No. 99-1281
In the Supreme Court of the United States
O.S.C. & ASSOCIATES, INC., PETITIONER
v.
COMMISSIONER OF INTERNAL REVENUE
ON PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
BRIEF FOR THE RESPONDENT IN OPPOSITION
SETH P. WAXMAN
Solicitor General
Counsel of Record
PAULA M. JUNGHANS
Acting Assistant Attorney General
ANN B. DURNEY
MARION E.M. ERICKSON
Attorneys
Department of Justice
Washington, D.C. 20530-0001
(202) 514-2217
QUESTION PRESENTED
Whether, on the facts of this case, the payments made by petitioner to its
shareholders were dividends rather than compensation for services rendered.
In the Supreme Court of the United States
No. 99-1281
O.S.C. & ASSOCIATES, INC., PETITIONER
v.
COMMISSIONER OF INTERNAL REVENUE
ON PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
BRIEF FOR THE RESPONDENT IN OPPOSITION
OPINIONS BELOW
The opinion of the court of appeals (Pet. App. A10-A39) is reported at 187
F.3d 1116. The opinion of the Tax Court (Pet. App. A1-A9) is reported at
T.C.M. (RIA) 1997-300.
JURISDICTION
The judgment of the court of appeals was entered on August 16, 1999. The
petition for rehearing was denied on November 2, 1999 (Pet. App. A40). The
petition for a writ of certiorari was filed on January 27, 2000. The jurisdiction
of this Court is invoked under 28 U.S.C. 1254(1).
STATEMENT
1. Petitioner O.S.C. & Associates was incorporated in 1982 (Pet. App.
A15). During the years at issue in this case (1990 - 1992), Allen Blazick
was the chief executive officer and owned 90% of the stock of petitioner.
His wife (Janette Blazick) was the secretary and treasurer of the company
but owned no stock. His brother-in-law (Steven Richter) was the vice president
and owned 10% of the stock. These three individuals were the sole members
of petitioner's board of directors. Allen Blazick started the company as
a small silk-screen business in 1970. Over the years, it grew into a large
printing business with approximately 200 employees (id. at A2, A15).
In 1985, petitioner adopted an Incentive Compensation Plan. The only participants
in the Plan were Blazick and Richter, who were petitioner's only shareholders
(Pet. App. A15). The terms of the Plan expressly provided for the annual
amount of incentive compensation to be allocated "according to stock
ownership" (id. at A16). The amount of incentive compensation was computed
at the end of each fiscal year by first calculating a hypothetical gross
margin amount-a figure derived by multiplying petitioner's actual total
sales by an adjusted industry gross margin ratio. The amount by which petitioner's
actual gross margin exceeded the hypothetical adjusted industry gross margin
was treated as the total incentive compensation amount (id. at A15).
The Plan further provided that, after computing the total incentive compensation
amount and allocating 90% of it to Blazick and 10% to Richter, each participant's
share would then be adjusted under a set formula. Blazick's incentive compensation
was reduced by any inventory shortages in excess of $100,000 for the fiscal
year and by any bad debts. Richter's incentive compensation was reduced
by any inventory spoilage in excess of $100,000 for the fiscal year and
by any production costs in excess of $100,000 for the fiscal year. Pet.
App. A16.
Under this Plan, payments were made to Blazick and Richter that equaled
82% to 94% of petitioner's net income (Pet. App. A16). The payments made
to the shareholders by the corporation during the relevant years were as
follows (id. at A17):
1990 1991 1992
Blazick
salary
$ 155,372
$ 175,485
$ 173,372
ICP
490,860
1,651,146
1,324,608
total
$ 646,232
$1,826,631
$1,497,980
Richter
salary
$ 57,791
$ 64,616
$ 60,000
ICP
98,036
183,461
149,179
total
$ 155,827
$ 248,779
$ 209,179
The accountant who made the annual calculations required by the Plan acknowledged
that the method used to determine petitioner's cost of goods sold was not
consistent with generally accepted accounting principles. He also acknowledged
that he had made numerous errors in calculating the amount of the incentive
compensation to be paid in each year in issue, all of which had the effect
of increasing the amounts paid to Blazick and Richter under the Plan (Pet.
App. A17-A18).
Since its incorporation, petitioner has never expressly declared or paid
any dividends to its shareholders (Pet. App. A18). A credit memorandum prepared
by an officer of Union Bank in 1992 contains the following statement (ibid.):
[Blazick's] salary for 1991 was over $1.8 MM. The reasoning behind the higher
salary is taxable income. Mr. Blazick does not intend to be taxed twice
for the profitability of his business. He contends taking the higher salary
will increase his personal tax liability, but this rate is lower than the
corporate tax rate.
For each year in issue, petitioner claimed a deduction on its income tax
return for the total amount of payments made to Blazick and Richter (Pet.
App. A5, A17). When the Commissioner of Internal Revenue disallowed most,
but not all, of the payments made pursuant to the Plan for each year, petitioner
sought review of the Commissioner's determinations in the Tax Court (id.
at A18).
2. Following a trial, the Tax Court upheld the Commissioner's determinations.
In doing so, the Tax Court applied (Pet. App. A6) the two-prong test set
forth in 26 U.S.C. 162(a)(1) and in Elliots, Inc. v. Commissioner, 716 F.2d
1241, 1243 (9th Cir. 1983). That test limits deductible salary expenses
to those that are (i) reasonable in amount and (ii) actually paid for services
actually provided. The factors relied on by the Tax Court in applying this
test included the following: (i) the total compensation paid to Blazick
and Richter represented approximately 90% of petitioner's net income, (ii)
petitioner never declared or paid a dividend, and (iii) petitioner's annual
payments "had the effect of arbitrarily increasing allocations above
the amounts the plan authorized" (Pet. App. A6-A7). The Tax Court noted
that "the most persuasive evidence of petitioner's lack of compensatory
intent is the plan itself," for (i) it applied only to shareholders,
(ii) payments were allocated according to stock ownership, and (iii) the
Plan did not even purport to use the value of services rendered as the basis
for calculating the amounts due (id. at A7). The Tax Court also sustained
the addition to tax for negligence because "the plan was both designed
and manipulated to direct the flow of corporate earnings to Messrs. Blazick
and Richter and to disguise such payments as compensation" (id. at
A9).
3. The court of appeals affirmed, with one judge dissenting (Pet. App. A10-A39).
The court held that the Tax Court had correctly applied the two-prong test
and that its finding that the payments were disguised dividends, and were
not made for services actually rendered, was not clearly erroneous (id.
at A21-A22). The court noted that, under its prior decision in Elliotts,
Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), "if there
is evidence that the payments contain disguised dividends, the corporation
must separately satisfy both the reasonableness and the compensatory intent
prongs of the test. Reasonableness alone will not suffice" (Pet. App.
A21).
Judge Wiggins dissented "from the well-written Majority Opinion"
(Pet. App. A23). He concluded that the Tax Court should have made an independent
apportionment between the amount allowed as deductible compensation and
the amount determined to be non-deductible disguised dividend payments (ibid.).
ARGUMENT
The decision of the court of appeals is correct and does not conflict with
any decision of this Court or any other court of appeals. Further review
is therefore not warranted.
1. a. Section 162(a) of the Internal Revenue Code allows a deduction for
"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." 26 U.S.C. 162(a)(1) (1994 & Supp. III 1997).
To be deductible under this Section, compensation must be reasonable in
amount and for personal services actually rendered. Elliotts, Inc. v. Commissioner,
716 F.2d at 1243; University Chevrolet Co. v. Commissioner, 199 F.2d 629,
630 (5th Cir. 1952). This two-pronged test is applied most commonly with
closely-held corporations "having few shareholders, practically all
of whom draw salaries," where "[a]n ostensible salary paid by
a corporation may be a distribution of a dividend on stock" and thus
a disguised distribution of profits.
26 C.F.R. 1.162-7(b)(1). Accord University Chevrolet Co. v. Commissioner,
199 F.2d at 630. Bonuses paid to employees are deductible "when such
payments are made in good faith and as additional compensation for the services
actually rendered by the employees, provided such payments, when added to
the stipulated salaries, do not exceed a reasonable compensation for the
services rendered." 26 C.F.R. 1.162-9. Regardless of its form, compensation
may not be deducted if it exceeds an amount that is reasonable under all
the circumstances-an amount that "would ordinarily be paid for like
services by like enterprises under like circumstances." 26 C.F.R. 1.162-7(b)(3).
When a taxpayer challenges the Commissioner's disallowance of a claimed
deduction, the taxpayer bears the burden of proving that the Commissioner's
determination is incorrect. Tax Ct. R. 142(a); Welch v. Helvering, 290 U.S.
111 (1933); Botany Worsted Mills v. United States, 278 U.S. 282, 289-290
(1929) (burden rests upon corporate taxpayer to show that payments to directors
were ordinary and necessary business expenses); see also Griffin & Co.
v. United States, 389 F.2d 802, 810 (Ct. Cl. 1968). The taxpayer bears the
burden of proving both that the payments were reasonable in amount and that
the payments were for services actually rendered. Nor-Cal Adjusters v. Commissioner,
503 F.2d 359, 362 (9th Cir. 1974); Ruf v. Commissioner, 1993 T.C.M. (RIA)
¶ 93,081, aff'd, 57 F.3d 1078 (9th Cir. 1995). This burden is particularly
heavy when, as here, the challenged compensation has been paid to the shareholders
and officers of the corporation. See, e.g., Rapco, Inc. v. Commissioner,
85 F.3d 950, 954 (2d Cir. 1996); Pepsi-Cola Bottling Co. of Salina, Inc.
v. Commissioner, 528 F.2d 176, 179 (10th Cir. 1975); Griffin & Co. v.
United States, 389 F.2d at 810. Particular scrutiny is warranted when such
payments are made to the shareholders of closely-held corporations, who
are in a position to direct distributions of corporate profits in the form
of excessive salary payments in an effort to obtain an improper deduction
for dividends. Botany Worsted Mills v. United States, 278 U.S. at 293. See
also Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1322-1323
(5th Cir. 1987); Charles Schneider & Co. v. Commissioner, 500 F.2d 148,
151 (8th Cir. 1974), cert. denied, 420 U.S. 908 (1975); 26 C.F.R. 1.162-7(b)(1).
b. The Tax Court correctly sustained the Commissioner's determination that
certain amounts paid by petitioner to Blazick and Richter were not reasonable
compensation for services actually rendered during the years at issue but
were instead dividends paid because of their stock ownership (Pet. App.
A8). The Tax Court's findings on this issue were properly upheld by the
court of appeals. As that court concluded (Id. at A21):
The Commissioner did indeed come forward with overwhelming evidence of disguised
dividends, evidence that fully supported the Tax Court's conclusion that
the plan allocations were not intended as compensation, regardless of whether
the amounts could be justified as reasonable.
These findings, "concurred in by two lower courts" (Rogers v.
Lodge, 458 U.S. 613, 623 (1982)), do not warrant further review. See Tiffany
Fine Arts, Inc. v. United States, 469 U.S. 310, 317-318 n. 5 (1985).
2. Petitioner errs in asserting that the courts below created and applied
"a new all-or-nothing 'compensatory intent' test" (Pet. 7). In
applying the two-pronged test under this statute, the Tax Court correctly
found that petitioner had failed to prove that payments made to Blazick
and Richter-in excess of the amounts allowed by the Commissioner- were made
for services actually rendered. The court of appeals agreed with the Tax
Court that the Commissioner had presented "overwhelming evidence of
disguised dividends, evidence that fully supported the Tax Court's conclusion
that the plan allocations were not intended as compensation" (Pet.
App. A21). The court cited numerous objective factors that supported that
finding: (i) that petitioner paid Blazick and Richter approximately 90%
of its net income each year; (ii) that petitioner had never paid dividends;
(iii) that the Plan was manipulated to increase the payments made to petitioners;
and (iv) that the Plan applied only to shareholders and allocated payments
according to stock ownership instead of according to the value of services
rendered (id. at A21-A22).
Petitioner incorrectly contends (Pet. 8-20) that, even though the challenged
payments were not compensation for services at all, the Tax Court should
nonetheless have made some sort of apportionment of the payments between
dividends and compensation. The burden was on petitioner to show that some
portion of the amount at issue was reasonable compensation paid for services
actually rendered. Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 362
(9th Cir. 1974). Petitioner failed to meet that burden in this case. Indeed,
as the court of appeals noted, it was petitioner that had urged an "all
or nothing" approach in this case (Pet. App. A18 n.2):
OSC does not raise and we do not address any apportionment issue, i.e.,
whether any further portion of the disallowed part of the incentive compensation
should have been allowed as reasonable compensation. OSC's contention is
that the entirety of the claimed amounts of incentive compensation should
have been allowed.
Petitioner is plainly wrong in claiming that "a finding that there
was no compensatory intent necessarily means that no services were provided"
(Pet. 19-20) (emphasis omitted). Independent of their "incentive"
plan payments, Blazick and Richter received significant salaries; the deductions
claimed by petitioner for those salary payments were allowed by the Commissioner.
Indeed, the Commissioner allowed deductions for compensation paid to Blazick
and Richter that totaled $444,606, $494,437, and $508,482 for the years
1990, 1991, and 1992, respectively. The Tax Court and court of appeals sustained
those determinations; neither they nor the Commissioner applied an "all-or-nothing"
test (Pet. App. A17).*
3. a. Petitioner errs in contending (Pet. 11-14) that the decision in this
case conflicts with Commissioner v. R.J. Reynolds Tobacco Co., 260 F.2d
9 (4th Cir. 1958). In R.J. Reynolds, the company adopted a by-law under
which a specified percentage of its profits was paid to employees each year
in proportion to their stock ownership of the company. The company paid
relatively small salaries, and the amount of stock owned by each employee
was not directly related to the employee's value to the company. The Commissioner
argued that the payments made under the by-law were dividends, rather than
compensation, and therefore not deductible by the company. The Fourth Circuit,
however, sustained a finding of the Tax Court that a portion of the by-law
payments for each year represented reasonable compensation rather than dividends.
The Fourth Circuit rejected the Commissioner's argument that all of the
by-law payments "were necessarily of the same nature, and hence either
all dividends or all compensation." 260 F.2d at 12. The court stated:
If there is a reasonable basis in the record for isolating that part of
the payment which is reasonable compensation for services, we think that
a deduction for that part should be allowed. This is true whether the excess
is classified as unreasonable compensation or as dividends. There is no
basis in reason, the Tax Code, or administrative practice for the insistence
that the part which is not deductible fatally infects the part which clearly
is.
Ibid. (emphasis added).
Contrary to petitioner's assertion (Pet. 13), the Commissioner did not make
the same "all-or-nothing" argument rejected by the court in R.J.
Reynolds. In this case, the Commissioner determined that all of the amounts
paid as salary plus a portion of the amounts paid to Blazick and Richter
under the ICP for each year were reasonable and were paid as compensation
for services rendered. Only a portion of the ICP payments was disallowed
for each year (Pet. App. A5). The conclusion of the courts below that, on
the record of this case, petitioner failed to prove that some additional
portion of the payments made under the Plan was for services rendered does
not conflict with the decision of the Fourth Circuit in R.J. Reynolds.
b. Petitioner similarly errs in asserting (Pet. 14-17) that the decision
in this case conflicts with the decision of the Fifth Circuit in Owensby
& Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (1987). Petitioner contends
(Pet. 16) that in Owensby, unlike in this case, "no independent, all-or-nothing
'compensatory intent' test was applied to preclude an apportionment of the
compensation payments." In fact, however, as we just described, the
courts below in this case held simply that the portion of the Plan payments
challenged by the Commissioner represented disguised dividends, rather than
compensation. Nothing in that finding, anchored as it is in the particular
facts of this case, conflicts with either the holding or the rationale of
Owensby.
CONCLUSION
The petition for a writ of certiorari should be denied.
Respectfully submitted.
SETH P. WAXMAN
Solicitor General
PAULA M. JUNGHANS
Acting Assistant Attorney General
ANN B. DURNEY
MARION E.M. ERICKSON
Attorneys
MARCH 2000
* Petitioner errs in asserting (Pet. 17-19) that the decision in this case
conflicts with 26 C.F.R. 1.162-7(a). That regulation states that "[t]he
test of deductibility in the case of compensation payments is whether they
are reasonable and are in fact payments purely for services." Ibid.
That is precisely the determination made by the courts below in this case.