Opinion ID: 489299
Heading Depth: 2
Heading Rank: 4

Heading: Dividend Practices and Return on Equity

Text: 42 It is undisputed that the corporations paid no dividends during the years at issue. The taxpayers and the Commissioner dispute, however, the inference to be drawn from this fact. It is true that a closely held corporation may have valid business reasons for not paying dividends. 38 As the taxpayers' expert testified, such a corporation, especially one that is growing rapidly, may choose to retain its earnings to fuel future growth. The taxpayers' expert did not, however, offer any reason why these specific corporations chose not to pay dividends. Indeed, he specifically stated that PME, the largest of the corporations, was certainly in a position to pay a dividend during the years at issue. We reject the so-called automatic dividend rule--under which even reasonable compensation to shareholder-employees is automatically deemed to include disguised dividends if the corporation has been profitable and has not paid dividends. 39 We conclude, however, that the absence of dividend payments by a profitable corporation that has offered no specific reason for its failure to pay dividends is one of the factors a court may consider when addressing the reasonableness of compensation paid by that corporation to its shareholder-employees. 40 43 A corporation's dividend practices should not, however, be viewed in a vacuum. An investor may garner a return on his investment through either dividends or appreciation in the value of his stock. For reasons acceptable under the tax code, many investors prefer stock appreciation over dividends. And indeed, many corporations with publicly traded stock pay no dividends. Therefore, the court should look not only at a corporation's dividend practices, but also at the total return the corporation is earning for its investors, its shareholders. 41 The prime indicator of the return a corporation is earning for its investors is its return on equity. 44 On a consolidated basis, the corporations' return on equity was 212.5 percent in 1978 and 47.6 percent in 1979. 42 These returns are impressive and are far in excess of the return on equity of most comparable, publicly traded corporations. As the taxpayers' expert testified, given the riskiness of this investment, an independent investor would undoubtedly be satisfied with such a return. 45 Relying on Elliott's, Inc. v. Commissioner, 43 taxpayers argue that if, after paying compensation to shareholder-employees, a corporation is earning a sufficient return to satisfy an independent investor, there exists a substantial presumption that compensation paid to shareholder-employees is reasonable. The taxpayers contend that the Tax Court erred in not considering this presumption. 46 We agree with the statement of the Ninth Circuit Court of Appeals in Elliott's, Inc. that if the company's earnings on equity remain at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary. 44 We do not agree, however, with the taxpayers' interpretation of this statement as creating a substantial presumption. The so-called independent investor test is simply one of the factors a court should consider, and in certain cases it may be a substantial factor. In this case, the Tax Court appropriately recognized the relevance of this factor and noted that it weighed in the taxpayers' favor.