Reilly examines key Tax Court case on reasonable comp

BVWireIssue #246-3
March 15, 2023

executive compensation, reasonable compensation, federal taxation

Nationally known valuation expert Robert Reilly (Willamette Management Associates) has done a comprehensive 17-page article on the Hood case—a Tax Court case with some important and practical guidance on determining reasonable compensation. While the case involved a federal tax matter, the guidance may also be helpful in other contexts, Reilly notes. The case involved a private company, Clary Hood Inc. (CHI), a C corporation in the construction industry. The outcome was “generally favorable” to the IRS, with the company paying back taxes and penalties for taking tax deductions for an unreasonable amount of compensation.

Multifactor approach: Of particular importance, Reilly points out, is the court’s thorough analysis of “the multifactor approach” to assessing the reasonableness of executive compensation. This approach takes into consideration certain factors, such as the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; and others. The court’s assessment of these factors was largely in favor of the company, except that it noted that the company never declared or paid a cash dividend even though it was profitable, an indication that some of the compensation paid was a disguised dividend.

Other jurisdictions use an “independent investor” test, which essentially asks whether an inactive, independent investor in the company would receive a reasonable return taking into account the compensation that was actually paid.

Experts stumble: Also important in this case, Reilly says, is the guidance it gives to experts who testify in reasonable comp matters. That’s where things really went wrong for the company, which presented two experts to testify as to how CHI’s compensation compared to similar companies. The first expert was not that familiar with the contents of the report that he co-wrote with a colleague (who was not called to testify). The court said that “perhaps most egregious” was the comparison of CHI, a private regional specialty construction firm, to the multinational conglomerate Caterpillar Inc., with “little attempt” at adjusting for the obvious and stark differences between the two. Also, the report focused on the independent investor test, not the multifactor test, which was controlling in that jurisdiction.

The second expert for the company had not written the report to which he was testifying although he reviewed and agreed with it. The court found the report lacked necessary supporting calculations and relied on unsound assumptions. For example, the report used data from much larger companies and discounted the data by 20%, a rate not supported by any empirical data. The court gave this expert’s testimony little or no weight.

On the other hand, the expert for the IRS prevailed, providing “the most credible and complete source of data, analyses, and conclusions in the record regarding what similar companies might be willing to pay” in terms of compensation, the court said. The amounts were significantly higher than the estimates provided in the IRS deficiency notice but were much less than the amounts the company originally deducted on its returns. Plus, the court found the company liable for a substantial understatement accuracy-related penalty for one of the years at issue.

Reilly discusses a number of other important issues in the article, which is available if you click here. The case is Clary Hood, Inc. v. Comm’r, T.C. Memo. 2022-15.

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