First Circuit reduces COGS & officer comp

First Circuit reduces taxpayer’s cost of goods sold and compensation deductions

Transupport, Inc. v. Comm, (CA 1 2/14/2018) 121 AFTR 2d ¶ 2018-454

The Court of Appeals for the First Circuit, affirming the Tax Court’s decision, upheld IRS’s notice of deficiency, which for tax years 2006 through 2008 reduced the cost of goods sold and compensation deductions taken by a wholesaler of engines and engine parts used in military vehicles.

Background—reasonable compensation. For compensation paid by an employer to be deductible under Code Sec. 162, the amount must be reasonable, and the payment must be purely for services rendered.

Courts have considered various factors in assessing the reasonableness of compensation, such as: employee qualifications; the nature, extent, and scope of the employee’s work; the shareholder-employees’ compensation compared with that paid to non-shareholder-employees; prevailing rates of compensation for comparable positions in comparable concerns; and comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers. No single factor is dispositive. Special scrutiny is given in situations where a corporation is controlled by the employees to whom the compensation is paid because there is a lack of arm’s-length bargaining. (Charles Schneider & Co., (CA 8 1974) 34 AFTR 2d 74-5422)

A taxpayer’s income from selling goods is calculated by taking the income generated by selling goods and subtracting the amount that the taxpayer paid for those goods, which is also known as the “cost of goods sold”. (Reg. § 1.61-3(a)) The cost of goods sold for a given tax year only includes the cost of the goods that the taxpayer sold in that tax year. Given this constraint, the cost of goods sold for a given tax year usually equals the beginning inventory (at cost) plus inventory purchases and inventory costs, minus the ending inventory (at cost). (Huffman, (2006) 126 TC 322)

Code Sec. 446(b) provides that if the taxpayer’s accounting method does not clearly reflect income, the computation of taxable income is to be made under such method as, in IRS’s opinion clearly reflect income. Code Sec. 471(a) provides that whenever in the opinion of IRS the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories will be taken by such taxpayer on such basis as IRS may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Facts. Transupport, Inc. was a wholesaler of engines and engine parts used in military vehicles. The portion of its business that was relevant to the dispute at issue involved buying parts in bulk lots from the U.S. Government and reselling them. Harold Foote (Foote) founded Transupport in ’72 and served as its president and chief executive officer. Foote’s sons, William (W. Foote), Kenneth, Richard, and Jeffrey (J. Foote), were Transupport’s only other full-time employees. Foote owned almost all of Transupport’s stock in ’99, but transferred Transupport’s nonvoting common stock to his sons in equal portions in 2005.

Transupport used the gross profit method to determine its cost of goods sold. So, instead of calculating the cost of goods sold by tracking changes in its inventory, Transupport selected a percent profit that it claimed to make on the sale of goods and used that figure to generate its cost of goods sold as well as estimates of its beginning and ending inventory. Transupport allegedly used a percent profit consistent with industry standards. Transupport’s cost of goods sold varied without explanation from year to year, and Transupport kept no records indicating how it selected its gross profit percentage.

When Transupport was audited by IRS in ’84, and ’92, the examining agents were aware that it did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory reported in its returns by using a percentage of sales as costs of goods sold. The IRS auditors did not require changes, and Transupport continued its use of the gross profit method. Its gross profit percentage changed each year, but remained between 39.3% and 31% from ’99 through 2008. It reported a cost of goods sold of $6,951,132 in 2006; $6,365,543 in 2007; and $7,519,086 in 2008, based on gross profit percentages of 33.4%, 39.3%, and 37%, respectively.

Transupport paid each of Foote’s sons $575,000 in 2006, $675,000 in 2007, and $720,000 in 2008. Foote made the compensation decisions alone, without consulting his accountant. The only apparent factors considered in determining annual compensation were reduction of reported taxable income, equal treatment of each son, and share ownership. Transupport did not pay dividends in the years at issue.

In 2007, Foote considered selling Transupport. He entered into a contract with a business broker who put together a “Confidential Offering Memorandum”, which included a “Recast Financial Summary” in which the profits of Transupport’s operations as reported on its financial statements and tax returns were substantially increased. Explanatory notes on the Recast Financial Summary included: “Five shareholder salaries recast to market rate of $50,000 annually each. Management has elected to use an accounting method that writes off the majority of inventory as purchased. It is conservatively estimated that actual gross profit on sales exceeds 75% on general part sales and 33% on distributor sales”.

Observation: Highlighting an aspect of a proposed sale of a company that sellers are unlikely to consider, the First Circuit noted that copies of these documents were circulated to potential purchasers, one of whom notified IRS’s Whistleblower Office of potential tax fraud.

On audit, IRS issued a notice of deficiency that adjusted the deductions Transupport took for compensation paid to Foote’s sons in every year between ’99 and 2008, including adjustments of $1,375,000 in 2006, $1,862,436 in 2007, and $2,123,804 in 2008. The notice of deficiency also adjusted Transupport’s cost of goods sold to reflect a 25% cost and a 75% profit on Transupport’s sales of surplus parts for those years, applied a fraud penalty, and applied an accuracy-related penalty to the extent that the fraud penalty did not apply.

The taxpayer sought relief in the Tax Court.

Tax Court decision. Two proceedings were held in the Tax Court. In the first, the Court held that IRS failed to prove fraud by its burden of proof of clear and convincing evidence, given that IRS had not required changes to Transupport’s tax reporting following the ’84 and ’92 audits. In a second, supplemental opinion, the Court upheld IRS’s notice of deficiency for 2006, 2007, and 2008.

Appellate court decision. On the question of whether the compensation at issue would have been offered in an arm’s-length bargain, the First Circuit rejected Transupport’s contention that the Tax Court committed reversible error by not considering the return on equity enjoyed by its shareholders.

The First Circuit found that there was no error because there was no reliable evidence of actual return on investment. Transupport’s sales materials indicated it was very profitable, but that did not square with its tax reporting. The expert witnesses on this issue never even attempted to reconcile the two. The company’s profitability and value depend heavily on its cost of goods sold but Transupport presented no credible evidence of its cost of goods sold. This made it exceedingly difficult to value the company, and if the company couldn’t be valued, neither could the return to shareholders be calculated as a percentage of that value. Accordingly, the Tax Court was correct to omit return-on-equity analysis when making its reasonable compensation determination.

The First Circuit also rejected Transupport’s argument that the Tax Court erred by not shifting the burden of proof to IRS on the reasonable compensation issue. While that burden can shift to IRS if the taxpayer shows that the notice of deficiency is arbitrary and excessive, the Tax Court found that IRS’s method of determining reasonable compensation (which was very similar to that of Transupport’s expert) was “rational and not arbitrary or unreasonable”. The Tax Court heard testimony from the IRS agent who performed IRS’s reasonable compensation analysis, describing his method, which involved comparing Foote’s sons’ compensation to that of officers at similarly sized companies in similar lines of business. While the IRS agent’s analysis was imperfect, any identified errors favored Transupport. Given that the notice was not arbitrary or excessive, the Tax Court’s decision not to shift the burden of proof was correct. The First Circuit also noted that IRS never disavowed its notice of deficiency (as the taxpayer contended), it merely attempted to pursue a larger deficiency at trial.

The First Circuit also rejected the contention that the Tax Court erred by basing its reasonable compensation determination on the fact that none of the Foote’s sons had special experience or educational backgrounds. Transupport countered that Foote’s sons gained valuable experience by working at the company for many years, and they were indispensable to its business. The First Circuit found that the Tax Court’s findings—that Foote’s sons lacked basic knowledge of the managerial roles they purportedly held, and that many of the tasks they performed were menial—had sufficient support in the record. Transupport, which did not challenge either of these findings on appeal, bore the burden of proof on this issue and failed to provide sufficient evidence justifying the deductions.

In addition, with regard to cost of goods, the First Circuit rejected Transupport’s argument that the Tax Court clearly erred by adopting IRS’s gross profit percentage. The Tax Court’s adoption of the 75% figure had sufficient support in the record. There was overwhelming evidence that Transupport had significantly underreported its gross profit percentage, that the 75% figure was based on Foote’s admissions in its sales literature and to IRS, and that Transupport’s own poor recordkeeping rendered a more accurate determination impossible. On these facts, and the wide discretion in Code Sec. 446(b) and Code Sec. 471(a), the Tax Court did not clearly err by upholding IRS’s adjustment. The Court further noted that the skepticism about IRS’s 75% figure expressed in the Tax Court’s first opinion had to be seen in light of the different burden of proof applicable in that first opinion where IRS attempted to show fraud on the taxpayer’s part.

References: For determination of reasonable compensation, see FTC 2d/FIN ¶ H-3706; United States Tax Reporter ¶ 1624.229.

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