Thursday, July 14, 2005

Elmo Would Be Tickled

In a memorandum decision, E.J. Harrison & Sons, Inc. v. Commissioner, the Ninth Circuit overruled the Tax Court's determination that certain payments allegedly for compensation of the principal shareholder were unreasonable and thus not deductible.

The corporation was owned by Mrs. Harrison and her three sons. (The founder, Elmo Harrison, had died prior to the years in question.) In the years 1995, 1996, and 1997, Mrs. Harrison was paid compensation of almost $2.3 Million. In the same three year period, each of the sons was paid approximately $1.3 Million. The Tax Court found that a reasonable compensation for Mrs. Harrison in the three years in question would only be a total of about $300,000. The Tax Court's decision was based upon its conclusion that Mrs. Harrison's role in the corporation was equivalent to that of an outside board chair. In particular, the Tax Court had rejected ascribing any part of her compensation to her agreeing to guarantee loans to the company.

With respect to the loan guarantee issue, the Circuit Court seemed to be doing its own fact finding. Thus, it stated that:
Although the Harrison sons also provided personal guarantees, Mrs. Harrison's guarantee was key because she possessed greater wealth than the others and the lender viewed her as the decision-maker.
Compare this statement to the findings of the Tax Court:
Petitioner has also failed to establish what amount, if any, would have constituted a reasonable fee for Mrs. Harrison's personal guaranties . . . . There is no evidence of any significant financial risk to her. She was one of four guarantors, each jointly and severally liable for the guaranteed amounts. None of her property was encumbered under the terms of the guaranties, and there was never any threat of default by petitioner as primary debtor. Nor has petitioner shown that there was a disproportionate reliance by the bank on Mrs. Harrison's personal assets to satisfy the potential obligations of the guarantors. Mr. Summers, when asked why the bank required Mrs. Harrison to sign the guaranties, responded that the bank "wanted additional strength or support behind * * * [the collateral], and with her liquidity base, it was important to have her involvement." But it is entirely possible that Mr. Summers would have provided a similar response had he been asked why the bank had required guaranties from [the sons]. Moreover, it appears that much of Mrs. Harrison's wealth may have actually been attributable to the estate of her late husband in the form of the Survivor's Trust that acted as the coguarantor of the $16 million replacement guaranty executed in 1998. There is no evidence as to the relative values of the interests of Mrs. Harrison, Myron, James, and Ralph in the assets of that trust. Finally, the financial risk to Mrs. Harrison from guaranteeing loans to petitioner was further reduced to the extent that the Bank of America line of credit resulted in loans to [a related corporation].
(Emphasis added.)

The Circuit Court also gave significant weight to the day-to-day services rendered by Mrs. Harrision and her alleged decision-making authority. The Tax Court was fairly dismissive of her contributions in both of these areas.

The Circuit Court remanded the case to the Tax Court for further consideration, concluding that:
The reasonableness of Mrs. Harrison's compensation should have been evaluated based on her actual role as President of the corporation. At the very least, Mrs. Harrison's reasonable compensation should not have dropped below that of her sons during the audit years.
The Ninth Circuit's opinion is three and a half pages long. It addresses a variety of factors, (e.g., the loan guarantees, the actual services rendered by Mrs. Harrison, etc.), but never in a terribly analytical manner. Thus, by way of example, the Court does not attempt to ascribe specific values to any individual factor.

In contrast, the Tax Court's opinion (excluding the findings of facts), runs for thirty-four pages. The detailed statement of facts adds an addition twelve pages. The Tax Court's opinion is extradinarily analytical, setting forth in detail, for instance, the factors that warrant a reasonable allowance for the extension of a personal guaranty, and detailing why those factors were not present in this case.

The Ninth Circuit's opinion is little more than an expression of its judgment, relatively untethered to principle. Ultimately, the holding in E.J.Harrision can be summed up by paraphrasing Justice Stewart: "We may not be able to define reasonable compensation, but we know it when we see it." Of course, this formulation, if it can be called that, provides no real guidance to taxpayers, tax practitioners, or the government.

No comments: