Aries Communications Inc. v. Commissioner, 2013 Tax Ct. Memo LEXIS 111 (April 10, 2013)

What qualifies as a reasonable success fee for the employee who is also the hands-on owner of the company and played a key role in the profitable sale of some of the company’s major assets? This was the issue for experts in front of the Tax Court following the IRS’s disallowance of most of the compensation the company had claimed as a deduction for the tax year ended (TYE) 2004.

In 1983, the owner/employee incorporated the petitioner in California. He was its sole shareholder and used the company to buy and sell radio stations. He also served as its president, CFO, and general manager for the various stations. The company was a complex enterprise with multiple subsidiaries that each owned stations. Before it sold off some of its major assets in 2003 and 2004, it had gross receipts of over $4.5 million. But records showed that from 1999 to 2002 and immediately after the two years of major asset sales, it was losing money. As early as 2001, the company guaranteed a $20 million Goldman Sachs debt, as did the owner personally. A forbearance agreement required it to sell some of its radio stations to satisfy its obligations under the debt.

In 2003, the owner hired a broker to assist with the sale of one station; specifically, the broker was to find prospective buyers of whom the employee was not aware. But the owner himself procured the first bid, which was in the $18 million-to-$20 million range; subsequently, he managed to persuade the bidder to increase the offer to $28 million. At the owner’s suggestion, the broker obtained a rival bid for $33 million, which persuaded the first bidder to agree to a final price of $35 million.

In 2004, the petitioner sold certain assets of another station, including FCC licenses. Before the sale, the prospective buyer offered $12 million for the station, but the owner rejected the bid, making it clear he wanted $18 million. He used the broker to complete the transaction at that price.

For TYE 2004, the petitioner showed a net profit of approximately $4 million and retained earnings of over $12.7 million. It paid the owner nearly $137,000 in salary, $62,500 in commissions, and $6.7 million as a bonus, totaling $6.9 million—all of which it claimed as a tax deduction.

The IRS issued a notice of deficiency, disallowing nearly $6.1 million and finding a deficiency of nearly $2.7 million. At trial, both parties presented expert testimony on reasonable compensation.

Regression analysis ‘not useful.’

The petitioner’s expert had over 40 years of experience in compensation and personnel matters. To render an opinion, he reviewed the financial statements of 10 publicly traded radio broadcasting companies, including Clear Channel. He calculated their pretax revenues and compared them to the petitioner’s revenue; similarly, he compared the compensation these companies paid to their CEOs to the amount the petitioner paid to the owner. Because the comparables were publicly traded and the compensation they
paid required approval of the boards of directors and state and federal regulators, the expert believed it represented an arm’s-length transaction.

In his report, he said that fixed compensation—annual salary and special benefits to the individual—”tended to” correlate to annual company sales or revenues. To show the correlation, he used a linear regression analysis, specifically the trend lines for the correlation of the CEOs’ fixed compensation to annual revenues at the 75th percentile to account for the employee’s experience in the industry and his status as owner/operator.

Using the same method, the expert also found that variable compensation—annual bonuses and the value of long-term stock awards or long-term incentive payouts during the year—suggested a correlation to the company’s profitability. He concluded that, in this case for TYE 2004, reasonable fixed compensation for the owner was approximately $439,000; as for variable compensation, approximately $3.2 million would have been a reasonable bonus for TYE 2003 and $4.7 million for TYE 2004.

The government initially presented an expert to challenge the analysis and conclusions of the petitioner’s expert. His rebuttal focused on four major flaws in the expert opinion: (1) It rested on a model analysis that used return on sales as its principal, if not sole, measure of financial performance; (2) given that the comparables the expert had used all had higher revenues than the petitioner, the regressions were used to extrapolate rather than interpolate; (3) on the basis of the p-values, the coefficients were not useful; and (4) on the basis of the R-squareds, the regressions did not explain the variation in either the fixed or the variable compensation. The expert’s regression analysis was “not useful” because it did not allow for a “positive conclusion about the reasonableness of the [owner’s] compensation,” the rebuttal expert stated.

Third expert frames issue differently.

Subsequently, the government retained a second expert with long experience in compensation to determine what would be reasonable compensation in this case. He, too, used regression analysis, and scattergrams, to show the correlation between compensation and revenue, net income and profit margin.

Focusing on the position of general manager, he first reviewed data from the National Association of Broadcasters (NAB) and from the Economic Research Institute on executive officer compensation and broadcaster gross income and profitability. Because the employee served as general manager for multiple stations and also as president and CEO, the expert applied a 75% premium to the stated figures. Averaging the resulting total compensation, he
arrived at approximately at $287,700 and compared it with the employee’s actual 2004 compensation. He then discounted the $287,700 backward to compare it with actual compensation in 2003, 2002, and 2001. The results, he stated, showed that for the four years the employee was underpaid by a total of about $173,100, excluding the bonus. If the calculation included the bonus, however, he was overpaid over four years by a total of nearly $8.4 million.

In addition, he compared the actual compensation to data from broadcast company proxies available on the kenexa.com database. But this information included compensation amounts for a number of television and radio companies that, based on revenues, were much large than the petitioner.

As he put it, the question as to the size of the bonus was this: “Assuming the owner acted as a consultant to [the broker], how much were his services worth to improve the $12 million offer to $18 million?” By the expert’s calculation, a reasonable bonus for securing the additional $6 million of value was $210,000. When he combined his methods, he found that total reasonable compensation for the owner was approximately $635,450.

By contrast, at trial the petitioner argued that all of the owner’s compensation for TYE 2004 was reasonable; it included “catch-up” payments for prior years of underpayment and a justifiable bonus considering the owner had “masterminded and facilitated” the sale of the two radio stations.

‘External comparisons are difficult.’

Following 9th Circuit law, the Tax Court considered several factors relevant to its reasonableness analysis. They included: (1) the employee’s role in the company; and (2) a comparison of the employee’s salary with salaries similar companies pay for similar services.

(1) Employee’s role in company. At issue was the overall significance of the employee to the company and his general importance to its success.

The government argued that, regardless of the key role the owner played in the company, he was not pivotal to the successful sale of the petitioner’s major assets. Rather, the sale was profitable because of the significant appreciation of the FCC licenses.

The Tax Court disagreed. That the licenses were “the principal driving force behind the sale and the key component of the sale price of the subsidiaries” did not diminish his contribution as an employee of the corporation, it said. The owner decided to acquire and maintain the licenses. But the court recognized that his role begged the question of whether he invested in the licenses personally, as a passive owner/investor in the company, or made an investment decision in his capacity as the CEO of the company. If the former, there would be justification for the government’s position to disallow the deduction of most of his salary. But since the corporate entities had bought the licenses, the owner had made the decisions to
do so in his role as CEO and the corporation should compensate him for his successful strategy, the court determined.

(2) Comparison of salaries. At the outset, the court recognized that the case presented a unique situation. The company was one of a very few in the industry in which the owner was also the operator. Because “external comparisons are difficult,” the court said, the parties retained experts to calculate reasonable compensation.

In assessing their “very divergent” opinions, the court referred to the concerns the government’s rebuttal expert had expressed about mathematical imprecision.

As to the objection that the petitioner’s expert used the regressions to extrapolate rather than interpolate, the court noted that scant financial data were publicly available for companies in the radio industry that were similar in size to the petitioner. Even the government’s second expert admitted that his data related to companies much larger than the petitioner, “yet I can still learn from their compensation practice.”

The court agreed with the rebuttal expert that the p-values showed that the petitioner expert’s regression analysis was not strong but said that these values did not make the analysis completely irrelevant in this case.

As to the R-squared value—”an indicator of the robustness of the regression equation”—the analyses of both government experts produced similar values, which were not strong in describing the mathematical precision of the results of the regression models, the court said. This finding went toward the weight the court would attribute to the experts’ conclusions.

In terms of fixed compensation, the petitioner’s expert and the government’s second expert agreed that the owner was underpaid for four years, the court noted. The former calculated that for that period a total of $1.7 million was reasonable compensation, while the latter said it was $1.1 million. The owner’s actual pay was $914,500. Given the R-squared values and p-values of the regression analysis of both experts, the court decided that their opinions
deserved equal weight. It averaged their conclusions and found the total should have been approximately $1.4 million. This meant the owner was underpaid by $462,000.

The greatest difference appeared with respect to the bonus, the court pointed out, rejecting both experts’ conclusions. Not only was the owner acting as CEO, responsible for increasing the sale from $12 million to $18 million, that is, by 50%, he also was significantly involved in acquiring, managing, and selling the investment. While it was true that, as a shareholder
and the chief executive of the company, he had reasons to pursue the highest sale price possible, “his efforts as an employee are still entitled to reasonable compensation for services actually rendered.” Based on “our best judgment” and the evidence on record, the court found an appropriate bonus would be one-third of the increase in the sale price, that is, $2 million.

Given these and several other considerations, the Tax Court concluded the petitioner could deduct a total of approximately $2.7 million as reasonable compensation: $462,000 representing four years of underpayment, $199,300 representing the actual fixed salary for TYE 2004, and the $2 million bonus the court found reasonable. It also held the petitioner liable for a section 6662(a) accuracy-related penalty.