Court Opinion

ID: 9492389
Source: CourtListenerOpinion
Date Created: 2023-08-05 14:40:23.348498+00
Date Added: 2024-06-11T17:55:17.286773
License: Public Domain

SILVERMAN, Circuit Judge:
A corporation’s payment of compensation to employees is tax deductible by the corporation; its payment of dividends to shareholders is not. In this ease, we once again examine the circumstances under which deductions for payments to shareholder-employees of a closely-held corporation, ostensibly as compensation for services, will be disallowed as disguised dividends. In Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir.1983), we applied a two-part test to deter*1118mine the deductibility of such payments: reasonableness of amount and compensatory intent. We said, “In the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised .dividend, the inquiry may expand into compensatory intent apart from reasonableness.” Id. at 1244.
This is such a case. We affirm the tax court’s finding that OSC’s payments to Blazick and Richter, whether or not reasonable in amount, were not intended as compensation. They were dividends in disguise.
FACTUAL AND PROCEDURAL BACKGROUND
In 1970, Allen Blazick bought a silk-screening business for $180.00. He and his wife operated the business on a part-time basis from their two-bedroom apartment while he continued to go to school and work at a bank during the day. As the business grew, Blazick hired Steven Richter, his brother-in-law, to assist with manufacturing. He was paid $2.00 per hour when they could afford it. In 1976, Blazick and Richter’s enthusiasm, energy and hard work started to pay off — Blazick landed Safeway Stores as a client. It is undisputed that Blazick and Richter continued to bring their extraordinary talent, dedication, and energy to the business, and it is undisputed that the business prospered remarkably as a direct result of their personal efforts. By 1991, Olympic Screen Crafts had moved from Blazick’s kitchen table to a 65,000 square-foot plant, had over 200 employees, and grossed over $13 million a year.
In 1982, the business was incorporated. Blazick became OSC’s President and Chief Executive Officer, and owned 90% of its stock; Richter became OSC’s Vice President, and was issued the remaining 10% of its stock. Blazick’s wife served as the secretary and treasurer.
Three years after OSC incorporated, it adopted an incentive compensation plan. According to OSC, its purpose was “to recognize and compensate Blazick and Richter for their distinct and different contributions to the business.” The incentive plan was developed by Leo Rosi, Blazick’s college acquaintance and OSC’s long-time certified public accountant. Blazick and Richter were the plan’s only participants. Under the terms of the plan, the amount of incentive compensation was to be determined at the end of each fiscal year by first calculating a hypothetical gross margin. The gross margin was calculated by multiplying OSC’s actual total sales by an adjusted industry gross margin ratio. The total incentive compensation pool consisted of the difference between OSC’s actual gross margin and the hypothetical adjusted industry gross margin.
The plan expressly provided that payments from the incentive compensation pool would be made “according to stock ownership.” It directed that after specific deductions were taken from each participant’s share, 90% of the total incentive compensation pool would be allocated to Blazick, with the remaining 10% going to Richter. Each year, Blazick’s incentive compensation was to be reduced by any inventory shortages in excess of $100,000 and by any bad debts. Likewise, Richter’s incentive compensation was to be reduced by. inventory spoilage in excess of $100,000 and production costs in excess of $100,000. As a practical matter, this formulation resulted in the corporation distributing nearly all (between 82% and 94%) of its net income as incentive payouts to Blazick and Richter in the years in question. All of the incentive compensation paid out to Blazick and Richter was deducted as compensation under § 162(a) of the Internal Revenue Code. The IRS disallowed a sub*1119stantial portion of those deductions.1
As the company’s accountant, Rosi performed the hands-on implementation of the plan. He acknowledged that the method he used to calculate the corporation’s cost of goods sold was not in accordance with generally accepted accounting principles. He also testified that in 1990 and 1991, he “miscalculated” OSC’s gross profits resulting in an arbitrary increase to the incentive compensation pool. He also acknowledged his failure to make other adjustments required by the plan, thus increasing the distributions to Blazick and Richter.
OSC never paid or declared a dividend, despite the fact that in 1988 or 1989, the years immediately following the incentive plan’s implementation, Rosi specifically advised OSC to pay them. Rosi testified that Blazick was strongly opposed to the idea. Rosi testified that because of Blaz-ick’s reaction to his advice, he never brought it up again. Blazick’s antipathy to dividends also was reflected in a credit memorandum prepared by an officer of Union Bank in 1992. It contained the following statement:
[Blazick’s] salary for 1991 was over $1.8MM. 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 of the tax years in issue, OSC deducted the full amounts paid to Blazick and Richter under the incentive plan. The IRS disallowed most but not all of it. The IRS assessed back taxes on the disallowed amounts and assessed an accuracy-related penalty pursuant to 26 U.S.C. § 6662(a).2
At trial before the Tax Court, OSC offered considerable evidence of Blazick and Richter’s extraordinary hard work and unique skills, and of the corporation’s phenomenal growth and better-than-average performance due to their personal efforts. Nevertheless, the Tax Court found that the plan allocations were not made with compensatory intent. It found that 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.” On that basis, it also upheld the imposition of a penalty for negligence.
I Deductibility of Compensation
Section 162(a)(1) of the Internal Revenue Code permits a corporation to deduct “a reasonable allowance for salaries or other compensation for services personally rendered.” 26 U.S.C. § 162(a)(1). The payment of dividends to shareholders, however, is not deductible. When pay*1120ments are made to an individual who is both a corporate employee and a principal shareholder, a two-prong test is applied to determine whether the distribution is truly compensatory. First, the amount of compensation must be reasonable; second, the payment must be purely for services, or have a purely compensatory purpose. Elliotts, 716 F.2d at 1243; Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361-62 (9th Cir.1974). Factual findings of the Tax Court are reviewed for clear error. Delk v. Commissioner, 113 F.3d 984, 986 (9th Cir.1997). The clear error rule applies to the “Tax Court’s findings of fact, derived from application of the appropriate factors,” in disguised dividend cases. See Elliotts, 716 F.2d at 1245.
In Nor-Cal, a closely-held corporation that had never declared or paid dividends deducted as compensation “bonuses and administrative salary” paid to its president, vice-president, secretary and treasurer who, together, owned 100% of the company’s stock. “Each of the bonus payments and administrative salary made by Nor-Cal to its four officer-shareholders during the year in issue was exactly proportionate to the recipient’s stockholding in Nor-Cal.” Id. at 361. We affirmed the Tax Court’s ruling that the payments in issue were disguised dividend distributions rather than payment for services rendered, id. at 362, and we upheld its reliance on the following factors:
1. The bonuses were in exact proportion to the officers’ stockholdings.
2. Payments were in lump sums rather than as the services were rendered.
3. There was a complete absence of formal dividend distributions by an expanding corporation.
4. The system of bonuses was completely unstructured having no relation to services performed.
5. The company’s consistently negligible taxable income was an indication that the bonus system was based on funds available rather than on services rendered.
6.Bonus payments were made only to the four officer-stockholders, no other employees.
Id. at 362.
We addressed this problem again in El-liotts. There, the corporation paid Edward Elliott, who was both its CEO and only shareholder, a $24,000 annual salary plus a year-end bonus of 50% of net profits. The total paid by Elliotts, Inc. to Edward Elliott approached $200,000 a year, which the corporation deducted in full as compensation. The IRS determined that this amount exceeded what could be deemed reasonable compensation, that it contained a disguised dividend, and that only $65,000 a year could be deducted as payment for services.
On appeal, we started with the premise that under § 162(a)(1), a corporation may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” We also acknowledged the two-prong test for deduc-tibility: “(1) the amount of the compensation must be reasonable and (2) the payments must in fact be purely for services.” 716 F.2d at 1243. We noted that intent is subjective and difficult to prove and usually can be inferred if the amount is reasonable, but not necessarily so.
The existence of a compensatory purpose can often be inferred if the amount of the compensation is determined to be reasonable under the first prong. For these reasons, courts generally concentrate on the first prong — whether the amount of the purported compensation is reasonable. Courts have generally not delved into whether a compensatory purpose exists under the second prong except in those rare cases where the Commissioner has come forward with evidence that purported compensation payments, although reasonable in amount, were in fact disguised dividends.
Id. (internal citations omitted) (emphasis added).
*1121We specifically held that "where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness." Id. at 1244.
 That brings us to the present case. USC would have had the Tax Court fixate entirely on the reasonableness of the amounts involved and then draw an inference of compensatory intent, without regard to the other evidence. However, as we recognized in Elliotts, 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.
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. The Tax Court relied on several factors in finding di~guised dividends in this case:
First, the percentages of OSC's net income paid to its two employee-shareholders was high, between 81% and 94% during the years in question. As we observed in Elliotts, if the bulk of corporate earnings are paid out as bonuses or the like, that is a strong indication that profits are being siphoned out of the company disguised as compensation. See Id. at 1243.
Second, OSC never paid or declared a dividend. Although not a dispositive factor, it is relevant in light of the history of profitability and Rosi's rejected advice to pay dividends.
Third, Rosi manipulated the actual implementation of the plan to increase the allocations above what the plan itself authorized.
Fourth, the design of the plan itself was inconsistent with compensatory intent: (a) it applied only to the corporation's shareholders and no other employees; (b) payments were calculated with reference to their proportionate stock ownership; and (c) the method of calculation was not based on the value of services rendered, but ~ias structured to distribute every dollar of gross profit in excess of the hypothetical gross profit.
Because these findings are not clearly erroneous, the Tax Court's determination that USC's incentive plan payments were not made with compensatory intent must be affirmed.3
II Negligence Penalty
 USC contends that the Tax Court clearly erred in concluding that its underpayment was attributable to negligence. Once an underpayment of taxes is established, the Commissioner's determination that underpayment was due to negligence is presumptively correct and must stand unless USC can establish that it was not negligent. See Hall v. Commissioner, 729 F.2d 632, 635 (9th Cir.1984). This Court reviews the Tax Court's determination for clear error. Wolf v. Commissioner, 4 F.3d 709, 715 (9th Cir.1993).
The Tax Court concluded that USC failed to exercise ordinary care in attempting to comply with the Internal Revenue Code. The record establishes that USC's incentive plan was designed to direct the flow of corporate earnings to its shareholders. Further, USC ignored the advice of its accountant to pay dividends. Because USC has presented insufficient evidence to overcome the presumption of negligence, we affirm the Tax Court's penalty assessment.
AFFIRMED.

. For the tax years at issue, OSC paid Blazick and Richter the following base salaries and bonuses pursuant to the incentive plan:
1990 1991 1992
Blazick
Base salary $155,372 175,485 173,372
Incentive Distribution $490,860 (83%) 1,651,146 (90%) 1,324,608 (90%)
TOTAL $646,232 1.826.631 1,497,980
Richter 1990 1991 1992
Base salary $57,791 64,616 60,000
Incentive Distribution $98,036 (17%) 183,461 (10%) 149.179 (10%)
TOTAL $155,827 248,779 209.179
Total Compensation Claimed Deductible $802,058 2,075,068 1,707,159
Amount Disallowed by IRS $357,453 1.580.631 1,198,677
Amount Allowed by IRS $444,606 494,437 508,482
The numbers in brackets reflect the percentage of the distribution from the incentive plan that each shareholder received during the respective tax years.

. 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.

. Because we affirm the Tax Court's finding on lack of compensatory intent, we need not address OSC's evidentiary objections relating to the evidence of reasonableness.