ensure the propriety of
deductions claimed for when business ventures and entertainment expenses are
comingled into the same events. The “clear business setting” standard laid out by Treas.
Reg. § 1-274-2(c)(3), provides regulatory flexibility for the myriad ways businesses may
communicate and handle business ventures and promotion.
In the instant case, Taxpayer has failed to provide evidence that overcomes the
inherent presumption of correctness afforded the Commissioner of Internal Revenue in its
determinations. See Welch v. Helvering, 290 U.S. 111, 115 (1933). At no point, did
Taxpayer provide any substantiation that provides that the expenditures or the activities
that took place therefrom were directly related to the active conduct of his trade or
business. The ruling of the court below creates an absurd result that cannot be squared
with the result of the statute, and accordingly, the ruling should be reversed.
6
ARGUMENT
I. The Appeals Court erred in reversing the Tax Court’s decision which properly disallowed Stump Inc.’s claimed deduction for shareholder employee compensation under §162(a)(1). The Internal Revenue Code outlines the federal tax laws for individuals,
corporations, closely held corporations, and other business entities. Tax Courts have an
obligation to oversee “cases commenced upon the issuance by the Commissioner of a
notice of deficiency in income.” 26 U.S.C. 13 (2008). For the 2013 taxable year, the
Commissioner issued a notice of deficiency against Stump Inc. for a $4,000,000
deduction it thought unreasonable under §162(a)(1) and the Appeals Court erred in
reversing the Tax Court’s decision for a few specific reasons. Specifically, §162(a)(1)
states:
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including, a reasonable allowance for salaries or other compensation for personal services actually rendered.” Treasury Regulations have deciphered §162(a)(1) and indicated that “[t]here 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. Treas. Reg. 1.162-7(a) (1960). In contrast, this Court
has stated that, “"extraordinary, unusual and extravagant amounts paid by a corporation
to its officers in the guise and form of compensation for their services, but having no
substantial relation to the measure of the services, and being utterly disproportioned to
their value, are not in reality payment for services and cannot be regarded as ‘ordinary
and necessary expenses’ …” See Botany Worsted Mills v. United States, 278 U.S. 282,
292 (1929). Thus, compensation is only deductible when (1) reasonable in relation to the
7
services performed and (2) the compensation is purely for services rendered. §162(a)(1);
26 C.F.R. § 1.162-7(a).
Historically nine factors were used to determine whether shareholder employee
compensation was reasonable. Mayson Mfg. Co. v. C.I.R., 178 F.2d 115, 119 (6th Cir.
1949). However, special scrutiny was given where a corporation was controlled by the
employees to whom the compensation was paid because of the lack of an arm's-length
bargain and the possibility and incentive to disguise taxable income and dividends which
could not appreciate or be reinvested. See Transupport Incorporated v. Commissioner of
Internal Revenue *7; Pepsi-Cola Bottling Company of Salina v. C.I.R, 528 F.2d 176, 179
(10th Cir. 1975). The nine Mayson factors are:
the employee's qualifications; the nature, extent and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the salary policy of the taxpayer as to all employees; and in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years. See Mayson, 178 F.2d at 119. Whether shareholder compensation is reasonable
under the Mayson factors, remains a question of fact that is resolved on the basis of an
examination of all the facts and circumstances of each particular case. See Charles
Schneider & Co. v. Commissioner, 500 F.2d 148, 15, (8th Cir. 1974). Therefore, the
Second Circuit had an affirmative duty to affirm the Tax Court’s decision unless after
considering all the facts before it, it was left with a definite and firm conviction that a
mistake had been committed. Gypsum Co., 333 U.S. at 395.
8
Courts have given no directions on how the Mayson factors should be weighed
and some courts have opted to do away with the nine factor Mayson test for a five factor
categorization. The five factor categorization outlines the independent investor test
which the Appellate Court erroneously suggested is a substantial presumption. See
Exacto Spring Corp. v. C.I.R., infra. at 835. Facially, the independent investor test
instructs that, when an inactive independent investor contemplating purchase of a
company would be willing to pay the distributed compensation, the test is an important
measure of the reasonableness of the shareholder employee compensation. CCH Tax
Research Consultant, COMPEN: 9,1114, Independent Inactive Investor Analysis to
Evaluate Reasonableness of Compensation.
However, courts have cautiously applied the independent investor test because
corporations can use the independent investor rationale to pay out exceedingly high
compensation if an independent investor would be satisfied with his or her return on
equity. In fact, closely held corporations find it beneficial to compensate employee
shareholders whilst refusing to pay dividends. Dexsil Corp. v. C.I.R., 147 F.3d 96, 100
(2nd Cir. 1998). This allows corporations such as Stump Inc. to fully deduct all its
distributions, to include disguised dividends, whilst decreasing its corporate tax bill. Id.
at 100; See infra Elliotts, 716 F.2d at 1243. Further, courts have concluded that when net
income is exceeded by a certain percentage an inference can be drawn that the
corporation is attempting to distribute compensation for reasons other than services
actually rendered, and in the instant case Stump Inc.’s compensation exceeded the net
income by 100%. Transupport, Inc., 2016 WL 6900913 * 8 (T.C. 2016).
A. The Independent Investor test should not be construed as a substantial presumption when extraneous facts suggests the ROE is an inaccurate
9
measure for determining whether shareholder employee compensation is reasonable. The independent investor test is but one factor that should be considered when the
return of equity (ROE) analysis fails to consider extraneous factors that suggest
shareholder employee compensation is due to a windfall, would reduce the ROE to zero,
or is not purely for services actually rendered. See Mulcahy, Pauritsch, Salvador & Co.,
Ltd., v. C.I.R., 680, F.3d 867, 872 (7th Cir. 2012); Exacto Spring Corp. v. C.I.R., 196
F.3d 833, 837-38 (7th Cir. 1999); Owensby & Kritikos, Inc. v. C.I.R., 819 F.2d 1315,
1326 (5th Cir. 1987).
Contrary to the Appeals Court decision, the Ninth Circuit did not blatantly reject
the Mayson factors but opted to establish five broad categories and an independent
investor test as a mechanism to more easily determine whether shareholder employee
compensation is reasonable under certain limited circumstances. Elliots, Inc. v. C.I.R.,
716 F.2d 1241, 1245 (9th Cir. 1983). Further, although the Elliots court rejected the Tax
Court’s decision to solely consider the element of a disguised dividend under the
automatic dividend rule, it did not state that a disguised dividend was never a factor the
court should consider when determining whether shareholder employee compensation is
reasonable. Id. at 1243 (emphasis added). Instead, the Elliots courts stated “if the
company’s return on equity remains at a level that would satisfy an independent investor,
there is a strong indication that management is providing compensable services and that
profits are not being siphoned out of the company disguised.” Id. at 1247. However, the
Court instructs that where there is evidence that an otherwise reasonable compensation
payment contains a disguised dividend the inquiry may expand into compensatory intent
apart from reasonableness. Id. at 1244. Therefore, an independent investor’s willingness
10
to pay and reasonableness of shareholder employee compensation depends largely on (1)
how much return on equity the taxpayer company is generating for investors, (2) whether
the employee is responsible for the rate of return and in certain limited cases (3) the
compensatory intent and as a result the Tax Court’s decision was not clearly erroneous.
See Elliots, 716 F.2d at 1244; CCH Tax Research Consultant, COMPEN: 9,1114,
Independent Inactive Investor Analysis to Evaluate Reasonableness of Compensation.
1. Stump Inc.’s return on equity was exaggerated when construed through the lens of an independent investor and the shareholder employee compensation was excessive for services actually rendered.
The Ninth Circuit indicated that in evaluating whether shareholder employee
compensation is reasonable, it is helpful to consider the matter from “the perspective of a
hypothetical independent investor. Elliots, 716 F.2d at 1245. Other Appellate Courts
have construed this statement differently, many are divided over how to apply the test,
and many have struggled to determine whether the test is dispositive. Id. However,
courts agree that the corporation's rate of return on equity is relevant to the independent
investor in assessing the reasonableness of compensation in a small corporation where
excessive compensation would noticeably decrease his or her rate of return. Id.
For example, Elliots concluded that when the bulk of a corporations earning is
being paid out in the form of compensation, an independent shareholder would probably
not approve of the compensation arrangement, i.e. if after payment of the compensation
there is not a reasonable return on the shareholder’s equity. 716 F.2d at 1247. Further,
the Second Circuit, in Dexsil Corp., adopted the independent investor test and construed
the paid out compensation through the lens of an investor. 147 F.3d at 101. The Court
considered various factors such as the President and CEO, Ted Lynn, salary and bonuses
11
which equaled $76,540 in 1989 and $168,000 in 1990. Id. at 98. In addition, the court
noted Ted’s, his family, and nonfamily member’s ownership in stock as, 61.62%, 29.11%
and 9% respectively. Id. The Court also considered bonus plans which paid Ted
approximately 11% of Dexsil’s gross sales whilst other employees enjoyed incentive
stock option plans or restricted stock award plan. Id. at 99. After considering the salaries
distributed, the stock holding of each corporate officer and the the salary plan, the Court
concluded the independent investor test was not a separate autonomous factor but
provided a lens through which the Mayson factors should be viewed, hence the test itself
must still take into consideration the Mayson factors. Id.
In conjunction, the Seventh Circuit has established that the independent investor
test should be construed as a “lens through which the nine Mayson” factors should be
construed but when other factors are present the test may be simply another factor to
consider. For example, in Exacto Spring Corp., a closely held corporation, paid its
cofounder, chief executive, and principal owner, William Heitz, $1.3 and $1.0 million,
respectively, in salary during the years in question. 196 F.3d at 833. The Commissioner
thought the compensation excessive and it assessed a deficiency. Id. As a result, the
court concluded that the presumption of reasonableness under the independent investor
test is a rebuttable presumption when there are extraneous factors. Id. Thus, although an
independent investor may be satisfied with its ROE, the shareholder employee salary may
nonetheless be unreasonable. Id.
The extraneous factor rebuttal was echoed in Mulcahy, where an accounting firm
petitioned for a redetermination of tax deficiencies that the Internal Revenue Service
reclassified as dividends. 680 F.3d at 872. Once again, the Seventh Circuit established
12
that independent investor test is a rebuttable presumption that must be construed with
other factors and is not dispositive alone. Id. at 871. More specifically the court
established that when a company’s success is “the result of extraneous factors, other
factors besides the percentage of return on equity have to be considered.” Id. (emphasis
added). Further the Court established that when treating a salary as an expense would
reduce a firm’s income to zero it would in theory additionally reduce an investor’s return
of equity to zero and as a practical matter flunk the independent investor test. Id.
The Record reflects that in 2013 Stump Incorporation grossed nearly $5,000,000
in revenue from licensing deals. R at 3. The Official Record also reflects that each
corporate officer was paid $1,000,000 bringing the total deductions for the 2013 taxable
year to $4,000,000 while in the same year Stump Inc. was liable for $24,750,000 in
unpaid balances and interests for the purchase of its 2010 Stump Garden building.
Facially, the 2013 $5,000,000 in gross receipts suggests that Stump had a high return on
equity as suggested by the Appeals Court. However, the First, Second, Sixth, and Ninth
Appellate Courts have all indicated that the independent investor test, which outlines the
ROE, is not dispositive when extraneous facts indicate that the compensation reduces the
ROE to zero, is not for services rendered or the compensation distributed is not
reasonable in light of the corporations outstanding debts.
In Mulcahy, the court blatantly indicated that one factor to consider is the net
income of the closely held corporation as it relates to the return on equity. 680 F.3d at
876. The Court reasoned that when the deductions taken reduce the net income to zero,
shareholder return to equity is also reduced to zero and therefore such a deduction would
be per se unreasonable. Id. If upheld, Stump Inc.’s 2013 deduction would reduce its
13
taxable income by 100% and gross receipts by 80%. R. at 4. As a result, it was not
clearly erroneous for the Tax Court to find the compensation unreasonable because an
independent investor would have had nearly zero return on equity considering the
distributed compensation.
Lastly, although the Appellate Courts agree that the independent investor test is
an important mechanism when determining whether shareholder employee compensation
is reasonable, Appellate courts have not indicated that the presumption is a substantial
presumption. In fact, many courts seem to indicate that the presumption is a rebuttable
presumption. As suggested in Mulcahy, ROE must be carefully observed in closely held
corporations because of possible inflations due to extraneous factors and windfalls. 680
F.3d at 872. In the current case, extraneous factors included: the nearly $25 million in
unpaid debts; the incentive to disguise dividends and gains as compensation; the fact that
there was no way for shareholder holdings to appreciate in value with each officer only
owning 1% and a windfall related solely to the corporate licensing and fame of the Stump
name; and lastly, the net income of the corporation was deduced to zero would suggest
that the return of equity was also zero.
2. Additional evidence suggested that Stump Inc.’s compensatory intent was to avoid taxes on distributed dividends.
Compensatory intent can be inferred when there is evidence that a closely held
corporation and its shareholder employees have an incentive to hide dividends in
compensation payments. See Elliots, 716 F.2d at 1244; Mulcahy, 680 F.3d at 872; Rutters
v. C.I.R., 52 T.C.M. (CCH) 326 (1986).
14
Courts have concluded that in closely held corporation’s employee shareholders
may have an incentive to distribute earnings in the form of compensation. See Eberl’s
Claim Service Inc. v. C.I.R., 259 F.3d 994, 998 (10th Cir. 2001). Primarily, absent third
party interests in limiting compensation for the sake of profitability, dividends may be
disguised as a salary and channeled out of the corporation tax free.” Id. Although the
Ninth Circuit rejected the automatic dividend rule, like the Tenth Circuit, it does suggest
that when there is evidence that there is an intent to hide dividends in compensation
payments, courts should consider the intent of the compensation. Elliots, 716 F.2d at
1243. Likewise, the Court established that where a corporation has multiple shareholders
“the existence of a plan which compensates shareholder-employees in proportion to their
ownership interests may be evidence that compensation payments contain disguised
dividends. Id.
Further, it has been indicated that when a corporation has a poor dividend
distribution history there may be an intent to avoid taxes altogether. For example, the
Tax court found that the petitioner in Rutter’s accumulated earnings and profits beyond
the reasonable needs of its business. 52 T.C.M. (CCH) 326 (1986). The earnings
accumulation, and the corporations three time distribution of dividends in a fifty year
period suggested to the court that the corporation’s intent was purely tax avoidance
because there were no other reasons not to distribute dividends. Id.
Stump Inc. has four shareholders, R. Stump, Oak Stump, Maple Stump, and
Willow Stump and they each own 97%, 1%, 1%, and 1% respectively of the corporate
shares. R. at 2. Unlike in Elliots where the court found there was no intent on the part of
the shareholder employee to disguise the distributed dividends, this case presents a
15
different narrative. 716 F.2d at 1244. As found by the Tax Court, and echoed by the
Appellate court “when the payments made are unquestionably at the high end of the
spectrum of the compensation” a correlation between stockholdings and compensation is
necessary to determine whether a portion of the compensation is a disguised dividend. R.
at 15. All three adult children were paid $1,000,000, each owned 1% of Stump Inc. and
though they may have contributed equally to the success of the Stump Inc., and the
compensation was not in proportion to the corporate shares, the equal compensation
infers that a portion of the salary may have been disguised as a dividend to avoid taxes on
pro rata shares.
Further, under certain conditions closely held corporations have an incentive to
distribute outstanding dividends through compensation so as to completely avoid
corporate and dividend taxes. Rutters, 52 T.C.M. (CCH) 326; Eberl’s Claim Service Inc.,
259 F.3d at 998. Stump Inc. has an incentive to avoid taxes because there are no checks
on the distribution of Stump Inc.’s dividends, Stump Inc. owes large sums in outstanding
debts, and the shareholder employees are all family reaping the benefits of the avoidance.
52 T.C.M. (CCH) 326 (1986). Rutters, indicated that by observing the deduction history,
dividend history, overall salary scheme, industry compensation levels, and business
operations and profits of a corporation, a court could determine whether the excessive
compensation was intended to avoid taxes. Id. In the current case, the record does not
reflect the dividend history, compensation levels or other business operations of the
corporation. However, the record does reflect the business operation and profits of the
corporation. Id.; R. at 3-5. Stump’s children each held administrative positions, assisted
with development products, and attended events for the Stump brand. R. at 2-3.
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However, the record further reflects that Stump Inc. was in debt by nearly $25 million
and that each adult child was compensated equally and equally possessed 1% of the
corporate shares. These inferences suggest that the Tax Court’s decision was not clearly
erroneous because though the Stump children should have been compensated handsomely
there was an incentive and an erroneous intent unreasonably compensate the children all
whilst decreasing Stump Inc.’s the taxable income – i.e. gains to zero. R. at 4.
Therefore, the independent investor test is at most a rebuttable presumption and
the Tax Court’s finding was not clearly erroneous because through the lens of an
independent investor, the ROE was insufficient because there was no return as all of the
taxable income, i.e. gains, were distributed, and the compensatory intent was improper.
B. Stump Inc.’s deduction for shareholder employee salary exceeds even the most liberal compensation benchmarks.
Courts measure compensation as a percentage of gross receipts and net income
but taxable net income tends to more accurately gauge whether a compensation includes
a disguised dividend. See Owensby & Kritikos, Inc., 819 F.2d at 1325.
Taxable income is computed by, allocating the gross income minus all allowable
deductions and exemptions and is in practice the amount of income used for calculation
of income taxes owed by an individual or a company. Blacks Law Dictionary (10th ed.
2014). Whilst, gross receipts or gross income is the total amount of money or other
consideration received by a business taxpayer for goods sold or services performed in a
taxable year, before deductions. Blacks Law Dictionary (10th ed. 2014). Although
Courts have been generally known to measure compensation as a percentage of gross
receipts or net income, net income (the taxable income (i.e. all income minus relevant
17
deductions)) accurately gauges whether a corporation is disguising distributed dividends
as compensation. See Owensby & Kritikos, Inc., 819 F.2d at 1325 -26.
For example, in Good Chevrolet, the Court addressed the reasonableness of
compensation paid to two employees of an automobile dealership which saw a historic
increase in sales. Good Chevrolet v. C.I.R., 36 T.C.M. (CCH) 1157 (1977). Together, the
employees held 100% of the corporation's stock. Id. In addition, the shareholder
employees controlled the affairs of the franchise and a “large portion” of the franchises
net income, approximately 60% in 1971 and 57% in 1972, was paid as compensation to
the shareholder employees while only 1.69% in 1971 and 2.0% in gross income was paid.
Id. In addition, Chevrolet’s parent company required that the franchising petitioner retain
a substantial networking capital account. Id. The court notes, that the compensation was
reasonable, however, had it not been for the networking capital account oversaw by the
parent corporation, additional amounts could have been paid out. Id.
In contrast, the Fifth Circuit has indicated that a portion of the shareholder
employee compensation is unreasonable when it exceeds the taxable income by 53.7% or
65.1%. Owensby & Kritikos, Inc., 819 F.2d at 1326. In Owensby & Kritikos, Inc., the
corporate taxpayers, entered into work agreements with Mr. Owensby and Mr. Kritikos.
Id. During the taxable years at issue, the “work agreement provided for a guaranteed
annual salary of $72,000, an incentive bonus of 3% of the net volume of yearly business,
and an additional bonus to be paid at the discretion of the board of director.” Id. In
conclusion, the Court held the “payments to shareholder employees constituted 12.3%
and 9.0% of the consolidated gross receipts during the two taxable years and 53.7% and
65.1% of consolidated taxable net income to be unreasonable because even in Good
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Chevrolet, the court noted that “each case turns on its own facts and circumstances. Id. at
1325-26; 36 T.C.M. (CCH) 1157 (1977).
Neither the Second Circuit nor this court owes deference to the Tax Court in
Good Chevrolet because this case is reviewable as a question of law. Elliotts, 716 F.2d at
1245. A review of the official record indicates, that the Tax Court’s decision was not
clearly erroneous because under the facts presented by Stump Inc. the large portion of net
income paid in compensation to the shareholder employees suggest that even under the
most liberal benchmark the compensation was unreasonable for services actually
rendered. See Good Chevrolet 36 T.C.M. (CCH) 1157 (establishing the 60% benchmark
referred to in the record). However, for the 2013 taxable year, the shareholder employee
compensation exceeded Stump Incorporations taxable and net income by a stunning
100%. R. at 4.
Further, although Stump Inc.’s issues closely mirror the issue addressed in Good
Chevrolet, where the court established that 60% of net income and 1.69% to 2.0% of
gross income in a good producing corporation is reasonable, Stump Inc.’s 2013
deductions fall short because its deductions exceeded gross income by 80% and net
income by 100%. In addition, there are no shareholder and employee bonuses which
could explain the $1,000,000 in salary, and Stump Inc. does not produce any goods for
which bonuses could incur. 36 T.C.M. (CCH) 1157. Likewise, in Good Chevrolet, the
court conceded that the compensation could be explained as a result of the capital account
that the Chevrolet franchise was required to maintain. Id. In the current case there is no
capital account in which to place revenue so as to enhance the value of the shareholder
employee holdings. Nor is there a parent entity in place to account for revenue that could
19
have been distributed in the form of dividends. As a result, the Tax Court’s decision was
not clearly erroneous because the compensation deductions were not just a “large
portion” of the taxable income but all of the taxable income
Lastly, though owing no deference to its holding, the Fifth Circuit established
relatively defined parameters in Owensby & Kritikos, Inc. As already outlined, the
Court’s decision focused on the potential for shareholder employee compensation but
concluded that shareholder employees are unreasonable when it exceeds the taxable
income by 53.7% or 65.1%. Supra, at 1326. In the current case Stump Incorporation’s
2013 deduction in employee compensation was 100% of the taxable income. R. at 4.
When taken literally, this indicates that the corporation itself saw zero income which
would suggest that the deduction itself fails the independent investor test because zero
income would suggest zero return on its equity.
Therefore, the Tax Court finding that the deductions for shareholder employee
compensation was not clearly erroneous because facts suggest that the deduction taken
exceeds even the most liberal interpretation of net income threshold.
II. The Appeals Court erred in reversing the Tax Court’s agreement with the determination of the Commissioner which properly disallowed Respondent’s claimed deduction of hockey tickets as a business entertainment expense under Internal Revenue Code §§ 162 and 274(a)(1)).
Deductions, under the Internal Revenue Code, are a matter of legislative grace, as
it is Congress who holds the discretion to allow or disallow such deductions. See
Commissioner v. Tellier, 383 U.S. 687, 693 (1966) (citing Commissioner v. Sullivan, 356
U.S. 27, 28 (1958)). In enforcing said legislative pronouncements, the Commissioner
issues – and this Court has upheld – disallowances of deductions that would frustrate
20
sharply defined national policies proscribing particular types of conduct, as pronounced
by a governmental declaration. Commissioner v. Heininger, 320 U.S. 467, 373 (1943);
Lilly v. Commissioner, 343 U.S. 90, 97 (1952). In the instant case, Congress specifically
enacted 26 U.S.C. § 274(a) to supplement § 162 to eliminate what was perceived as
widespread abuse of expense accounts and business entertainment expenses. See
Hippodrome Oldsmobile, Inc. v. United States, 474 F.2dc 959, 961 (6th Cir. 1973); see
also Danville Plywood Corp. v. United States, 899 F.2d 3, 7 (Fed. Cir. 1990). As a result,
claimed deductions for business entertainment expenses are subject to a more stringent
standard with respect to the proximate relationship of the expense to the active conduct of
the business. See D. A. Foster Trenching Co., v. United States, 473 F.2d 1398, 1400
(Ct.Cl. 1973).
The Commissioner’s asserts that Taxpayer failed to sufficiently overcome the
Commission’s presumption of correctness regarding application of both the four-factor
“directly related test” and the “clear business setting” test for the deductions claimed. See
generally Welch v. Helvering, 290 U.S. 111, 115 (1933) (citing Wickwire v. Reinecke,
275 U.S. 101 (1927); providing that the rulings of the Commissioner have the
presumption of correctness and the petitioner has the burden of proving it to be wrong)).
In addition, Taxpayer has failed to properly substantiate the claimed deductions, as
required by § 274(d). The court below incorrectly applies the statutes, regulations, case
law, and legislative history to the record provided in determining that the hockey games
constitute a “directly related” expense in a “clear business setting,” and thus giving rise to
an appropriate deduction. See Treas. Reg. §§ 1.274-2(c)(3), (4). In so doing, in addition
to improperly granting the deduction, the ruling below, as a matter of law, creates an
21
absurd result, eviscerating the efficacy and countermanding the legislative intent of the
federal statute as applied to Taxpayer, creating problematic enforcement inefficiencies
for similarly situated cases. As a result of the foregoing, this Court should reverse the
court below and uphold the determination of the Commissioner, as found by the Tax
Court.
A. The court below failed to thoroughly examine the threshold issue of establishing the expenses as both “necessary” and “ordinary,” as required by § 162 and interpreted by this Court’s jurisprudence.
Prior to approaching the “directly related” or “associated with” standards,
allowable business expense deductions must be established as “ordinary and necessary.”
IRC § 162. This Court has established the parameters of a “necessary” expense as those
that are appropriate and helpful to the development of the petitioner’s business. See
Welch, 290 U.S. at 113. The Government does not dispute this contention as applied to
Taxpayer’s claim for the deduction; however, the elements require the expenses to also
be “ordinary.” IRC § 162. This Court has examined the meaning of “ordinary” in the
statute, identifying that there must always be a strain of constancy within it, which can be
affected by time, place, and circumstance. Id.
The Welch court provided that expenses are ordinary when examined in
accordance with the ways and conduct and forms of speech prevailing in the business
world. Id. at 114. To do so, the record must evince that the expense is not unique in the
life of similar businesses such that the court can “stabilize its judgment, making it certain
and effective.” Id. at 114. In said case, a business owner – in order to establish and
solidify reputations with his customers – expended sums to eliminate prior debts. Id.
There, we stated – in a ruling ultimately upheld by this Court – that the payments were
22
not deductible from income as ordinary and necessary expenses, but rather were in the
nature of capital expenditures, an expenditure for the development of reputation and good
will. Id. (emphasis added). The Welch court stated directly:
“Reputation…[is] akin to capital assets, like the good will of an old partnership. For many they are the only tools with which to hew a pathway to success. The money spent in acquiring them is well and widely spent. It is not an ordinary expense of the operation of the business.” Id. at 116. (emphasis added). In the instant case, based on the record, the
petitioner failed to establish and, inexplicably, the court below failed to thoroughly
examine this threshold question. Here, as in Welsh, the record similarly fails to provide
any substantiation of these expenses being ordinary within the business world with
similar businesses akin to Taxpayer. Moreover, the record poignantly chronicles this and
other similar expenses by the Taxpayer as pointed to and motivated by increasing
reputational value. R. 2-4 ¶¶ 8, 9, 13, 22. This Court spoke authoritatively and should
accordingly reaffirm the notion that these expenses are not “ordinary” within the meaning
of IRC ¶ 162.
B. Taxpayer failed to properly and sufficiently establish that the hockey games, for which the tickets were purchased, qualify as “directly related to” or “associated with” the active conduct of the taxpayer’s trade or business.
Courts, in reviewing the Internal Revenue Code, have reaffirmed IRC § 162,
providing that “ordinary and necessary” business expenses of a taxpayer are generally
deductible, but will be disallowed if they fail to adhere to both the “directly related”
standards of § 274(a) and the substantiation requirements of § 274(d). Berkley Machine
Works and Foundry Co. v. Commissioner of Internal Revenue, 623 F.2d 898, 901 (4th
Cir. 1980). Specifically, the Internal Revenue Code categorically disallows deductions
23
for business entertainment expenses unless the expenses are “directly related to” the
active conduct of Taxpayer’s trade or business. See I.R.C. § 274(a)(1)(A). In the case of
entertainment directly preceding or following a substantial and bona fide business
discussion, the expenses must be “associated with” the active conduct of a taxpayer’s
trade or business. Id; see Treas. Reg. § 1-274-2(a)(1).
The Treasury Regulations are designed to effectuate the intent of its authorizing
statute, IRC § 274, namely to have the taxpayer illustrate a closer nexus between the
entertainment expenditure and the taxpayer’s trade or business than was required under §
162. See St. Petersburg Bank & Trust Co. v. United States, 362 F. Supp 674, 677-9
(1973) (citing H.R.Rep 1447, 1962-3 Cum.Bul. at 424). In so doing, they set up four
requirements which must be met by a claimant Taxpayer:
(1) at the time of the entertainment expense, the taxpayer had more than a
general expectation of deriving some income or other specific business
benefit other than good will from the person(s) entertain at some indefinite
future time from the making of the expenditure,
(2) during the entertainment period related to the expenditure, the taxpayer
actively engaged in a business meeting, discussion, negotiation, or other bona
fide business transaction for the purpose of obtaining such income or other
specific trade or business benefit,
(3) in light of the facts and circumstances of the case, the principal character
or aspect of the combined business and entertainment to which the
expenditure was related was the active conduct of the taxpayer’s trade or
business, and
24
(4) the expenditure was allocable to the taxpayer and person(s) with whom
the taxpayer engaged in the active conduct of trade or business.
See Treas. Reg. § 1-274-2(c)(3); see also St. Petersburg, 362 F. Supp at 679-80.
Under the record provided, Taxpayer meets none of the provided requirements,
despite the fact that, under the regulation, one must meet all of the requirements of Treas.
Reg. § 1-274-2(c)(3). The opinion of the court below provides that the Taxpayer does not
contend that any business discussions took place during these sporting events, which
alone disqualifies any compliance with the requirements; however, we address
specifically Treas. Reg. § 1-274-2(c)(3)(i).
Courts hold that taxpayers, in claiming entertainment expenses, cannot simply
have a general expectation of deriving some income at some indefinite future time.
Handelman v. Commissioner of Internal Revenue, 509 F.2d 1067 (2d Cir. 1975). The
record, here, indicates the expenditure for seats at the game, with the intention of
attending home games, provides no specific, active conduct of Taxpayers trade or
business. The creation of publicity and reputation value for the brand is built with the
expectation that potential customers are, in the future, drawn to and partner with the
Taxpayer’s brand. R. 2-4 ¶¶ 8, 9, 13, 22. As such, such expenses are impermissible as
“directly related” and thus, our determination should be upheld.
C. Taxpayer failed to properly establish that the hockey games, for which the tickets were purchased, qualify as a “clear business setting.”
Treasury Regulations, in execution of 26 U.S.C. § 274, generally establish that
“no deduction shall be allowed for any expenditure for entertainment unless the taxpayer
establishes that the expenditure was directly related to the active conduct of his trade or
25
business.” See Treas. Reg. § 1.274-2(c)(1). Taxpayer can show that entertainment
occurred in a clear business setting by “clearly establishing that any recipient of the
entertainment would have reasonably known that the taxpayer had no significant motive,
in incurring the expenditure, other than directly furthering his trade or business.” See
Moore v. United States, 943 F. Supp. 603, 618 (E.D. Va. 1996) (citing Treas. Reg. §
1.274-2(c)(4)). In evaluating the clear business setting standard, the regulation establishes
a nexus between the recipient(s) of the entertainment and their reasonable knowledge and
understanding that the purpose of the entertainment to which they were subjected or
invited had any other significant motive other than the advancement of the taxpayer’s
business. This becomes an objective, fact-based inquiry as to a simple question: whether
for the reasonable attendee, the facts, in sum, point to an objective and obvious
subordination of entertainment activities to furthering a clear business purpose, as defined
by the Treasury Regulations.
Moore v. United States provides a correct example of the analysis necessary to
properly establish the clear business setting standard. There, the court reviewed the
Government’s determination that a party hosted by the petitioner, Moore, did not
constitute a clear business setting and, consequently, was not deductible as defined by
Treas. Reg. § 1.274-2(c)(4). The court noted that the petitioners averred that the attendees
at their event all knew that the only reason the Moores incurred the expense of the party
was to promote their realty business, despite substantial distractions alleged by the
Government under Treas. Reg. § 1.274-7. See Moore, 943 F. Supp at 619. The court
agreed with the Moores that the expense of their party was incurred in a clear business
setting. In the case, the court noted two ways in which the petitioner satisfied the
26
requirements of the Treasury Regulations. First, through testimony from attendees at the
party, the court established that any attendee at the party would have reasonably known
that the expense of the party was incurred only to further the Moores’ business. Id.
Secondly, petitioners in the case established the lack of meaningful personal or social
relationships between the Moores and the recipients of the entertainment. Both of these
evidentiary items together led the court to find that the party was akin to one of the
illustrations of entertainment expenses occurring in a clear business setting, per Treas.
Reg. § 1.274-2(c)(4).
In this wise, the court below fails to properly follow the standard set forth by
Treas. Reg. § 1.274-2(c)(4) in that its analysis erroneously focuses on Taxpayer’s self-
averred motivation rather than establishing that any recipient of the entertainment would
have reasonably known that the taxpayer had no significant motive, in incurring the
expenditure, other than directly furthering his trade or business. Further, of those known
to attend the hockey games, namely his children, they fall outside of both the objective
evidentiary standard required to be determinative for establishing motive, as well the
necessary lack of meaningful personal or social relationship between the taxpayer and the
recipients of the entertainment. Cf. Moore, 943 F. Supp at 619. The only other guidance
provided by the Official Record are the expert opinions of Prof. Harold Hill, who does
not allege or otherwise infer that he was a recipient of the entertainment in question and,
therefore, would be unable to properly establish the standard provided by Treas. Reg. §
1.274-2(c)(4). See. R. 5 ¶ 30.
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CONCLUSION
This Court should reverse the Second Circuits decision and reaffirm the Tax
Court’s decision because Tax court’s decision was not clearly erroneous since the
independent investor test is at most a rebuttable presumption and the $4,000,000
deduction exceeded even the most liberal net income threshold. exceeded the taxable
income by 100% exceeded the gross receipts by 80%. In addition, the Taxpayer has
failed to provide evidence to meet the requirements of §§ 274(a), 274(d), or Treas. Reg. §
1-274-2(c)(3) in claiming his expenses as being in a “clear business setting” so as to
properly claim a deduction. The result of the court below is contrary to the public policy
pronouncements made by Congress and should be overturned. We, therefore, respectfully
request the reversal of the Court below.
Respectfully submitted,
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