Justia Federal District Court Opinions

Section 162(a) of the Internal Revenue Code, 26 U.S.C. § 162(a), provides that:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--

(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;....

At issue in this case is whether the amount of salary and bonuses paid by Dexsil during the 1989 and 1990 tax years to Ted Lynn--Dexsil's president, chief executive officer, treasurer, and chief financial officer--was reasonable compensation for his services and thus deductible by Dexsil as a business expense, or was instead to some degree unreasonable, with the unreasonable amount representing, in effect, a hidden dividend payment. The Tax Court found that Dexsil's deduction for compensation to Lynn for the 1989 and 1990 tax years was unreasonable in amounts of $76,540 and $168,000, respectively, and ordered Dexsil to pay the resulting deficiencies of $33,504 and $95,778. For the following reasons, we vacate the Tax Court's judgment and remand for further proceedings.

BACKGROUND

Dexsil Corporation was founded in 1977 by Ted Lynn ("Lynn") and John Churchill, who each made initial capital contributions of $7,000. The company was originally formed to manufacture and market Dexsil, a high-temperature polymer used for gas chromatography. In 1981, following unsuccessful attempts to lower the production costs of the polymer, Lynn purchased Churchill's interest in the company for $20,000 and became the president of Dexsil.

With Lynn at the helm, the company set out to develop, manufacture, and market field-test kits to be used for the on-site detection of hazardous contaminants regulated by the Environmental Protection Agency. By 1990, sales of these kits--named Clor-N-Oil, Clor-D-Tect, Clor-N-Soil, and Q4000--comprised the bulk of Dexsil's business. From 1981 until 1983, Dexsil was wholly owned by members of the Lynn family. In 1983 the company raised $105,000 of needed capital by selling approximately ten percent of the company's shares to about a dozen outside investors at $200 per share. During the tax years in question, 1989 and 1990, Lynn owned 61.62% of Dexsil's stock, other family members owned a combined total of 29.11%, and the balance, a little over 9%, was owned by non-family employees and outside investors.

The company enjoyed tremendous growth and its workforce expanded from 2.5 employees in 1983 to at least 30 employees in 1990. Lynn functioned as the company's president, chief executive officer, treasurer, and chief financial officer during this period, working approximately 60 to 65 hours per week. Lynn's annual salary and bonus grew in rough proportion to Dexsil's annual gross sales. Both Lynn and Dexsil's accountant, Richard Kaczynski, testified that at least since 1982, they had employed an informal formula whereby Lynn would be paid approximately 11% of the year's gross sales. With respect to its other employees, Dexsil instituted an incentive stock-option plan and a restricted stock awards plan for key non-officer employees and it disbursed bonuses to each of its employees. It appears, however, that shareholder-employees received bonuses that were considerably larger than non-shareholder employees. According to Dexsil's audited financial statements and payroll records, the company's gross sales, return on equity, retained earnings, and dividends, as well as the salary and bonus it paid to Lynn were as follows:

 FISCAL    GROSS SALES   RETURN ON   RETAINED    DIVIDENDS     LYNN'S     % OF
  YEAR                    EQUITY*    EARNINGS      PAID      SALARY AND   SALES
                                                               BONUS
  9/77     $    52,974      --        $   2,684     --         $   0        0%
  9/78          68,391     4.7%           3,483     --          15,000     22
  9/79          83,736      7.3           4,802     --           6,000      7
  9/80          96,505      4.5           5,676     --          20,000     21
  9/81          83,488     40.8           8,628   $5,676        13,000     16
  9/82          96,868    (209.2)      (15,683)    2,400        10,000     10
  9/83         113,179      2.5        (14,439)     --          12,000     11
  9/84         698,719     56.6          75,617     --          73,000     10
  9/85       1,875,038     76.2         344,512     --         232,400     12
  9/86       2,492,631     43.7         617,150     --         288,600     12
  9/87       2,406,396     31.8         904,536     --         252,000     10
  9/88       2,702,491     31.0       1,273,074    6,890       277,880     10
  9/89       3,419,984     26.3       1,670,919   16,090       376,540     11
  9/90       4,899,359     25.5       2,168,087   25,992       488,000     10

* Calculated by dividing after-tax net income by year's average shareholders'

equity