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As a boy, Hood learned the land grading business from his father. He joined his father’s firm when he graduated from high school in 1967 and worked there until 1980. In 1980, Mr. Hood struck out on his own, founding Clary Hood Inc. with two employees and $60,000 worth of used equipment. The firm provided land grading and excavation services.
The company grew slowly. From 2000 to 2010, profits were irregular and net income was less than $1 million most years. The firm was hammered by the 2008 “Great Recession,” suffering three straight years of operating losses. Clary Hood stayed afloat when other companies were going under because it did not have too much debt, employee pay was temporarily reduced, $800,000 of equipment was sold to offset losses, and Mr. Hood skipped his own salary when needed to meet payroll.
One of Clary Hood’s biggest customers was Walmart. Projects for them provided about 20% of the firm’s revenue from 1999 to 2011. However, the company had to bid competitively to get each new project, and the profit margin on this work fell to unsatisfactory levels. In the summer of 2011, to the surprise of the firm’s executives, Mr. Hood announced that they would no longer accept jobs from Walmart. It was a risky move, but it paid off. New projects were found to replace the lost business, and they had much better profit margins.
The company went from a net loss of $120,530 in 2011 to a net income of over $7 million from 2013 to 2015, and $14.5 million in 2016. The growth was substantially attributable to Mr. Hood’s efforts as CEO.
In 2014 the company consulted with their accountants and decided to award Mr. Hood a $5 million bonus 2015. This was to compensate him for the success that year, as well as for the earlier years in which he had taken less compensation than he might have to help keep the company afloat. In 2016, which was even more profitable for the firm, the same $5 million bonus was approved.
This caught the eye of the IRS, which believed that such compensation was unreasonable. Like many closely held companies, Clary Hood, Inc. never paid any dividends. Dividends are not deductible by the corporation, and so a corporate income tax must be paid on them, 35% for the years in issue. Once paid, the dividends are again taxable to the shareholder at rates up to 39.6% for those years. It’s much more sensible to pay the owners more in compensation, which has the potential to be taxed only once.
With large compensation payouts, the IRS argues that part of the compensation is a disguised dividend, and therefore not deductible by the corporation. In this case, the IRS said that reasonable compensation for Mr. Hood was $517,964 in 2015 and $700,792 in 2016. For those two years, that meant the company owed over $3.2 million in additional corporate income tax and more than $330,000 in tax penalties for the understatements.
A trial ensued. The company argued for the “independent investor test” to determine reasonableness. That is, what would an independent investor be willing to pay someone to achieve the results that were accomplished? The successes the Mr. Hood achieved in bringing the firm to $70 million in revenue with 150 employees by 2016 easily satisfied this test.
But that is only one factor, the Tax Court ruled, and not a test that has been accepted by all courts. In the battle of the experts that ensued, the testimony from the IRS witness was given the most weight. The deliberations with the accountants for the 2015 bonus were well documented, and it covered past as well as current services. Accordingly, $3.2 million was reasonable for that year, the Court concluded, and there was no penalty for understatement of tax due. But for 2016, when the firm simply paid another $5 million bonus without stating the justification for it, only $1.3 million was reasonable compensation for doubling the firm’s net profit from $7 million to $14 million, according to the Tax Court’s crystal ball. And the penalty for understatement of taxes was in order.
If you have ignored this part of your compensation planning, now would be a good time to start paying attention to it. Give us a call by dialing 920-563-6616 ext. 3070, or email wealth@bankwithpremier.com to let us know how we can assist you with your estate planning needs.
© 2022 M.A. Co. All rights reserved.
Any developments occurring after April 1, 2022, are not reflected in this article.
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