Unpublished Disposition, 899 F.2d 1225 (9th Cir. 1977)

No. 88-7331.

United States Court of Appeals, Ninth Circuit.

Before JAMES R. BROWNING, PREGERSON and DAVID R. THOMPSON Circuit Judges

MEMORANDUM^* 

LeRoy Hilt challenges the Tax Court's determination of a deficiency in his 1977 income tax return.¹  Hilt and his three children owned and operated several related businesses, including Hilt Truck Lines (HTL), incorporated under subchapter S of the Internal Revenue Code. This case is one of several that arose after the IRS assessed deficiencies for the tax years 1975-82 against all the Hilts and the Hilt corporate taxpayers.

The Hilts paid the alleged deficiencies for the years 1975-76, and sought and obtained a refund in the district court of Nebraska. See Trucks, Inc. v. Commissioner, 588 F. Supp. 638 (D. Neb. 1984), aff'd, 763 F.2d 339 (8th Cir. 1985). The Hilts petitioned the Tax Court for review of the alleged deficiencies for the years 1977-82. The Tax Court determined that a portion of the Hilts' salaries was not reasonable compensation for personal service, taxable at 50%, but profit distribution, taxable at a 70% rate. All of the Hilt taxpayers except LeRoy obtained review in the Eighth Circuit, which affirmed the Tax Court. See RTS Inv. Corp. v. Commissioner, 53 T.C.M. (CCH) 171 (1987), aff'd, 877 F.2d 647 (8th Cir. 1989) (per curiam). Because he resided in Nevada, LeRoy appealed the Tax Court decision as to him to this court. See 26 U.S.C. § 7482(b) (1) (A). The sole issue before us is the reasonableness of the compensation payments HTL made to LeRoy in a single tax year--the year ending December 31, 1977. We affirm.

* The relevant factors to be considered in determining the reasonableness of compensation paid to a shareholder/employee of a closely held corporation are: (1) the employee's role in the company; (2) a comparison of the employee's salary with those paid by similar companies for similar services; (3) the character and condition of the company; (4) the potential for a conflict of interest between the employee and the company; and (5) any evidence of internal inconsistency in a company's treatment of payments to employees. Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-48 (9th Cir. 1983).²  No single factor is controlling. Pacific Grains, Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968). The taxpayer has the burden of establishing the reasonableness of the compensation received. E.g., Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361 (9th Cir. 1974).

Whether the Tax Court identified and considered the appropriate factors is a question of law reviewed de novo. Elliotts, Inc., 716 F.2d at 1245. The Tax Court's factual findings are reviewed only for clear error. Id.

II

The Tax Court made the following findings regarding LeRoy Hilt's role in HTL. LeRoy Hilt founded HTL, made all the major decisions in that corporation, and was the driving force behind its growth and success. He was president and treasurer of HTL during the tax year in question, and regularly worked a 100 hour week. The Tax Court was impressed with the dedication and cooperation of LeRoy Hilt and his children in running HTL, and recognized that LeRoy Hilt, " [o]f all the Hilts, ... was undoubtedly the most qualified and the most experienced in terms of operating a trucking business." However, Hilt moved from Nebraska to Las Vegas, Nevada, in 1977, and the Tax Court found he neither maintained the same degree of control of overall company business nor his intense working style after the move.

Both the Hilts and the Commissioner presented expert testimony concerning compensation levels in the industry. The Hilts' expert, Henry Vanderkam, compared HTL to other common carriers on the basis of several criteria, but provided no information that would permit the Tax Court to compare the Hilts' compensation to the compensation paid to individual executives by other companies in the transportation industry. The Hilts thus failed to meet their burden of proof on this significant factor. E. Wagner & Son, Inc. v. Commissioner, 93 F.2d 816, 819 (9th Cir. 1937). In contrast, the Commissioner's expert, E. James Brennan, compared the Hilts' level of compensation with that of other top executives in the transportation industry and concluded no transportation firm of equivalent size in the country paid as much to its individual top executives. The Tax Court was entitled to accept the opinion of the Commissioner's expert and to reject the opinion of the Hilts' expert. Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988); Penn v. Commissioner, 219 F.2d 18, 21 (9th Cir. 1955).

We reject LeRoy Hilt's argument that comparing his compensation to that of chief executive officers in similar companies was inappropriate. He asserts his services defied categorization--that he did the work of several employees. The Tax Court specifically found "the evidence indicates only that the Hilts worked long hours and shared responsibilities and decision-making; it does not establish that any one of them performed the work of more than one employee in a comparable concern." (Emphasis in original).³  One of the Commissioner's expert witnesses testified that the most successful executives are those who manage efficiently, work fewer hours per week, and train subordinates to whom they can delegate non-executive duties. Moreover, in allowing a figure substantially in excess of the compensation paid to chief executive officers of comparable firms, the Tax Court acknowledged LeRoy Hilt's special contribution to HTL, his long hours and dedication to work.

The Hilts' expert, Vanderkam, compared HTL to other common carriers on the basis of: (1) return on equity before officers' salaries; (2) return on equity; (3) gross revenue per employee; (4) officers' salaries and total wages and benefits as a percentage of revenue; (5) earnings per employee before payroll and fringe benefits; and (6) after-tax earnings per employee. On appeal, LeRoy Hilt argues HTL's extraordinary return on equity compels a conclusion that the compensation paid him was reasonable. Vanderkam's analysis showed a return on equity of 949.67% in the tax year 1977, based on an equity value of $66,072, the amount of the original investment capital in HTL upon its incorporation adjusted for a small surplus payment. This figure does not account for appreciation, or for the value of goodwill developed over the years; and is inconsistent with the amount reported on HTL's corporate tax return. The Commissioner's calculation of HTL's return on equity in 1977, based on figures HTL reported to the Interstate Commerce Commission, was 14.61%. This compared to an industry average of 21.16%. The Tax Court's rejection of Vanderkam's analysis of HTL's return on equity was supported by substantial evidence. In any event, whether a company's return on equity after the payment of salaries would satisfy an independent investor is only one of several factors to be considered in determining the reasonableness of compensation and is not itself determinative. Elliotts, Inc., 716 F.2d at 1247.

The Tax Court properly considered the fact that LeRoy's total salary and bonuses nearly doubled in 1977 over the preceding year although prior annual increases were in the range of 25% and business conditions had deteriorated in 1977. LeRoy Hilt offered no evidence to explain the extraordinary increase in the year at issue.

The Tax Court determined LeRoy's reasonable compensation for 1977 was approximately $80,000 less than the amount allowed by the Nebraska District Court for the 1976 tax year. The difference is justified by evidence indicating deterioration in the company's financial condition and a lessening of LeRoy's participation in company-wide management and control after moving to Nevada.

LeRoy asserts the savings realized by HTL because the Hilts performed their own legal work and brokered their own hauling contracts justify the compensation received. Thomas Hilt's preparation of ICC tariffs and other required filings at best can have only a tangential relevance to LeRoy Hilt's compensation. There is no evidence LeRoy himself performed any substantial legal work for HTL in 1977, particularly after he moved to Nevada. Regarding the alleged savings of broker fees, HTL itself functioned in large part as a broker. If HTL had used outside brokers, it would have given away much of its own work. Furthermore, no evidence was presented showing the relationship between brokerage fees saved and compensation received by trucking executives who secured their own freight instead of working through brokers.

With respect to potential conflicts of interest, LeRoy Hilt's status as controlling shareholder of HTL indicates a "potentially exploitable relationship" between him and HTL. See Elliotts, Inc., 716 F.2d at 1246. Moreover, HTL's board of directors was composed solely of LeRoy Hilt and his children, who owned the remaining shares of HTL. This family relationship indicates compensation decisions may not have been the result of free bargaining. See id. Indeed, the Tax Court noted the Hilts "do not dispute the lack of arm's-length negotiations" as to their compensation arrangement. The testimony of both Leroy and his son Robert support the Tax Court's finding that the salaries of family members "were usually based on need and desire instead of merit and services."

Payments to LeRoy Hilt in 1977 as a proportion of total salary and bonuses to all employees closely tracked LeRoy Hilt's stock holdings, another circumstance suggesting the payments may not have been reasonable compensation for service. Elliotts, Inc., 716 F.2d at 1247. Similarly, although LeRoy and his children received substantial bonuses, non-shareholder employees, Pat Esche and John Hornung, received none. The fact that Esche and Hornung did not hold management positions did not necessarily negate the inference that bonuses to family members may not have been paid entirely for services.

III

LeRoy further argues his 1977 salary and bonus represent in part adjustments for undercompensation in prior years. Current deductions are permitted for compensation paid for past services, but the burden is on the taxpayer to show the amount of undercompensation per year and the number of years in which it occurred. American Foundry v. Commissioner, 536 F.2d 289, 293 & n. 2 (9th Cir. 1976). LeRoy Hilt failed to meet this burden.

IV

It is clear the Tax Court considered the appropriate factors in determining the level of Leroy Hilt's reasonable compensation for tax year 1977, and that substantial evidence supports the Tax Court's figure of $301,352.

AFFIRMED.