Reasonable People Can Disagree

June 15, 2023

Clary Hood, Inc. v. Commissioner T.C Memo. 2022-15 raised the issue of reasonable compensation under IRC Sec. 162(a)(1). The IRS questioned whether the amounts paid to Mr. Hood were deductible as a necessary business expense.

In 1980, Clary Hood and his wife founded Clary Hood, Inc, a successful construction company. Mr. Hood and his wife were the sole shareholders and sole members of the board of directors of the C corporation. Mr. and Mrs. Hood provided debt guaranties and surety bond guaranties for the company for which they were not compensated. Mr. Hood’s bonus was set by the board of directors at $5 million for each of 2015 and 2016 and was meant in part to compensate him for undercompensation in prior years.

The IRS issued a notice of deficiency to the company claiming Mr. Hood’s compensation exceeded reasonable compensation under 26 U.S.C. § 162 and disallowed portions of the compensation in each year assessing additional tax of $1,581,202 and $1,613,308 for 2015 and 2016 and accuracy-related penalties of over $300,000 for each year.

Treas. Reg. § 1.162-7(b)(1) state “[a]n ‘ostensible salary’ paid by a closely held corporation to one of its shareholders is likely to constitute a disguised dividend where the amount is ‘in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees’”.

While the tax court acknowledged that Mr. Hood was entitled to some degree of additional compensation for the prior services, it held that the petitioner could not deduct the full amount of compensation paid to Mr. Hood because the company failed to adequately establish how the entire amount was both reasonable and paid solely as compensation for his services during the review period.

The facts weighing against the company were the failure to pay or accrue dividends over the 16 year period reviewed, Mr. Hood’s compensation relative to the compensation of other company executives appeared excessive and the board lacked evidence to support the amounts that were due for past services.

In determining the appropriate level or remuneration, the Tax Court found the IRS expert’s testimony most helpful. He considered the multifactor approach, included compensation for the surety bond guaranties, and offered a comparison of petitioner and Mr. Hood’s salary against industry standards.

Mr. Hood’s total compensation for 2015 and 2016 was $5,711,105 and $5,874,585. The Tax Court held that the record supported reasonable compensation of $3,681,269 for tax year 2015 and $1,362,831 for tax year 2016 which was higher than the IRS initial assertion of $517,964 and $700,792, respectively.

Chaffe regularly uses the multifactor approach and can assist you in a reasonable compensation analysis.