Tax advisers who specialize in assisting small businesses might initially assume that a case involving “reasonable compensation” pertains to the IRS alleging that an S corporation owner did not declare a sufficient portion of their earnings as salary. In such instances, the agency typically aims to reclassify distributions as disguised salary.

However, those of us who have been in the tax profession for a longer period, predating the Tax Reform Act of 1986, recall a distinct other kind of unreasonable compensation case that is seen far less often today. This particular case arises with closely held C corporations, where the IRS contends that a portion of the owner’s reported compensation should instead be treated as a dividend. It is precisely this type of case that the Fourth Circuit Court of Appeals addressed in Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4.[1]

Mr. Hood’s C Corporation

As is customary, let us commence by examining the court’s rendition of the facts in the case. The fundamental background of the case is elucidated as follows::

Hood, Inc. was founded in 1980 as a subchapter C corporation, and during the period relevant to this appeal, Clary Hood and his wife, Gail Hood, each owned 50% of the company’s stock. They were also the only members of its board of directors, and Mr. Hood served as the company’s CEO. From 2000 to 2010, the company averaged approximately $21 million in revenue, earning an average of less than $1 million each year in net income before taxes. Seeking to increase revenue, Mr. Hood decided in 2011 to pivot the company away from retail-related projects to other commercial and industrial projects, and this decision proved to be especially astute. Revenues immediately increased, and by 2015, the company’s revenue had grown to $44 million and by 2016, to $69 million. Net income before taxes also increased, as did cash and cash equivalents. The company also grew in size during this period, from approximately 80 employees in 2011 to approximately 150 employees in 2016.

The Tax Court recognized the significance of Mr. Hood’s various contributions, crediting mostly him with the success of Hood, Inc.[2]

The Court then proceeded to delve into a discussion regarding Mr. Hood's compensation in the years preceding the ones under scrutiny by the IRS in this case:

For the years 2000 to 2010, Hood, Inc. paid Mr. Hood an annual salary of roughly $130,000. In some of those years Mr. Hood also received a bonus in addition to his salary, with the largest bonus amounting to $320,981. As the company's only board members, Mr. and Mrs. Hood set Mr. Hood's salary and bonuses. In 2013, Hood, Inc. began to increase Mr. Hood's salary and bonuses, and for 2013, it paid him a salary of $381,707 and a $1 million bonus, and for 2014 it paid him a salary of $181,538 and a $1.5 million bonus.[3]

At this juncture, the Company embarked on an assessment of Mr. Hood’s previous compensation and arrived at the determination that he had been inadequately remunerated in the preceding years:

During the company’s fiscal year ending May 31, 2015, in which the company realized significant growth, Hood, Inc.’s Chief Financial Officer (“CFO”) began an assessment of Mr. Hood’s past compensation, and he concluded that in prior years, Mr. Hood had been undercompensated. To determine how much to compensate Mr. Hood for the 2015 fiscal year and the years thereafter, the CFO sought the advice of the company’s accountants at Elliott Davis Decosimo, LLC (“Elliott Davis”). The record is not clear to what extent Mr. Hood participated in this assessment. But, as the Tax Court noted, Mr. Hood later acknowledged “that he was aware that he needed to start making necessary preparations from an ‘income tax’ perspective in ‘getting money out of’ the company in anticipation of ‘a changing of the guard.’” After meeting with the company’s accountants, Hood, Inc.’s CFO determined that Mr. Hood had been undercompensated since 2000 and that the total amount that would both remedy that past undercompensation and recognize Mr. Hood’s service for the 2015 year was $7.1 million.[4]

The question arises as to why Mr. Hood did not simply opt for taking distributions from the corporation as a means to extract funds before the business transitioned to its successor owners. Although such distributions would subject Mr. Hood to taxation on qualified dividends, which may attract more favorable long-term capital gain rates, it is worth noting that the corporation would not be eligible for any deduction on these payments. In contrast, if the amounts were disbursed to Mr. Hood as salary, the corporation would be able to claim a deduction.

This tax outcome elucidates why, particularly within the realm of closely held C corporations, the IRS frequently harbors skepticism when compensation paid to the owner exceeds what is deemed justifiable for their services. Conversely, the owner, especially in light of pre-Tax Cuts and Jobs Act corporate tax rates that would apply in the years before the Court, endeavors to extract a substantial portion of the funds they intend to withdraw as salary. This preference stems from the fact that the additional tax paid at the C corporation level surpasses the extra taxes the owner would incur by receiving salary instead of a qualified dividend.

Given the circumstances, it is unsurprising that the CFO relied on the findings of this assessment to substantiate the provision of substantial bonuses to Mr. Hood, without any dividends being distributed to the owner during the years in question:

The CFO thus suggested that Hood, Inc. pay Mr. Hood a $5 million bonus in 2015, some portion of which was to remedy past undercompensation, with the balance of the undercompensation amount to be paid in “future years.” The company’s accountants gave their approval to this suggestion and concluded that the CFO’s proposal was “reasonable.” Accordingly, at the meeting of Hood, Inc.’s board of directors, Mr. and Mrs. Hood approved paying Mr. Hood a $5 million bonus, in addition to Mr. Hood’s $168,559 salary. The minutes of that meeting explained that the bonus was approved in recognition of Mr. Hood’s “many years of sacrificial work done on the Company’s behalf.”

The following year, after Hood, Inc. went through the same process as it did for determining the bonus for the 2015 fiscal year, Mr. and Mrs. Hood as board members again approved a bonus to Mr. Hood of $5 million for the 2016 fiscal year, again in addition to Mr. Hood’s salary, which in 2016 was $196,500.

Despite substantial retained earnings and cash, however, Hood, Inc. did not consider paying any dividends to its two shareholders, i.e., Mr. and Mrs. Hood. Indeed, the company had never paid any dividends.[5]

The IRS Exam, the Battle of the Experts and the IRS Victory in the Tax Court

Subsequently, the IRS initiated an examination of the corporation, with a particular emphasis on the substantial bonuses paid to Mr. Hood. Following its examination, the IRS reached the conclusion that a significant portion of these bonuses did not genuinely reflect compensation for services provided by Mr. Hood. As a result, the corporation was deemed ineligible to deduct this portion of the bonuses.

Following an audit of Hood, Inc.’s federal income tax returns, the IRS issued a notice of deficiency to the company for its 2015 and 2016 tax years, finding that a substantial portion of Mr. Hood’s compensation was excessive and therefore not deductible under 26 U.S.C. §162(a) as reasonable compensation for services rendered. It calculated tax deficiencies for 2015 and 2016 to be roughly $1.6 million for each year. Additionally, the IRS determined that the company was liable for a 20% penalty for each year because the company’s understatements of income tax were “substantial.”[6]

The taxpayer decided to pursue the matter with the Tax Court, seeking resolution. The appellate panel describes the proceedings before the Tax Court as follows

During a six-day trial, the Tax Court heard from fact witnesses regarding the important role that Mr. Hood played in growing the company and increasing its revenues, as well as the process that Hood, Inc. followed in determining Mr. Hood’s bonuses for the 2015 and 2016 fiscal years. And both the company and the IRS presented expert testimony.

The IRS’s expert, David Fuller, agreed that Mr. Hood was undercompensated for the period of 2000 to 2012 but found that Hood, Inc. had started to remedy this condition beginning with its payment of approximately $1.4 million in total compensation to Mr. Hood in 2013. Based on survey data of compensation paid to other similarly situated executives, the specific characteristics of Hood, Inc., and Mr. Hood’s contributions, Fuller concluded in his report that Mr. Hood was undercompensated in total by approximately $2.3 million as of May 31, 2014. Taking this undercompensation amount into account, as well as interest on that amount, Fuller concluded that the total reasonable compensation amounts for Mr. Hood would be $3,681,269 for 2015 and $1,362,831 for 2016, and that any amounts above those figures constituted excess or “unreasonable” compensation.

Hood, Inc. submitted two expert reports, but the Tax Court afforded them “little to no weight” based on the “dubious assumptions” underlying the reports and the lack of supporting calculations.[7]

The Tax Court's significant criticism of the taxpayer's experts' reports predictably lead to the outcome of the case resulting in a resounding victory for the IRS:

In its thorough 64-page opinion, the Tax Court accepted Fuller’s calculations and thus found that the amounts deductible as reasonable compensation to Mr. Hood for his services were $3,681,269 for 2015 and $1,362,831 for 2016. The court did not impose a “substantial underpayment” penalty under 26 U.S.C. §6662 for 2015, finding, pursuant to 26 U.S.C. §6664, that the company had established a reasonable-cause defense to any penalty for that year because it reasonably relied on professional tax advice in good faith. But the court found that the company had not established the same defense for 2016, and therefore it sustained the imposition of a penalty for that tax year.

The Tax Court entered its final decision on May 12, 2022, finding that Hood, Inc. was liable for a $550,866 income tax deficiency for 2015 and a $1,411,991 deficiency for 2016. It also imposed a penalty of $282,398 for 2016.[8]

The corporation opted to appeal the decision of the Tax Court to the Fourth Circuit Court of Appeals.

The Law for Reasonable Compensation per the Fourth Circuit Panel

Having examined the factual background of this case, let us now turn our attention to the legal framework that governs the application of these facts. We will begin by delving into the Fourth Circuit’s analysis of the law regarding the reasonableness of compensation. The Court initiates its discussion by considering the application of this rule to taxpayers as a whole:

The Internal Revenue Code allows a taxpayer to deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including . . . a reasonable allowance for salaries or other compensation for personal services actually rendered.” 26 U.S.C. §162(a)(1) (emphasis added). IRS regulations explain further that, in order to be deductible as an ordinary business expense, compensation “may not exceed what is reasonable under all the circumstances,” taking into account “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” 26 C.F.R. § 1.162-7(b)(3) (emphasis added). And any bonuses paid similarly must not exceed what is reasonable for the services rendered in order to be deductible as an ordinary business expense. 26 C.F.R. § 1.162-9.[9]

The panel highlights that when the same individual both provides the services and exercises control over the corporation, the Court exercises heightened scrutiny in assessing the reasonableness of such payments.

In cases that involve “a closely held corporation whose controlling shareholders set their own level of compensation, the reasonableness of the compensation paid to the shareholder-employee is subject to close scrutiny.” Dexsil Corp. v. Comm’r, 147 F.3d 96, 100 (2d Cir. 1998). This scrutiny is warranted because such corporations may more readily choose to pay out larger salaries and bonuses, which are deductible by the corporation under §162(a), rather than pay dividends from profits, which are not. Id. Thus, if some portion of the ostensible salary or bonus paid to a shareholder-employee is in fact a disguised dividend, rather than compensation for services rendered, it is not deductible. 26 C.F.R. § 1.162-7(b)(1). For these reasons, the close scrutiny to which closely held corporations are subject should focus on whether bonuses paid to shareholder-employees are compensation for only services actually rendered — which would make the payment deductible — or are the corporation’s effort to transfer profits to the shareholder-employees — which would not be deductible and therefore would have the effect of increasing the corporation’s tax liability.[10]

Lastly, the panel delineates its approach to applying a reasonableness standard to the deduction claimed by the corporation for compensation.

To make this determination, we apply a standard of reasonableness “under all the circumstances,” taking into account practices and payments “by like enterprises under like circumstances.” 26 C.F.R. § 1.162-7(b)(3). This, we conclude, calls for application of a multifactor approach that assesses the reasonableness of compensation under the totality of the circumstances. See, e.g., Charles Schneider & Co. v. Comm’r, 500 F.2d 148, 151-52 (8th Cir. 1974); Kennedy v. Comm’r, 671 F.2d 167, 173-74 (6th Cir. 1982); Elliotts, Inc. v. Comm’r, 716 F.2d 1241, 1245 (9th Cir. 1983); B.B. Rider Corp. v. Comm’r, 725 F.2d 945, 952 (3d Cir. 1984); Owensby & Kritikos, Inc. v. Comm’r, 819 F.2d 1315, 1323 (5th Cir. 1987); Dexsil Corp., 147 F.3d at 100; Eberl’s Claim Serv., Inc. v. Comm’r, 249 F.3d 994, 999 (10th Cir. 2001); Haffner’s Serv. Stations, Inc. v. Comm’r, 326 F.3d 1, 3-5 (1st Cir. 2003). As we have previously explained, albeit in an unpublished opinion, under the multifactor approach, no single factor is decisive, but rather we consider numerous factors, such as

the employee’s qualifications; the nature, extent and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; [and] the salary policy of the taxpayer as to all employees.

Richlands Med. Ass’n v. Comm’r, 953 F.2d 639, 1992 WL 14603, at *2 (4th Cir. 1992) (unpublished) (per curiam) (quoting Owensby & Kritikos, Inc., 819 F.2d at 1323). And in the context of small corporations that have a limited number of officers, additional factors may be considered, such as the amount of compensation paid to the officer in previous years, see Mayson Mfg. Co. v. Comm’r, 178 F.2d 115, 119 (6th Cir. 1949), and whether the officer personally guaranteed debts or other obligations of the corporation, see Owensby & Kritikos, Inc., 819 F.2d at 1325 n.33. Moreover, we find appropriate the suggestion of some other courts of appeal that the various relevant factors may be reviewed through the “lens” of, Dexsil Corp., 147 F.3d at 101, or “from the perspective of,” a hypothetical independent investor by asking “whether [such an] investor would be willing to compensate the employee as he was compensated,” Elliotts, Inc., 716 F.2d at 1245.[11]

The taxpayer contends that the panel should adopt the independent investor test employed by the Seventh Circuit in the Menard, Inc. case, which this author previously discussed during the update courses I gave back in 2009. In that opinion, Judge Posner, writing for a unanimous Seventh Circuit panel, was rather scathingly skeptical of the use of a multi-factor test.

However, the panel, although acknowledging that considering a reasonable return to independent investors is a relevant factor, deems it inappropriate to rely solely on this factor.

Hood, Inc. contends that because we have not formally adopted the multifactor test, the Tax Court erred in applying it here and that we should consider the adoption of a singular “independent investor” test, which establishes a rebuttable presumption that an executive’s compensation is reasonable if the corporation’s shareholders are receiving a sufficiently high rate of return on their equity investment. See Menard, Inc. v. Comm’r, 560 F.3d 620, 622-23 (7th Cir. 2009); Exacto Spring Corp. v. Comm’r, 196 F.3d 833, 839 (7th Cir. 1999). Hood, Inc. reasons that under that test we should approve Mr. Hood’s bonuses because Hood, Inc. generated a 22% return on equity for its shareholders in 2015 and a 36% return in 2016 after accounting for Mr. Hood’s total compensation.

While it might be reasonable to consider the Seventh Circuit’s independent investor test along with other factors relevant to the totality of the circumstances, we conclude that solely using that test to establish a presumption of reasonableness, as Hood, Inc. urges, would be too narrow in light of the regulatory demand that we consider “what is reasonable under all the circumstances.” 26 C.F.R. § 1.162-7(b)(3). For instance, under the independent investor test, an executive’s compensation could be presumed to be reasonable even if it exceeded the amount that was genuinely compensation “for personal services actually rendered,” 26 U.S.C. §162(a)(1), and that “would ordinarily be paid for like services by like enterprises under like circumstances,” 26 C.F.R. § 1.162-7(b)(3). By contrast, the multifactor test allows for consideration of the numerous other relevant factors. Accordingly, we conclude that it is the appropriate test to apply and that the Tax Court did not err in applying it here.[12]

Upon examining the Menard's case, it becomes apparent that, despite Judge Posner's disapproval of the multi-factor test, Menard, Inc. presented a more favorable set of circumstances compared to Hood, Inc. Menard had a history of paying dividends, had an established program for calculating and disbursing bonuses, and the bonus programs encompassed executives beyond John Menard himself. Additionally, Judge Posner highlighted that two years after John Menard received his bonus, the new CEO of Home Depot (one of the individuals whose salary was compared to Mr. Menard's) received a $124 million bonus.

As should become clear from the rest of the Fourth Circuit’s opinion, it seems likely that the Fourth Circuit panel would have arrived at the same result as did the Seventh Circuit panel, accepting John Menard’s compensation as reasonable, had they heard the appeal of that case.

The Tax Court Properly Applied the Multi-Factor Analysis to Mr. Hood’s Compensation

The panel goes on to look at the way the Tax Court applied the multi-factor analysis, first citing the taxpayer’s complaints about how the Tax Court applied the analysis:

Hood, Inc. contends that the Tax Court did not adequately account for the return on equity generated for the company’s shareholders; that it did not appropriately credit Mr. Hood’s extraordinary performance and recognize that such performance could justify compensation in excess of the norm; and that it placed too much emphasis on the comparison of Mr. Hood’s compensation with that of similarly situated executives in the industry.[13]

But the panel rejected the taxpayer’s complaints:

These arguments, however, simply raise questions regarding the weight to assign the factors, as the Tax Court considered them among the many factors it addressed in its extensive opinion.[14]

The panel underscores that the Tax Court did indeed take into account Mr. Hood’s exceptional contribution to the company’s returns, which the hypothetical independent investor would have received even considering the compensation paid and deducted.

As a starting point, the Tax Court recognized that Mr. Hood was “extraordinarily talented in his industry,” served as the company’s “key employee and driving force from its inception,” and that the company’s business of land excavation and grading was “more complex than that of a general construction company.” The court also acknowledged that the trend of Hood, Inc.’s increasing revenue, culminating with an annual revenue of roughly $69 million in 2016, “[could] not be credited to economic conditions alone” and that Mr. Hood was instrumental in transitioning the business to more profitable projects. The court took account of these factors as well as others in its opinion, allowing reasonable compensation to Mr. Hood for his personal services in this regard.

The Tax Court also recognized that it was permissible for Hood, Inc. to compensate Mr. Hood for undercompensation in prior years, as explained in Alpha Medical, Inc. v. Commissioner, 172 F.3d 942, 950 (6th Cir. 1999). In Alpha Medical, the court noted that “[a] taxpayer making such a claim must show: (1) the insufficiency of the officer’s compensation in the previous year[s]; and (2) the amount of the current year’s compensation that was intended as compensation for that underpayment.” 172 F.3d at 950. Thus, the Tax Court agreed with Mr. Hood that he was entitled to some degree of additional compensation for the services rendered in prior years.[15]

However, the panel acknowledges that this consideration alone does not conclude the analysis, as mandated by the regulations. Consequently, the panel agrees with the Tax Court's emphasis on three factors that indicate Mr. Hood's compensation was excessive.

The panel references the Tax Court’s determination that the corporation’s consistent failure to distribute dividends was a factor supporting the argument that a portion of Mr. Hood’s compensation should be reevaluated. Additionally, the panel notes Mr. Hood’s testimony that the compensation process was driven by an “income tax perspective” aimed at extracting funds from the corporation.

First, the court noted that Hood, Inc. had never declared or paid a cash dividend to its shareholders, even after it began to accumulate significant capital during the period from 2013 to 2016. Although companies are not required to pay dividends, a court may nonetheless consider a profitable corporation’s failure to do so in determining the reasonableness of compensation paid to its shareholder-employees. See Miles-Conley Co., 173 F.2d at 960; see also Paul E. Kummer Realty Co. v. Comm’r, 511 F.2d 313, 315 (8th Cir. 1975). In this case, the Tax Court agreed that Hood, Inc. had advanced persuasive reasons for not declaring dividends for many years, such as 2010, when business was slow and capital needs were high. It also recognized, as Hood, Inc. pointed out, that Hood, Inc.’s business was capital-intensive due to the cost of obtaining and maintaining heavy equipment. But the court noted that this rationale became less persuasive in later years given that Hood, Inc.’s year-end shareholder equity value had increased nearly sixfold, from approximately $5.5 million in 2010 to over $31 million in 2016. Yet the company opted to pay out large bonuses to Mr. Hood rather than paying any dividends. And the lack of dividends became especially suspect in light of Mr. Hood’s testimony that in 2015, he was aware that he needed to start making preparations from an “income tax” perspective for “getting money out of [the] corporation” in preparation for “a changing of the guard.” (Emphasis added).[16]

The panel agrees that the Tax Court rightly took into account the absence of a structured system to determine compensation. The fact that Mr. Hood and his wife made the determination each year was considered a factor indicating that the payments were more closely linked to his ownership stake rather than being tied directly to the services he provided.

Second, the Tax Court noted that Hood, Inc. had “no structured system in place” for determining compensation and that Mr. Hood’s compensation was set by himself and his wife. “Bonuses that have not been awarded under a structured, formal, consistently applied program generally are suspect. . . .” Elliotts, Inc., 716 F.2d at 1247. Moreover, “salaries paid to controlling shareholders are open to question if, when compared to salaries paid non-owner management, they indicate that the level of compensation is a function of ownership, not corporate management responsibility.” Id. (emphasis added). Thus, the Tax Court’s suspicion was enhanced by the fact that in 2015 and 2016, Mr. Hood’s compensation represented almost 90% of the total compensation that Hood, Inc. paid to its officers, despite the fact that other non-shareholder officers worked similar hours and shared similar responsibilities. While some of that discrepancy could have been attributed to the need to remedy Mr. Hood’s past undercompensation, it was nonetheless glaring that Hood, Inc.’s other officers each received a bonus of $100,000 or less for the 2015 and 2016 tax years, while Mr. Hood received a bonus of $5 million for each year.[17]

The panel also determined that the Tax Court appropriately placed emphasis on comparing Mr. Hood's compensation with that of similarly positioned executives in comparable companies.

Finally, the Tax Court placed considerable weight on the comparison of Mr. Hood’s compensation with that paid to similarly situated executives in comparable companies. While no single factor is decisive under the multifactor test, such comparisons have been described as “a most significant factor.” Aspro, Inc. v. Comm’r, 32 F.4th 673, 680 (8th Cir. 2022) (quoting Charles Schneider & Co., 500 F.2d at 154); see also 26 C.F.R. § 1.162-7(b)(3) (requiring consideration of what “would ordinarily be paid for like services by like enterprises under like circumstances”). Relying on survey data included in Fuller’s expert report about comparably sized site-preparation contractors and their compensation of employee-shareholders, the Tax Court noted that for the years 2013 through 2016, Fuller treated Mr. Hood as meriting compensation in the 99th percentile based on the company’s success and still found that the compensation actually paid to Mr. Hood exceeded what was reasonable. Instead, relying on this comparative data, the Fuller report calculated that reasonable compensation for Mr. Hood would amount to $3,681,269 for 2015 and $1,362,831 for 2016. The Tax Court found these calculations to be “the most credible and complete source of data, analyses, and conclusions.” At the same time, the court discounted the testimony of Hood, Inc.’s expert witnesses because they “did not provide satisfactory countervailing evidence . . . that would credibly support a greater allowable amount.” It noted, for example, that one of Hood, Inc.’s expert reports based its analysis on survey data for CEO compensation from 2011 to 2016 for companies with a revenue of up to $500 million, which, the Tax Court concluded, was a poor match for both Hood, Inc.’s size and the relevant time period at issue.

At bottom, the Tax Court held that a reasonable total compensation for Mr. Hood was $3,681,269 for 2015 and $1,362,831 for 2016, and that a $5 million bonus for each year — on top of his salary — was excessive.[18]

The panel ultimately concludes that the taxpayer did not demonstrate any clear error by the Tax Court, including its decision to rely on the expert report provided by the IRS rather than the one presented by the taxpayer.

We find that Hood, Inc. has not demonstrated that the Tax Court’s factual findings were clearly erroneous or that its reliance on Fuller’s report was inappropriate. The court explained its reason for relying on Fuller and rejecting Hood, Inc.’s experts, and we see no basis to disturb that determination. See United States v. Hall, 664 F.3d 456, 462 (4th Cir. 2012) (“Evaluating the credibility of experts and the value of their opinions is . . . a function best committed to the district courts, and one to which appellate courts must defer, and we should be especially reluctant to set aside a finding based on the trial court’s evaluation of conflicting expert testimony” (cleaned up)).[19]

In summary, the panel expressed its view on the compensation issue as follows:

Mr. Hood’s business acumen and his contribution to Hood, Inc.’s prosperity were fully recognized by the Tax Court, and the Tax Court thus concluded that Hood, Inc. was entitled to compensate Mr. Hood well. And we agree.

This case is not about such compensation but rather about whether the amount paid was entirely for Mr. Hood’s personal services or whether it included profits distributable to him as a function of his ownership of the company. To make that determination, the Tax Court took a multifactor approach designed to measure the portion of compensation that was attributable only to Mr. Hood’s personal services and concluded that not all his compensation was so attributable.[20]

However the Panel Did Not Agree with Tax Court’s View That the Corporation Should be Assessed a Penalty for One Year

Although the IRS emerged victorious in its contention regarding the proper deductible compensation paid to Mr. Hood, the panel disagreed with the Tax Court’s determination that the corporation should be penalized for the understatement in one of the years.

The corporation asserts that it had exercised reasonable care in ascertaining the appropriate amount of compensation deduction to report on its tax returns. It argues that it acted in good faith and relied on the advice of qualified experts to determine the claimed amount on both year’s returns, so it should have escaped any penalty for both years.

Finally, Hood, Inc. contends that the Tax Court clearly erred in imposing a penalty for the 2016 tax year. It emphasizes that the Tax Court found that Hood, Inc. had reasonably relied in good faith on its tax advisers when paying the 2015 bonus and that therefore no penalty should be imposed for that year, and based on this finding, it argues that because it relied on the same tax advice for paying the 2016 bonus, the Tax Court should also have found good faith in 2016 and therefore should not have imposed the penalty for that year.[21]

The panel engaged in a discussion regarding the relevant law pertaining to the penalty in question under IRC §6662(a), as well as the provision of a good faith exception to the penalty outlined in IRC §6664(c)(1):

The Internal Revenue Code provides for the imposition of a 20% penalty on “any portion of an underpayment of tax” that is attributable to the taxpayer’s “substantial understatement” of income tax liability on its tax return. 26 U.S.C. §6662(a), (b)(2). Generally, an understatement is substantial if it exceeds 10% of the tax required to be shown on the return. Id. §6662(d)(1)(B)(i). A defense to the imposition of the penalty is provided, however, “with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” Id. §6664(c)(1) (emphasis added). In determining whether a taxpayer acted with reasonable cause and in good faith, “all pertinent facts and circumstances” must be considered, but “[g]enerally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” 26 C.F.R. § 1.6664-4(b)(1). Whether a taxpayer acted with reasonable cause and in good faith is a question of fact that we review for clear error. Est. of Kechijian v. Comm’r, 962 F.3d 800, 810 (4th Cir. 2020).[22]

A crucial avenue for taxpayers to establish reasonable cause is by demonstrating that they relied in good faith upon the guidance of qualified tax advisers who possessed all the pertinent facts.

Reliance on the advice of a professional tax adviser has been held to demonstrate reasonable cause and good faith if “(1) [t]he adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment.” Neonatology Assocs., P.A. v. Comm'r, 115 T.C. 43, 99 (T.C. 2000), aff'd, 299 F.3d 221 (3d Cir. 2002); see also United States v. Boyle, 469 U.S. 241, 250 (1985) (“Courts have frequently held that 'reasonable cause' is established when a taxpayer shows that he reasonably relied on the advice of an accountant . . . even when such advice turned out to have been mistaken”); Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 548 (5th Cir. 2009) (“The validity of this reliance turns on the quality and objectivity of the professional advice which [the taxpayer] obtained” (cleaned up)).[23]

The panel discussed how the Tax Court found good faith reliance on a tax adviser for one year but not another—but was not impressed with the analysis and its conclusion.

In this case, Hood, Inc. reported an income tax obligation for 2015 of $1,675,996, and the Tax Court found a deficiency of $550,866, which exceeded the 10% threshold for triggering a penalty. Similarly, Hood, Inc. reported an income tax obligation for 2016 of $4,040,956, while the Tax Court found a deficiency of $1,411,991, which again exceeded the 10% threshold for triggering a penalty. But with respect to the 2015 tax year, the court found that Hood, Inc. had established the reasonable-cause defense based on its reliance on the tax advice of two competent and experienced professional accountants at Elliott Davis. The company had provided Elliott Davis with accurate information regarding Mr. Hood's historic compensation and the proposed method of calculating his future compensation, and the two Elliott Davis accountants confirmed that they believed a $5 million bonus for Mr. Hood was reasonable. Yet with respect to the 2016 tax year, the Tax Court found that the evidence was lacking as to what advice the company may have received relating to Mr. Hood's 2016 compensation, observing that this absence of evidence was “particularly notable when considering that the record also does not show that, when awarding Mr. Hood the 2015 amount, [Hood, Inc.] felt Mr. Hood remained undercompensated or that additional backpay compensation might be warranted in the future for these prior services.” We conclude, however, that the Tax Court overstated the discrepancy in evidence relating to the two years.[24]

The panel then provides its own analysis that finds that the corporation qualifies for relief from the penalty for both years.

When Hood, Inc.’s CFO provided the backpay calculation to Elliott Davis in May 2015, he wrote, “Bonus due at 5/31/15 is $7,141,000. Pay $5,000,000 5/31/15 balance to future years.” (Emphasis added). Thus, contrary to the Tax Court’s observations, this evidence indicated that Hood, Inc. believed that Mr. Hood would still be undercompensated in 2016 following the payment of the $5 million bonus in 2015 and would therefore require additional backpay compensation in the future. Further, several of Hood, Inc.’s witnesses, including accountants at Elliott Davis, testified that they followed the same process to determine the bonus amount in 2016 as they did in 2015, and this fact went uncontroverted. Because the record indicates that Hood, Inc. anticipated remedying Mr. Hood’s past undercompensation in installments over multiple years and discussed that plan with its tax advisors at Elliott Davis, who approved it as reasonable, we conclude that the Tax Court’s finding regarding the reasonable-cause defense for the 2015 tax year should also have applied to the 2016 tax year.

Accordingly, we vacate the portion of the Tax Court’s decision imposing a $282,398 penalty for 2016.[25]

[1] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/fourth-circuit-affirms-ceo-compensation-deduction%2c-vacates-penalty/7gtk2 (retrieved June 2, 2023)

[2] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[3] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[4] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[5] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[6] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[7] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[8] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[9] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[10] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[11] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[12] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[13] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[14] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[15] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[16] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[17] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[18] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[19] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[20] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[21] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[22] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[23] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[24] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023

[25] Clay Hood, Inc. v. Commissioner, Case No. 22-1573, CA4, May 31, 2023