United States Court of Appeals

For the First Circuit

No. 02-1761

HAFFNER'S SERVICE STATIONS, INC.,

Petitioner, Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent, Appellee.

APPEAL FROM A DECISION OF THE UNITED STATES TAX COURT

[Hon. David Laro, U.S. Tax Court Judge]

Before

Boudin, Chief Judge,

Torruella and Lipez, Circuit Judges.

Kenneth A. Cohen, P.C. with whom Don M. Kennedy, P.C., Jeffrey

Alan Simes, Collin O'Connor Udell and Goodwin Procter LLP were on

brief for petitioner.

Andrea R. Tebbets, Tax Division, Department of Justice, with

whom Richard Farber, Tax Division, Department of Justice, and

Eileen J. O'Connor, Assistant Attorney General, were on brief for

respondent.

March 31, 2003
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BOUDIN, Chief Judge. The Commissioner of Internal Revenue

(the "Commissioner" or "IRS") assessed deficiencies against the

taxpayer Haffner's Service Stations, Inc. ("the company" or the

"taxpayer") for the three subject years (1990-1992), disallowing the

deduction of certain bonuses and imposing the accumulated earnings

tax. 26 U.S.C. §§ 162, 531-37 (2000). The Tax Court agreed with

the Commissioner, Haffner's Serv. Stations, Inc. v. Comm'r, 83

T.C.M. (CCH) 1211 (2002), and the company has now appealed to this

court. 26 U.S. § 7482 (2000).

The background facts are undisputed. The taxpayer is a

close corporation that sells oil and gas in Massachusetts and New

Hampshire through its own service stations and by delivery. 

Throughout the tax years in question, Louise Haffner held all of the

voting shares of the company, and together with her husband Emile

Fournier a significant minority of the nonvoting shares. The

remaining nonvoting shares were held by their children, and by two

trusts of which Louise was the trustee (Emile was co-trustee of one)

and their children the beneficiaries.

In 1989, two of Louise and Emile's five children (Susan

and Richard) filed suit against them in state court, alleging breach

of fiduciary duty arising from a 1961 transfer of voting shares from

one of the trusts to Louise. In July 1990, Louise and Emile offered

to settle Richard's suit for $650,000, including a redemption of

Richard's shares in the corporation. Richard countered that his
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shares were worth at least $16 million, and no settlement occurred.

In 1995, a third child (Joline) joined the suit. In 1996, a state

court ruled that a breach had occurred, and that the transfer of

shares had to be rescinded and an independent trustee appointed.

After the rescission, Louise still held about 84 percent of all

voting shares. Haffner's, 83 T.C.M. (CCH) at 1214.

During each subject year, Louise, Emile and their sons

Haff and Richard, were employees of the company; Louise, Emile and

Haff also constituted the board of directors. Haff was the

president of the company and made most major business decisions.

For the three subject years, Haff received compensation of

approximately $742,400 (including a bonus of $625,000), $592,000,

and $469,250, respectively. Richard was the vice president of the

company, responsible for monitoring station condition and collecting

money from three of the stations. His compensation was

approximately $50,000 in each subject year. Haffner's, 83 T.C.M.

(CCH) at 1215.

Louise was the treasurer of the company, and Emile the

assistant treasurer and secretary. Louise and Emile performed

various office duties, such as answering the telephone and signing

checks; but they also discussed many of the business decisions with

Haff. Their salaries were never higher than $20,000 per year and

there is no evidence that they received substantial bonuses in prior

years. For the subject years, Louise and Emile received identical
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bonuses of $625,000, $475,000, and $250,000. The company allocated

$100,000 from each of their 1990-91 bonuses to a related corporate

entity, and deducted the rest on its tax return. The IRS disallowed

the company's deductions as unreasonable. Haffner's, 83 T.C.M.

(CCH) at 1215-16.

The company has never paid a dividend. In 1989, its

accountant recommended a build-up in reserves in contemplation of a

share redemption in connection with the family litigation. At the

end of 1989, the company's unappropriated retained earnings were

roughly $4.9 million; this figure rose to $6.3 million, $7.2

million, and $7.9 million, respectively, at the end of each subject

year. In 1996, the IRS notified the taxpayer that it would impose

the accumulated earnings tax on the increase in retained earnings

for the three years in question. See 26 U.S.C. § 535(a). The

company argued in the Tax Court that the accumulation was reasonable

for various business purposes, including the redemption of the

shares of dissenting shareholders. 

The Tax Court rendered a detailed opinion, sustaining the

Commissioner's deficiency assessments but striking down the

Commissioner's imposition of penalties. Haffner's, 83 T.C.M. (CCH)

at 1212. The taxpayer has now appealed to challenge both the

disallowance of the bonuses and the imposition of the accumulated

earnings tax. We review questions of law de novo but fact findings

of the Tax Court only for clear error. 26 U.S.C. § 7482(a)(1); Fed.
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R. Civ. P. 52; MedChem (P.R.), Inc. v. Comm'r, 295 F.3d 118, 122

(1st Cir. 2002). Clear error exists if, on the entire record, the

court is "left with the definite and firm conviction that a mistake

has been made." Mitchell v. United States, 141 F.3d 8, 17 (1st Cir.

1998).

Compensation. Under current law, both dividends and wages

are treated as ordinary income to the recipient and taxed at the

same rate. But for the corporation that makes the payments, wages

are deductible while dividends are not. In close corporations,

there is an obvious incentive to disguise dividend distributions as

compensation expenses. See 26 C.F.R. § 1.162-7(b)(3) (2002). The

opportunity exists because leading shareholders are also often

managers of the company, and the benefit is obvious: by reducing

corporate taxes, more accrues to the shareholders. See generally,

e.g., 7 Mertens Law of Federal Income Taxation §§ 25E:04, 25E:29

(1996) ("Mertens").

The Internal Revenue Code limits deductibility to

"reasonable" compensation, 26 U.S.C. § 162(a)(1), which serves in

part as a safeguard against conversion of dividends into salary.

Treasury regulations--which are binding on us unless inconsistent

with the statute, see Boeing Co. v. United States, No. 01-1209, slip

op. at 9-10 (U.S. March 4, 2003)--require reasonableness to be based

on "all circumstances." 26 C.F.R. § 1.162-7(b)(1) (2002). What
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subsidiary factors are considered in this test of reasonableness is

apparently a question of first impression in this circuit.

Other circuits and the Tax Court have employed multifactor tests, the factors ranging from a handful to almost two dozen

in various formulations. See Bittker & Lokken, Federal Taxation of

Income, Estate and Gifts ¶ 22.2.2 (3d ed. 1999) (collecting cases

and discussing factors); 7 Mertens, § 25E:11-29 (same). By and

large, longer lists include elements that, in shorter ones, are

grouped together. The Second Circuit offers a typical example of a

short collection: the employee's role, payments by comparable

companies, nature and condition of the company (e.g., earnings),

incentives to distort, and consistency of compensation within the

company. Dexsil Corp. v. Comm'r, 147 F.3d 96, 100 (2d Cir. 1998).

The Seventh Circuit, in Exacto Spring Corp. v.

Commissioner, 196 F.3d 833 (7th Cir. 1999), has vividly criticized

the existing multi-factor tests as unpredictable. Id. at 835. The

company reads the decision as laying down a single-factor test which

asks whether "an independent investor" would approve the disputed

compensation as a reasonable reward for the manager's performance.

It asks us to adopt the test for this circuit. But in Exacto Judge

Posner conceded that the independent investor test was not an

exclusive answer to the problem, id. at 839, and Exacto's emphasis
1The compensation at issue in Exacto was that of the chief

executive, presumptively due the primary credit for any successes,

196 F.3d at 839, and all the traditional factors favored the

taxpayer or were neutral, id. at 836-37.

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on the company's profits reflected in part the character of that

case.1

There is always a balance to be struck between simplifying

doctrine and accuracy of result, and for the present we think that

multiple factors often may be relevant. Exacto remains a useful

reminder that reasonableness under section 162(a)(1) is not a moral

concern or a matter of fairness; the inquiry aims at what an arm'slength owner would pay an employee for his work. The problem is

that the actual payment--ordinarily a good expression of market

value in a competitive economy--does not decisively answer this

question where the employee controls the company and can benefit by

re-labeling as compensation what would otherwise accrue to him as

dividends.

Turning to the principal pertinent factors, the one

nominally most helpful to the taxpayer here is its general

performance and, in particular, the return on equity ("ROE"), which

averaged 24.6 percent during the period 1977-92 as compared with

17.4 percent for peer companies. The Tax Court said that the data

underlying the comparison were unreliable, Haffner's, 83 T.C.M.

(CCH) at 1218-19; and as support the IRS notes that the average

pertained to the 16-year period rather than the subject years and
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that the ROE and net income both declined substantially during the

subject years.

Certainly the ROE for the longer period looks impressive

and other factors (growth in revenues and profits) show an upward

curve over that period. But the decline in ROE and net income

during the subject years, accompanied by a spike in bonuses, does

raise substantial questions as to whether the increase was for

performance, whether the performance merited the compensation, and

whether, in any case, any successful performance can be properly

attributed to Louise and Emile.

Comparability of compensation is another common gauge, see

26 C.F.R. § 1.162-7(b)(3), operating in two quite different

dimensions. One is with pay for similar jobs at like companies; the

other is a comparison with others within the same company,

especially non-owner employees, making the appropriate adjustment

for differing responsibilities. Here, the Tax Court found that the

comparability evidence either affirmatively undercut or did not

support the company's position. Haffner's, 83 T.C.M. (CCH) at 1224.

In the end, the issue depends in part on what roles Louise and Emile

played.

As to horizontal comparison across companies, the

taxpayer's expert said that Louise and Emile's compensation for the

subject years was about 7-8 percent of gross income (20-23 percent

of net) and within the range for peer companies. The Tax Court
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criticized this assessment on several grounds (e.g., that the

comparison grouped the top three executives together and that

publicly traded companies were not comparable) and found the numbers

still too high. Haffner's, 83 T.C.M. (CCH) at 1220, 1222. The IRS

argues as well that a comparison with peer companies based on

similar job titles means little where, as here, Louise and Emile did

not (in the Commissioner's view) perform meaningful roles.

As to comparability within the company, the data at best

do not help the taxpayer and at worst hurt its position. Haff

himself received handsome bonuses, but he was the CEO and his

responsibility is undisputed. No one else in the company received

significant bonuses and, as the IRS points out, Louise and Emile's

bonuses in 1990 were each 12.5 times the salary of the next highest

paid employee. Of course, if Louise and Emile were the strategic

brains of the company, the differential can be explained; but it

turns out that they were not.

This brings us to their roles in the company. The

taxpayer showed that they were devoted to the business and worked

long hours, but there was little concrete evidence that their roles

during the years in question were very important. Many of their

functions were mundane (e.g., answering the telephone); and

relabeling the signing of checks as "responsible for . . . banking

relationships," as the taxpayer did here, is poor stuff. Neither

Haff, who testified that he consulted with his parents regularly,
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nor other employees could give specific examples of policy decisions

that Louise and Emile made during the subject years.

The Tax Court's view that Louise and Emile did not play

major executive roles is not clearly erroneous and this conclusion

undermines the support for very high bonuses. Even if the company

performed well in the subject period and even if executives at

comparable companies got large packages--both disputable premises--a

neutral owner would not pay Louise and Emile handsomely for

producing results for which others, or merely good economic times,

were responsible.

The company argues that present compensation can

legitimately reward past underpayment, and we do not mechanically

exclude this possibility. See, e.g., Bittker & Lokken, ¶ 22.2.2, at

22-24 & n.22. But such make-ups can be more convincingly defended

as market-based where performance is improving and retention of a

key executive a matter of forward-looking concern. Here,

performance was not improving; evidence of past executive

contributions was sparse; and there was almost nothing to show that

Louise and Emile were vital cogs in the subject years or likely to

be so in the future.

In the end, we agree with the Tax Court that the bonuses

deducted by the company were unsupported; the IRS has not challenged

the portion of the bonuses allocated to an affiliated company but,

as the affiliate is a subchapter S corporation, deductibility is not
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an issue. Perhaps a more modest bonus from the taxpayer would not

have been challenged or could have been more easily defended, but

the taxpayer has staked its position on defending the bonuses

actually paid and we have no basis for substituting a smaller figure

for which it has not argued.

Accumulated Earnings Tax. Section 531 of the Internal

Revenue Code imposes an accumulated earnings tax on a corporation

"availed of for the purpose of avoiding" the personal income tax on

shareholders by accumulating rather than distributing earnings.

Although this language is couched in terms of purpose, the statute

goes on to provide that an accumulation beyond the reasonable needs

of the business is ordinarily "determinative of the purpose to

avoid" tax. 26 U.S.C. § 533(a); United States v. Donruss Co., 393

U.S. 297, 307 (1969). In this case, as in most section 531 cases,

the touchstone is reasonableness.

In the Tax Court, the company offered several potentially

legitimate business reasons for this accumulation, among them to

resolve family litigation, to counter competition from better

financed and more established companies, to finance necessary

supplies of oil and gas, and to pay for regulatory compliance. The

Tax Court rejected the first ground on the merits and the others as

contrived after-thought justifications. We start with the family

litigation ground initially advanced by the taxpayer and then return

to the others.
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In 1989, the same year that Richard and Susan began their

law suit, the company accountant told the company that a redemption

of their stock was a plausible solution and that the company should

"start building up the reserves." One figure demanded by Richard

was $16 million, although the company thought at the time that this

was wildly inflated. The company asserted in the Tax Court that it

needed a reserve of $10 million to protect against litigation costs

and the potential cost of redemption--admittedly, this amount

exceeds its full retained earnings including the three-year

accumulation contested by the IRS.

Although this might at first appear a promising argument

for accumulation, the Tax Court rejected the claim root and branch:

it held that the accumulation was not in fact based on the asserted

purpose, that there was no specific plan to use the funds for

redemption, and that in this instance such a redemption was not

connected to the taxpayer's interests, however much it might have

helped Louise and Emile. Haffner's, 83 T.C.M. (CCH) at 1225-26. It

buttressed these conclusions with a considerable discussion of the

evidence. 

On appeal, the company complains of Tax Court error,

first, in allegedly requiring that the stock redemption be

"necessary" for the company's survival rather than merely reasonably

connected with a business purpose, and, second, in supposedly

demanding that the plan of accumulation be a formal one, e.g., one
2A strict requirement that the redemption be "necessary" for

corporate survival would be legal error; the law only requires that

the redemption be "directly connected with the needs of the (2002);

see also Mountain State Steel Foundries, Inc. v. Comm'r, 284 F.2d

737, 745 (4th Cir. 1960); 10 Mertens, § 39.120, at 172.

3There is no requirement that the plan be formal; indeed, the

accumulated earnings tax is almost always directed at close

corporations which are likely to be less formal in their recordkeeping. See Brookfield Wire Co. v. Comm'r, 667 F.2d 551, 555 (1st

Cir. 1981). But the lack of a paper record is still evidence as to

whether any plan existed. 

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committed to paper. It is not clear that the Tax Court adopted

either a "necessity" test,2 see Haffner's, 83 T.C.M. (CCH) at 1226,

or a formal plan requirement,3 but we need not pursue these issues

because at least a "specific plan" was required to justify the

accumulation, and none was present here.

The statute makes no reference to specific plans, formal

or otherwise, but the Treasury has adopted regulations implementing

the "reasonable needs" provision which include the following

language:

In order for a corporation to justify an

accumulation of earnings and profits for

reasonably anticipated future needs, . . . the

corporation must have specific, definite, and

feasible plans for the use of such

accumulation.

26 C.F.R. § 1.537-1(b)(1) (2002). The company does not challenge

the regulation as unauthorized or as inconsistent with the statute.

See 26 U.S.C. § 7805.

The regulation is fatal to the company's position.

Dispensing with formality does not create a license for vague,
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uncertain or indefinite plans. Brookfield, 667 F.2d at 555-56; 26

C.F.R. § 1.537-1(b)(1). Beyond the accountant's initial

recommendation, the Tax Court found virtually nothing in the record

to support a plan of accumulation for redemption: according to the

Tax Court, there were no written projections, no board resolution,

no evidence even of a board discussion of the matter, let alone any

careful study of amounts or likely need.

 The company makes no effort to counter these factual

findings, and these findings make it impossible to describe the Tax

Court's ultimate conclusion--that no specific plan existed--as clear

error or unreasonable (one could argue for either standard but the

outcome would not be affected). The Tax Court did not adopt any per

se rule that the absence of some single element (such as writing or

projections) would be fatal under the specificity requirement; it

simply found that under all the circumstances no specific plan

existed in this case. It thus does not matter whether a plan if it

existed could have been justified.

The plan requirement is worth bearing in mind as we turn

to the other reasons offered on appeal--in fact, the taxpayer puts

them ahead of the redemption claim in its brief--to justify the

accumulation: competition, environmental regulations, securing

supply. As a first claim of error, the company argues that the Tax

Court improperly refused to consider most of this evidence, and

instead limited the taxpayer to the single rationale of family
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litigation (already discussed), because the taxpayer did not present

its other justifications until the case came to court. It says that

had these justifications been considered, the evidence would have

supported the accumulation.

After some prior discussions between the company and the

IRS with respect to the accumulated earnings tax, the IRS notified

the company in November 1996 that a deficiency notice was about to

issue, and invited the company to respond. The company answered in

December 1996, and mentioned only family litigation as a reason for

the accumulation. This remained for some time the sole

justification claimed by the company; it did not assert the other

business reasons until, at the earliest, sometime in late 1999,

roughly three years after the IRS notification.

The company suggests that the Tax Court took the late

proffer of these other business reasons as precluding their

assertion at trial. This, if true, would have been legal error:

the omission of the other business reasons from the December 1996

response merely left the burden of proof with respect to these

reasons with the taxpayer. 26 U.S.C. § 534(a). But this is not

what occurred. Rather, the taxpayer's argument is an imaginative

attempt to convert an evidentiary decision into a statutory error.

In its decision, the Tax Court did say that it would

"focus solely" on the family litigation explanation for the

accumulated earnings, and this in part resulted from the company's
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late proffer of the other business reasons. Haffner's, 83 T.C.M.

(CCH) at 1225. But at trial the Tax Court did not exclude evidence

of the other business reasons, nor did it fail to consider them in

its decision; instead, it found these reasons to be "an after the

fact rationalization" not worthy of acceptance. Id. It was this

factual finding--not any misreading of section 534--that doomed the

alternative justifications. Thus, the Tax Court said:

Petitioner asserts in brief that it also

accumulated earnings during the subject years

for reasons other than a stock redemption.

Neither the petitioner's December 16, 1996,

letter nor its pleadings in this case set forth

any reason for the earnings accumulation other

than a stock redemption. Nor did petitioner's

authorized representative state any other

reason when, during petitioner's audit, he

responded to the IDR. In fact, the first time

that petitioner asserted that it was also

accumulating earnings to meet certain business

contingencies and to provide working capital

was at or about the time of trial. Such an

after the fact rationalization to support the

accumulation of earnings is unavailing.

Id. (footnote omitted).

We accept as correct, or at least not clearly erroneous,

the Tax Court's finding that these late-proffered reasons were not

the actual, subjective motives for the accumulation. The company

does not explicitly contest this finding on appeal; the fragments

of evidence it cites on this issue are so vague and qualified as to

underscore, rather than undermine, the Tax Court's own finding.

Principally, its brief on appeal simply proceeds from the

proposition that section 534 does not prevent the taxpayer from
4See, e.g., 26 C.F.R. § 1.537-1(b)(2) (2002) ("[S]ubsequent

events may be considered to determine whether taxpayer actually

intended to consummate" plan of accumulation.); see also, e.g.,

Northwestern Ind. Tel. Co. v. Comm'r, 127 F.3d 643, 647 (7th Cir.

1997) (noting the lack of contemporaneous planning records and

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objectively justifying the accumulation on competition, supply and

government regulation grounds. This in turn poses a question of

some interest: whether the reasons proffered to justify the

accumulation need to have been the actual reasons that in fact

motivated the taxpayer's accumulation.

If one looked solely at statutory language, it might be

plausible to argue that, in the absence of conclusive proof of the

forbidden "purpose to avoid" (a purpose which is alone fatal under

section 531(a)), an after-the-fact justification that is objectively

reasonable would suffice. One could also argue that it would be

unfair or unreasonable to penalize a taxpayer who lacked an

avoidance purpose for having accumulated an otherwise legal amount

of earnings for the wrong reasons. The form of the company's

argument implicitly assumes that this is the law.

We need not pursue this issue because the "specific plan"

requirement in the regulations is again fatal to the taxpayer: on

a sensible reading, one cannot have a "specific. . . plan[ ]" to

accumulate "for" a reasonable business need unless that need is an

actual reason for the accumulation. Other language in the

regulation underscores the requirement that the reasonable needs

must be recognized at the time of the accumulation.

4 This
disbelieving ex post justifications), cert. denied, 525 U.S. 810

(1998); Herzog Miniature Lamp Works, Inc. v. Comm'r, 481 F.2d 857,

863 (2d Cir. 1973) (similar).

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requirement may be overkill as to the main thrust of the statute,

but it obviously serves a valid purpose in preventing contrived post

hoc explanations. 

Of course, section 533 merely creates a rebuttable

presumption that tax avoidance was "a" purpose (the statute says

"the" but the Supreme Court says "a" purpose to avoid is enough to

condemn an accumulation, Donruss, 393 U.S. at 307-09). The statute

provides that unreasonable accumulation is "determinative" against

the taxpayer "unless" the taxpayer proves the contrary, so in

principle the taxpayer could unreasonably accumulate and still avoid

the tax. See 26 U.S.C. § 533(a). But in this case the company has

not sought to walk the camel through this aperture in the needle.

Affirmed.