Tax Court Finds Compensation Paid to Sons of Company Founders Was Reasonable

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The Tax Court has allowed the entire amounts of $4 million and $7.3 million paid to sons of the founders of a concrete contracting business deductible as reasonable compensation. 

In the case of H.W. Johnson, Inc., T.C. Memo 2016-95, the court also ruled a payment of $500,000 to a company controlled by the brothers was ordinary and necessary to compensate their company for securing a concrete supply at preferential prices.

Compensation must be reasonable to be deductible under section 162 of the Tax Code. The Ninth Circuit, which would hear an appeal on this case, applies five factors to determine the reasonableness of compensation: (1) the employee’s role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements.

After weighing these factors, the Tax Court concluded in May that the amounts paid to the sons, Bruce and Donald, were reasonable and deductible under section 162.

During 2003 and 2004, Bruce and Donald together managed all aspects of their parents’ business, H.W. Johnson, Inc., which was one of the largest curb, gutter, and sidewalk contractors in Arizona. Operations were split into two geographical divisions, eastern and western, with each brother managing a division’s operations. Bruce and Donald each supervised more than 100 employees in their respective divisions, including superintendents and foremen, and worked 10 to 12 hours a day, five to six days a week. They were at the job sites daily and regularly operated equipment while there. The brothers were readily available if problems at a jobsite arose and were known in the local industry for their responsive and hands-on management style.

The Tax Court found that Bruce and Donald were integral to H.W. Johnson’s success during the years at issue. Under their management, H.W. Johnson’s annual contract revenue increased dramatically, from approximately $4 million in 1993 to over $38 million in 2004. Therefore, the court concluded, the compensation they received was reasonable, and deductible under section 162.

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