CASE NO. 17-01

IN THE

Supreme Court of the United States _________

COMMISSIONER, INTERNAL REVENUE COMMISSION, Petitioner,

v.

STUMP INCORPORATION, Respondent.

_________

On Writ of Certiorari to the United States Court of Appeals

for the Second Circuit

_________

BRIEF FOR THE PETITIONERS

TEAM 3:

PETITIONER

CASE NO. 17-01

IN THE

Supreme Court of the United States _________

COMMISSIONER, INTERNAL REVENUE COMMISSION, Petitioner,

v.

STUMP INCORPORATION, Respondent.

_________

On Writ of Certiorari to the United States Court of Appeals

for the Second Circuit

_________

BRIEF FOR THE PETITIONERS

TEAM 3

i

QUESTIONS PRESENTED

I. Whether the Commissioner rightfully disallows a deduction for shareholder

employee compensation under § 162(a)(1), when the independent investor test fails

to consider extraneous factors that the compensation is unreasonable, and the

deduction taken exceeds the corporate net income by 100% and the corporate gross

receipts by 80%?

II. Whether Taxpayer sufficiently overcame the presumption of correctness afforded to

the Commissioner on its disallowance of an improperly claimed deduction for

business entertainment expenses, which was not in accordance with the “ordinary

and necessary” or “directly related” standards, under § 271(a).

PARTIES TO THE PROCEEDING Petitioner is the Commissioner of the Internal revenue commission. The

respondents are, Stump Incorporation; J. Ronald Stump founder and president of Stump

Incorporation; Oak Stump Vice President of Stump Incorporation; Maple Stump

Corporate Treasurer of Stump Incorporation; and Willow Stump Corporate Secretary of

Stump Incorporation.

  ii

TABLE OF CONTENTS

QUESTIONS PRESENTED ................................................................................................ i PARTIES TO THE PROCEEDING .................................................................................... i TABLE OF CONTENTS .................................................................................................... ii TABLE OF AUTHORITIES ............................................................................................. iv STATEMENT OF JURISDICTION................................................................................... 1 OPINIONS BELOW ........................................................................................................... 1 STAUTORY PROVISIONS INVOLVED ......................................................................... 1 STATEMENT OF THE CASE ........................................................................................... 2 SUMMARY OF THE ARGUMENT ................................................................................. 4 ARGUMENT ...................................................................................................................... 6

I. The Appeals Court erred in reversing the Tax Court’s decision which properly disallowed Stump Inc.’s claimed deduction for shareholder employee compensation under §162(a)(1). .................................................................................. 6

A. The Independent Investor test should not be construed as a substantial presumption when extraneous facts suggests the ROE is an inaccurate measure for determining whether shareholder employee compensation is reasonable. ................. 8

B. Stump Inc.’s deduction for shareholder employee salary exceeds even the most liberal compensation benchmarks. ............................................................................ 16

II. The Appeals Court erred in reversing the Tax Court’s agreement with the determination of the Commissioner which properly disallowed Respondent’s claimed deduction of hockey tickets as a business entertainment expense under Internal Revenue Code §§ 162 and 274(a)(1)). ......................................................... 19

A. The court below failed to thoroughly examine the threshold issue of establishing the expenses as both “necessary” and “ordinary,” as required by § 162 and interpreted by this Court’s jurisprudence. .......................................................... 21

  iii

B. Taxpayer failed to properly and sufficiently establish that the hockey games, for which the tickets were purchased, qualify as “directly related to” or “associated with” the active conduct of the taxpayer’s trade or business. ................................... 22

C. Taxpayer failed to properly establish that the hockey games, for which the tickets were purchased, qualify as a “clear business setting.” .................................. 24

CONCLUSION ................................................................................................................. 27

  iv

TABLE OF AUTHORITIES

Cases Berkley Machine Works and Foundry Co. v. C.I.R., 623 F.2d 898 (4th Cir. 1980) ......... 20 Botany Worsted Mills v. United States, 278 U.S. 282 (1929) ............................................. 4 Commissioner v. Heininger, 320 U.S. 467 (1943) ............................................................ 17 D. A. Foster Trenching Co., v. United States, 473 F.2d 1398 (Ct.Cl. 1973) .................... 17 Danville Plywood Corp. v. United States, 899 F.2d 3 (Fed. Cir. 1990) ........................... 17 Dexsil Corp. v. C.I.R., 147 F.3d 96 (2d Cir. 1998) ......................................................... 5, 8 Eberl’s Claim Service Inc. v. C.I.R., 259 F.3d 994 (10th Cir. 2001) .......................... 11, 12 Elliots, Inc. v. C.I.R., 716 F.2d 1241 (9th Cir. 1983) .......................................... 6, 8, 11, 12 Exacto Spring Corp. v. C.I.R., 196 F.3d 833 (7th Cir. 1999) ......................................... 6, 8 Good Chevrolet v. C.I.R., 36 T.C.M. (CCH) 1157 (1977) ......................................... 14, 15 Handelman v. C.I.R., 509 F.2d 1067 (2d Cir. 1975) ......................................................... 21 Lilly v. C.I.R., 343 U.S. 90 (1952) .................................................................................... 17 Mayson Mfg. Co. v. C.I.R., 178 F.2d 115 (6th Cir. 1949) ................................................... 5 Moore v. United States, 943 F. Supp. 603 (E.D. Va. 1996) .............................................. 22 Mulcahy, Pauritsch, Salvador & Co., Ltd., v. C.I.R., 680, F.3d 867 (7th Cir. 2012) 6, 9, 11 Owensby & Kritikos, Inc. v. C.I.R., 819 F.2d 1315 (5th Cir. 1987) ........................... passim Pepsi-Cola Bottling Company of Salina v. C.I.R., 528 F.2d 176, 179 (10th Cir. 1975) ..... 4 Rutter v. C.I.R., 52 T.C.M. (CCH) 326 (1986) ................................................................. 11 Schneider & Co. v. Commissioner, 500 F.2d 148, (8th Cir. 1974) ...................................... 5 Hippodrome Oldsmobile, Inc. v. United States, 474 F.2d 959 (6th Cir. 1973) ................ 17 St. Petersburg Bank & Trust Co. v. United States, 362 F. Supp 674 (1973) .................... 20

  v

Transupport, Incorporated v. Commissioner of Internal Revenue, 2016 WL 6900913 * 8 (T.C. 2016) .......................................................................................................................... 6 United States v. United States Gypsum Co., 333 U.S. 364 (1948) ..................................... 2 Welch v. Helvering, 290 U.S. 111 (1933) ......................................................................... 17

Statutes 26 U.S.C. 13 (2008) ............................................................................................................ 3 26 U.S.C.§ 162(a)(1) (2014) ...................................................................................... passim 26 U.S.C. § 274(a)(1) (2014) .............................................................................................. 1 Other Authorities Blacks Law Dictionary (10th ed. 2014) ............................................................................. 13 CCH Tax Research Consultant, COMPEN: 9,1114, Independent Inactive Investor Analysis to Evaluate Reasonableness of Compensation ..................................................... 5

Regulations Treas. Reg. § 1.162-7(a) (1960) .......................................................................................... 4 Treas. Reg. § 1.274-2(c)(4) ............................................................................................... 23 Treas. Reg. § 1-274-2(c)(3)(i) ........................................................................................... 21 Treas. Reg. § 1.162-7(a) (1960) .......................................................................................... 4

1

STATEMENT OF JURISDICTION1

A Formal Statement of Jurisdiction has been omitted in accordance with the

University of Buffalo Law School 2017 Albert R. Mugel National Tax Court

Competition.

OPINIONS BELOW

The decision of the court of appeals reversing the tax court’s decision is reported

at 123 F.4th 1(2016). The tax court’s decision holding the deduction for the

compensation and tickets improper is unreported.

STAUTORY PROVISIONS INVOLVED

This case involves two provisions of the United States Tax Code 26 U.S.C.§

162(a)(1) (2014) and 26 U.S.C. § 274(a)(1)(A) (2014). First, §162(a)(1) states, “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 a reasonable

allowance for salaries or other compensation for personal services actually rendered. In

conjunction, this case involves compensation to shareholder-employees that was

deducted in 2013.

Further, 26 U.S.C. § 274(a)(1) states, “No deduction otherwise allowable under

this chapter shall be allowed for any item—With respect to an activity which is of a type

generally considered to constitute entertainment, amusement, or recreation, unless the

taxpayer establishes that the item was directly related to, or, in the case of an item

directly preceding or following a substantial and bona fide business discussion (including                                                                                                                1 References to the Official Record appear as “R##”

2

business meetings at a convention or otherwise), that such item was associated with, the

active conduct of the taxpayer’s trade or business. This case involves a deduction of

hockey tickets as a business entertainment expense.

STATEMENT OF THE CASE

I. STATEMENT OF FACTS

This case involves a Notice of Deficiency served on Stump Incorporation

(“Taxpayer” or “Stump Inc.”) for the 2013 taxable year. R. at 5. Stump Inc. is a closely

held corporation in Buffalo, New York. R. at 2. Its founder, president and CEO, J.

Ronald Stump owns approximately 97% of Stump Inc.’s corporate stock, while Stump’s

older children, Oak Stump, the Vice President of Stump Inc., Maple Stump, Treasurer,

and Willow Stump, Stump Inc.’s corporate secretary, each own 1% of Stump Inc.’s

corporate shares. Id. Stump Inc. is known throughout New York, for its expertise in real

estate development, including the development of a Western New York casino and

waterfront. R. at 2. Stump Inc.’s success in the real estate development business has

created a “buzz” throughout most of the New York area and as a result, the Stump name

now appears on restaurants, spa’s, gentlemen club’s, and golf courses. Id. However,

aside from Stump Gardens, a property Stump Inc. purchased with borrowed funds in

2010 for $25,000,000, Stump Inc. nor its shareholder employees own any of the listed

properties or real estate assets. Id. Instead, the Stump enterprise success has resulted

mainly from the licensing of the Stump name to real estate properties and other luxury

goods. Id. at 4.

In fact, the Stump name has become so popular throughout the region, in 2013

alone Stump Inc. grossed nearly $5,000,000 in revenue from its licensing deals. R. at 4.

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Testimony at trial indicated that the Stump brand’s popularity has thus far accounted for

the financial success of a number of firms. As a result, Stump Inc. paid each of its

shareholder employees $1,000,000 in compensation for services rendered to build the

Stump brand. Id. At the time of the notice of deficiency, Stump Inc. had not distributed

dividends to its shareholder employees but deducted $4,000,0000 on its 2013 tax return

for the shareholder employee compensation. Stump Inc. also deducted $100,000 for four

season tickets to the Buffalo Sabres as necessary business expenses. R. at 5. In

conclusion, Stump Inc. paid $0.00 in taxes for the 2013 taxable year after grossing

$5,000,000 in revenue, distributing $4,000,000 in compensation, and deducting an

additional $100,000 for business expenses. Id.

II. NATURE OF PROCEEDINGS

Following Stump Inc.’s 2013 deductions, the Commissioner served a Notice of

Deficiency on Stump Inc. The Commissioner claimed that the $4,000,000 deduction for

shareholder employee compensation and the $100,000 deduction for hockey tickets were

improper and unreasonable under the tax code. R. at 5. At the Tax Court, both parties

introduced evidence in support of its respective theory. However, after considering

considering Stump Inc.’s grossed revenue, outstanding debts, and structure of the closely

held Corporation, the Tax Court agreed with the Commissioner and upheld the 2013

deficiency as improper or excessive. Id. Stump Inc. appealed and the Second Circuit

Court of Appeals reversed the Tax Court’s decision, finding that Stump Inc.’s 2013

deductions for shareholder employee compensation was reasonable under §162(a)(1) and

the expenses for the Sabres tickets was reasonable under § 274(a)(1).

4

SUMMARY OF THE ARGUMENT

The Second Circuit, as are all of United States Appellate Courts, is a court of

limited jurisdiction. In the proceeding below, the Second Circuit should have affirmed

the Tax Court’s decision unless clearly erroneous. This Court has established that “a

finding is clearly erroneous when although there is evidence to support it, the reviewing

court on the entire evidence is left with the definite and firm conviction that a mistake has

been committed.” United States v. United States Gypsum Co., 333 U.S. 364, 395 (1948)

(emphasis added). Accordingly, the Second Circuit reversal of the Tax Court’s decision,

which concluded that Stump Inc.’s 2013 deductions for shareholder employee

compensation and business entertainment expenses were improperly claimed and

unreasonable, should be reversed because when viewed holistically the compensation and

business expenses were unreasonable.

Specifically, 26 U.S.C. §162(a)(1) authorizes reasonable deductions for ordinary

and necessary expenses paid or incurred during the taxable year. In the current case, the

$4,000,000 deduction for shareholder employee compensation was improper,

unreasonable, and not clearly erroneous because §162(a)(1) disallows deductions for

compensation when the compensation is not reasonable or distributed purely for services

rendered. Courts have outlined a nine factor test to determine whether shareholder

employee compensation is reasonable but some courts have redefined the nine factor test

into a five factor categorization. The courts are divided over how to treat the nine factor

test and the five factor categorization when determining whether compensation paid to

shareholder employees is reasonable. However, the Appellate Court’s decision should be

reversed because the Tax Court’s finding that Stump Inc.’s 2013 $4,000,000 deduction

5

fails the independent investor rebuttable presumption and exceeds even the most liberal

corporate gross and net income threshold.

In addition, the court below erred in its reversal of the Tax Court’s decision to

uphold the determination of the Commissioner as to its disallowance of the improperly

claimed deduction of sporting tickets as a business entertainment expense. While

governed by § 162 of the Internal Revenue Code, business entertainment expenses must

also satisfy the more rigorous requirements of § 274(a), as well as the substantiation

requirements of § 274(d). Berkley Machine Works and Foundry Co. v. Commissioner of

Internal Revenue, 623 F.2d 898, 901 (4th Cir. 1980). The “directly related” requirements

of the statute follow the intent of Congress to avoid abuse and to ensure the propriety of

deductions claimed for when business ventures and entertainment expenses are

comingled into the same events. The “clear business setting” standard laid out by Treas.

Reg. § 1-274-2(c)(3), provides regulatory flexibility for the myriad ways businesses may

communicate and handle business ventures and promotion.

In the instant case, Taxpayer has failed to provide evidence that overcomes the

inherent presumption of correctness afforded the Commissioner of Internal Revenue in its

determinations. See Welch v. Helvering, 290 U.S. 111, 115 (1933). At no point, did

Taxpayer provide any substantiation that provides that the expenditures or the activities

that took place therefrom were directly related to the active conduct of his trade or

business. The ruling of the court below creates an absurd result that cannot be squared

with the result of the statute, and accordingly, the ruling should be reversed.

6

ARGUMENT

I. The Appeals Court erred in reversing the Tax Court’s decision which properly disallowed Stump Inc.’s claimed deduction for shareholder employee compensation under §162(a)(1). The Internal Revenue Code outlines the federal tax laws for individuals,

corporations, closely held corporations, and other business entities. Tax Courts have an

obligation to oversee “cases commenced upon the issuance by the Commissioner of a

notice of deficiency in income.” 26 U.S.C. 13 (2008). For the 2013 taxable year, the

Commissioner issued a notice of deficiency against Stump Inc. for a $4,000,000

deduction it thought unreasonable under §162(a)(1) and the Appeals Court erred in

reversing the Tax Court’s decision for a few specific reasons. Specifically, §162(a)(1)

states:

“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, a reasonable allowance for salaries or other compensation for personal services actually rendered.” Treasury Regulations have deciphered §162(a)(1) and indicated that “[t]here may

be included among the ordinary and necessary expenses paid or incurred in carrying on

any trade or business a reasonable allowance for salaries or other compensation for

personal services actually rendered. Treas. Reg. 1.162-7(a) (1960). In contrast, this Court

has stated that, “"extraordinary, unusual and extravagant amounts paid by a corporation

to its officers in the guise and form of compensation for their services, but having no

substantial relation to the measure of the services, and being utterly disproportioned to

their value, are not in reality payment for services and cannot be regarded as ‘ordinary

and necessary expenses’ …” See Botany Worsted Mills v. United States, 278 U.S. 282,

292 (1929). Thus, compensation is only deductible when (1) reasonable in relation to the

7

services performed and (2) the compensation is purely for services rendered. §162(a)(1);

26 C.F.R. § 1.162-7(a).

Historically nine factors were used to determine whether shareholder employee

compensation was reasonable. Mayson Mfg. Co. v. C.I.R., 178 F.2d 115, 119 (6th Cir.

1949). However, special scrutiny was given where a corporation was controlled by the

employees to whom the compensation was paid because of the lack of an arm's-length

bargain and the possibility and incentive to disguise taxable income and dividends which

could not appreciate or be reinvested. See Transupport Incorporated v. Commissioner of

Internal Revenue *7; Pepsi-Cola Bottling Company of Salina v. C.I.R, 528 F.2d 176, 179

(10th Cir. 1975). The nine Mayson factors are:

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 the gross income and the 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; the salary policy of the taxpayer as to all employees; and in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years. See Mayson, 178 F.2d at 119. Whether shareholder compensation is reasonable

under the Mayson factors, remains a question of fact that is resolved on the basis of an

examination of all the facts and circumstances of each particular case. See Charles

Schneider & Co. v. Commissioner, 500 F.2d 148, 15, (8th Cir. 1974). Therefore, the

Second Circuit had an affirmative duty to affirm the Tax Court’s decision unless after

considering all the facts before it, it was left with a definite and firm conviction that a

mistake had been committed. Gypsum Co., 333 U.S. at 395.

8

Courts have given no directions on how the Mayson factors should be weighed

and some courts have opted to do away with the nine factor Mayson test for a five factor

categorization. The five factor categorization outlines the independent investor test

which the Appellate Court erroneously suggested is a substantial presumption. See

Exacto Spring Corp. v. C.I.R., infra. at 835. Facially, the independent investor test

instructs that, when an inactive independent investor contemplating purchase of a

company would be willing to pay the distributed compensation, the test is an important

measure of the reasonableness of the shareholder employee compensation. CCH Tax

Research Consultant, COMPEN: 9,1114, Independent Inactive Investor Analysis to

Evaluate Reasonableness of Compensation.

However, courts have cautiously applied the independent investor test because

corporations can use the independent investor rationale to pay out exceedingly high

compensation if an independent investor would be satisfied with his or her return on

equity. In fact, closely held corporations find it beneficial to compensate employee

shareholders whilst refusing to pay dividends. Dexsil Corp. v. C.I.R., 147 F.3d 96, 100

(2nd Cir. 1998). This allows corporations such as Stump Inc. to fully deduct all its

distributions, to include disguised dividends, whilst decreasing its corporate tax bill. Id.

at 100; See infra Elliotts, 716 F.2d at 1243. Further, courts have concluded that when net

income is exceeded by a certain percentage an inference can be drawn that the

corporation is attempting to distribute compensation for reasons other than services

actually rendered, and in the instant case Stump Inc.’s compensation exceeded the net

income by 100%. Transupport, Inc., 2016 WL 6900913 * 8 (T.C. 2016).

A. The Independent Investor test should not be construed as a substantial presumption when extraneous facts suggests the ROE is an inaccurate

9

measure for determining whether shareholder employee compensation is reasonable. The independent investor test is but one factor that should be considered when the

return of equity (ROE) analysis fails to consider extraneous factors that suggest

shareholder employee compensation is due to a windfall, would reduce the ROE to zero,

or is not purely for services actually rendered. See Mulcahy, Pauritsch, Salvador & Co.,

Ltd., v. C.I.R., 680, F.3d 867, 872 (7th Cir. 2012); Exacto Spring Corp. v. C.I.R., 196

F.3d 833, 837-38 (7th Cir. 1999); Owensby & Kritikos, Inc. v. C.I.R., 819 F.2d 1315,

1326 (5th Cir. 1987).

Contrary to the Appeals Court decision, the Ninth Circuit did not blatantly reject

the Mayson factors but opted to establish five broad categories and an independent

investor test as a mechanism to more easily determine whether shareholder employee

compensation is reasonable under certain limited circumstances. Elliots, Inc. v. C.I.R.,

716 F.2d 1241, 1245 (9th Cir. 1983). Further, although the Elliots court rejected the Tax

Court’s decision to solely consider the element of a disguised dividend under the

automatic dividend rule, it did not state that a disguised dividend was never a factor the

court should consider when determining whether shareholder employee compensation is

reasonable. Id. at 1243 (emphasis added). Instead, the Elliots courts stated “if the

company’s return on equity remains at a level that would satisfy an independent investor,

there is a strong indication that management is providing compensable services and that

profits are not being siphoned out of the company disguised.” Id. at 1247. However, the

Court instructs that where there is evidence that an otherwise reasonable compensation

payment contains a disguised dividend the inquiry may expand into compensatory intent

apart from reasonableness. Id. at 1244. Therefore, an independent investor’s willingness

10

to pay and reasonableness of shareholder employee compensation depends largely on (1)

how much return on equity the taxpayer company is generating for investors, (2) whether

the employee is responsible for the rate of return and in certain limited cases (3) the

compensatory intent and as a result the Tax Court’s decision was not clearly erroneous.

See Elliots, 716 F.2d at 1244; CCH Tax Research Consultant, COMPEN: 9,1114,

Independent Inactive Investor Analysis to Evaluate Reasonableness of Compensation.

1. Stump Inc.’s return on equity was exaggerated when construed through the lens of an independent investor and the shareholder employee compensation was excessive for services actually rendered.

The Ninth Circuit indicated that in evaluating whether shareholder employee

compensation is reasonable, it is helpful to consider the matter from “the perspective of a

hypothetical independent investor. Elliots, 716 F.2d at 1245. Other Appellate Courts

have construed this statement differently, many are divided over how to apply the test,

and many have struggled to determine whether the test is dispositive. Id. However,

courts agree that the corporation's rate of return on equity is relevant to the independent

investor in assessing the reasonableness of compensation in a small corporation where

excessive compensation would noticeably decrease his or her rate of return. Id.

For example, Elliots concluded that when the bulk of a corporations earning is

being paid out in the form of compensation, an independent shareholder would probably

not approve of the compensation arrangement, i.e. if after payment of the compensation

there is not a reasonable return on the shareholder’s equity. 716 F.2d at 1247. Further,

the Second Circuit, in Dexsil Corp., adopted the independent investor test and construed

the paid out compensation through the lens of an investor. 147 F.3d at 101. The Court

considered various factors such as the President and CEO, Ted Lynn, salary and bonuses

11

which equaled $76,540 in 1989 and $168,000 in 1990. Id. at 98. In addition, the court

noted Ted’s, his family, and nonfamily member’s ownership in stock as, 61.62%, 29.11%

and 9% respectively. Id. The Court also considered bonus plans which paid Ted

approximately 11% of Dexsil’s gross sales whilst other employees enjoyed incentive

stock option plans or restricted stock award plan. Id. at 99. After considering the salaries

distributed, the stock holding of each corporate officer and the the salary plan, the Court

concluded the independent investor test was not a separate autonomous factor but

provided a lens through which the Mayson factors should be viewed, hence the test itself

must still take into consideration the Mayson factors. Id.

In conjunction, the Seventh Circuit has established that the independent investor

test should be construed as a “lens through which the nine Mayson” factors should be

construed but when other factors are present the test may be simply another factor to

consider. For example, in Exacto Spring Corp., a closely held corporation, paid its

cofounder, chief executive, and principal owner, William Heitz, $1.3 and $1.0 million,

respectively, in salary during the years in question. 196 F.3d at 833. The Commissioner

thought the compensation excessive and it assessed a deficiency. Id. As a result, the

court concluded that the presumption of reasonableness under the independent investor

test is a rebuttable presumption when there are extraneous factors. Id. Thus, although an

independent investor may be satisfied with its ROE, the shareholder employee salary may

nonetheless be unreasonable. Id.

The extraneous factor rebuttal was echoed in Mulcahy, where an accounting firm

petitioned for a redetermination of tax deficiencies that the Internal Revenue Service

reclassified as dividends. 680 F.3d at 872. Once again, the Seventh Circuit established

12

that independent investor test is a rebuttable presumption that must be construed with

other factors and is not dispositive alone. Id. at 871. More specifically the court

established that when a company’s success is “the result of extraneous factors, other

factors besides the percentage of return on equity have to be considered.” Id. (emphasis

added). Further the Court established that when treating a salary as an expense would

reduce a firm’s income to zero it would in theory additionally reduce an investor’s return

of equity to zero and as a practical matter flunk the independent investor test. Id.

The Record reflects that in 2013 Stump Incorporation grossed nearly $5,000,000

in revenue from licensing deals. R at 3. The Official Record also reflects that each

corporate officer was paid $1,000,000 bringing the total deductions for the 2013 taxable

year to $4,000,000 while in the same year Stump Inc. was liable for $24,750,000 in

unpaid balances and interests for the purchase of its 2010 Stump Garden building.

Facially, the 2013 $5,000,000 in gross receipts suggests that Stump had a high return on

equity as suggested by the Appeals Court. However, the First, Second, Sixth, and Ninth

Appellate Courts have all indicated that the independent investor test, which outlines the

ROE, is not dispositive when extraneous facts indicate that the compensation reduces the

ROE to zero, is not for services rendered or the compensation distributed is not

reasonable in light of the corporations outstanding debts.

In Mulcahy, the court blatantly indicated that one factor to consider is the net

income of the closely held corporation as it relates to the return on equity. 680 F.3d at

876. The Court reasoned that when the deductions taken reduce the net income to zero,

shareholder return to equity is also reduced to zero and therefore such a deduction would

be per se unreasonable. Id. If upheld, Stump Inc.’s 2013 deduction would reduce its

13

taxable income by 100% and gross receipts by 80%. R. at 4. As a result, it was not

clearly erroneous for the Tax Court to find the compensation unreasonable because an

independent investor would have had nearly zero return on equity considering the

distributed compensation.

Lastly, although the Appellate Courts agree that the independent investor test is

an important mechanism when determining whether shareholder employee compensation

is reasonable, Appellate courts have not indicated that the presumption is a substantial

presumption. In fact, many courts seem to indicate that the presumption is a rebuttable

presumption. As suggested in Mulcahy, ROE must be carefully observed in closely held

corporations because of possible inflations due to extraneous factors and windfalls. 680

F.3d at 872. In the current case, extraneous factors included: the nearly $25 million in

unpaid debts; the incentive to disguise dividends and gains as compensation; the fact that

there was no way for shareholder holdings to appreciate in value with each officer only

owning 1% and a windfall related solely to the corporate licensing and fame of the Stump

name; and lastly, the net income of the corporation was deduced to zero would suggest

that the return of equity was also zero.

2. Additional evidence suggested that Stump Inc.’s compensatory intent was to avoid taxes on distributed dividends.

Compensatory intent can be inferred when there is evidence that a closely held

corporation and its shareholder employees have an incentive to hide dividends in

compensation payments. See Elliots, 716 F.2d at 1244; Mulcahy, 680 F.3d at 872; Rutters

v. C.I.R., 52 T.C.M. (CCH) 326 (1986).

14

Courts have concluded that in closely held corporation’s employee shareholders

may have an incentive to distribute earnings in the form of compensation. See Eberl’s

Claim Service Inc. v. C.I.R., 259 F.3d 994, 998 (10th Cir. 2001). Primarily, absent third

party interests in limiting compensation for the sake of profitability, dividends may be

disguised as a salary and channeled out of the corporation tax free.” Id. Although the

Ninth Circuit rejected the automatic dividend rule, like the Tenth Circuit, it does suggest

that when there is evidence that there is an intent to hide dividends in compensation

payments, courts should consider the intent of the compensation. Elliots, 716 F.2d at

1243. Likewise, the Court established that where a corporation has multiple shareholders

“the existence of a plan which compensates shareholder-employees in proportion to their

ownership interests may be evidence that compensation payments contain disguised

dividends. Id.

Further, it has been indicated that when a corporation has a poor dividend

distribution history there may be an intent to avoid taxes altogether. For example, the

Tax court found that the petitioner in Rutter’s accumulated earnings and profits beyond

the reasonable needs of its business. 52 T.C.M. (CCH) 326 (1986). The earnings

accumulation, and the corporations three time distribution of dividends in a fifty year

period suggested to the court that the corporation’s intent was purely tax avoidance

because there were no other reasons not to distribute dividends. Id.

Stump Inc. has four shareholders, R. Stump, Oak Stump, Maple Stump, and

Willow Stump and they each own 97%, 1%, 1%, and 1% respectively of the corporate

shares. R. at 2. Unlike in Elliots where the court found there was no intent on the part of

the shareholder employee to disguise the distributed dividends, this case presents a

15

different narrative. 716 F.2d at 1244. As found by the Tax Court, and echoed by the

Appellate court “when the payments made are unquestionably at the high end of the

spectrum of the compensation” a correlation between stockholdings and compensation is

necessary to determine whether a portion of the compensation is a disguised dividend. R.

at 15. All three adult children were paid $1,000,000, each owned 1% of Stump Inc. and

though they may have contributed equally to the success of the Stump Inc., and the

compensation was not in proportion to the corporate shares, the equal compensation

infers that a portion of the salary may have been disguised as a dividend to avoid taxes on

pro rata shares.

Further, under certain conditions closely held corporations have an incentive to

distribute outstanding dividends through compensation so as to completely avoid

corporate and dividend taxes. Rutters, 52 T.C.M. (CCH) 326; Eberl’s Claim Service Inc.,

259 F.3d at 998. Stump Inc. has an incentive to avoid taxes because there are no checks

on the distribution of Stump Inc.’s dividends, Stump Inc. owes large sums in outstanding

debts, and the shareholder employees are all family reaping the benefits of the avoidance.

52 T.C.M. (CCH) 326 (1986). Rutters, indicated that by observing the deduction history,

dividend history, overall salary scheme, industry compensation levels, and business

operations and profits of a corporation, a court could determine whether the excessive

compensation was intended to avoid taxes. Id. In the current case, the record does not

reflect the dividend history, compensation levels or other business operations of the

corporation. However, the record does reflect the business operation and profits of the

corporation. Id.; R. at 3-5. Stump’s children each held administrative positions, assisted

with development products, and attended events for the Stump brand. R. at 2-3.

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However, the record further reflects that Stump Inc. was in debt by nearly $25 million

and that each adult child was compensated equally and equally possessed 1% of the

corporate shares. These inferences suggest that the Tax Court’s decision was not clearly

erroneous because though the Stump children should have been compensated handsomely

there was an incentive and an erroneous intent unreasonably compensate the children all

whilst decreasing Stump Inc.’s the taxable income – i.e. gains to zero. R. at 4.

Therefore, the independent investor test is at most a rebuttable presumption and

the Tax Court’s finding was not clearly erroneous because through the lens of an

independent investor, the ROE was insufficient because there was no return as all of the

taxable income, i.e. gains, were distributed, and the compensatory intent was improper.

B. Stump Inc.’s deduction for shareholder employee salary exceeds even the most liberal compensation benchmarks.

Courts measure compensation as a percentage of gross receipts and net income

but taxable net income tends to more accurately gauge whether a compensation includes

a disguised dividend. See Owensby & Kritikos, Inc., 819 F.2d at 1325.

Taxable income is computed by, allocating the gross income minus all allowable

deductions and exemptions and is in practice the amount of income used for calculation

of income taxes owed by an individual or a company. Blacks Law Dictionary (10th ed.

2014). Whilst, gross receipts or gross income is the total amount of money or other

consideration received by a business taxpayer for goods sold or services performed in a

taxable year, before deductions. Blacks Law Dictionary (10th ed. 2014). Although

Courts have been generally known to measure compensation as a percentage of gross

receipts or net income, net income (the taxable income (i.e. all income minus relevant

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deductions)) accurately gauges whether a corporation is disguising distributed dividends

as compensation. See Owensby & Kritikos, Inc., 819 F.2d at 1325 -26.

For example, in Good Chevrolet, the Court addressed the reasonableness of

compensation paid to two employees of an automobile dealership which saw a historic

increase in sales. Good Chevrolet v. C.I.R., 36 T.C.M. (CCH) 1157 (1977). Together, the

employees held 100% of the corporation's stock. Id. In addition, the shareholder

employees controlled the affairs of the franchise and a “large portion” of the franchises

net income, approximately 60% in 1971 and 57% in 1972, was paid as compensation to

the shareholder employees while only 1.69% in 1971 and 2.0% in gross income was paid.

Id. In addition, Chevrolet’s parent company required that the franchising petitioner retain

a substantial networking capital account. Id. The court notes, that the compensation was

reasonable, however, had it not been for the networking capital account oversaw by the

parent corporation, additional amounts could have been paid out. Id.

In contrast, the Fifth Circuit has indicated that a portion of the shareholder

employee compensation is unreasonable when it exceeds the taxable income by 53.7% or

65.1%. Owensby & Kritikos, Inc., 819 F.2d at 1326. In Owensby & Kritikos, Inc., the

corporate taxpayers, entered into work agreements with Mr. Owensby and Mr. Kritikos.

Id. During the taxable years at issue, the “work agreement provided for a guaranteed

annual salary of $72,000, an incentive bonus of 3% of the net volume of yearly business,

and an additional bonus to be paid at the discretion of the board of director.” Id. In

conclusion, the Court held the “payments to shareholder employees constituted 12.3%

and 9.0% of the consolidated gross receipts during the two taxable years and 53.7% and

65.1% of consolidated taxable net income to be unreasonable because even in Good

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Chevrolet, the court noted that “each case turns on its own facts and circumstances. Id. at

1325-26; 36 T.C.M. (CCH) 1157 (1977).

Neither the Second Circuit nor this court owes deference to the Tax Court in

Good Chevrolet because this case is reviewable as a question of law. Elliotts, 716 F.2d at

1245. A review of the official record indicates, that the Tax Court’s decision was not

clearly erroneous because under the facts presented by Stump Inc. the large portion of net

income paid in compensation to the shareholder employees suggest that even under the

most liberal benchmark the compensation was unreasonable for services actually

rendered. See Good Chevrolet 36 T.C.M. (CCH) 1157 (establishing the 60% benchmark

referred to in the record). However, for the 2013 taxable year, the shareholder employee

compensation exceeded Stump Incorporations taxable and net income by a stunning

100%. R. at 4.

Further, although Stump Inc.’s issues closely mirror the issue addressed in Good

Chevrolet, where the court established that 60% of net income and 1.69% to 2.0% of

gross income in a good producing corporation is reasonable, Stump Inc.’s 2013

deductions fall short because its deductions exceeded gross income by 80% and net

income by 100%. In addition, there are no shareholder and employee bonuses which

could explain the $1,000,000 in salary, and Stump Inc. does not produce any goods for

which bonuses could incur. 36 T.C.M. (CCH) 1157. Likewise, in Good Chevrolet, the

court conceded that the compensation could be explained as a result of the capital account

that the Chevrolet franchise was required to maintain. Id. In the current case there is no

capital account in which to place revenue so as to enhance the value of the shareholder

employee holdings. Nor is there a parent entity in place to account for revenue that could

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have been distributed in the form of dividends. As a result, the Tax Court’s decision was

not clearly erroneous because the compensation deductions were not just a “large

portion” of the taxable income but all of the taxable income

Lastly, though owing no deference to its holding, the Fifth Circuit established

relatively defined parameters in Owensby & Kritikos, Inc. As already outlined, the

Court’s decision focused on the potential for shareholder employee compensation but

concluded that shareholder employees are unreasonable when it exceeds the taxable

income by 53.7% or 65.1%. Supra, at 1326. In the current case Stump Incorporation’s

2013 deduction in employee compensation was 100% of the taxable income. R. at 4.

When taken literally, this indicates that the corporation itself saw zero income which

would suggest that the deduction itself fails the independent investor test because zero

income would suggest zero return on its equity.

Therefore, the Tax Court finding that the deductions for shareholder employee

compensation was not clearly erroneous because facts suggest that the deduction taken

exceeds even the most liberal interpretation of net income threshold.

II. The Appeals Court erred in reversing the Tax Court’s agreement with the determination of the Commissioner which properly disallowed Respondent’s claimed deduction of hockey tickets as a business entertainment expense under Internal Revenue Code §§ 162 and 274(a)(1)).

Deductions, under the Internal Revenue Code, are a matter of legislative grace, as

it is Congress who holds the discretion to allow or disallow such deductions. See

Commissioner v. Tellier, 383 U.S. 687, 693 (1966) (citing Commissioner v. Sullivan, 356

U.S. 27, 28 (1958)). In enforcing said legislative pronouncements, the Commissioner

issues – and this Court has upheld – disallowances of deductions that would frustrate

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sharply defined national policies proscribing particular types of conduct, as pronounced

by a governmental declaration. Commissioner v. Heininger, 320 U.S. 467, 373 (1943);

Lilly v. Commissioner, 343 U.S. 90, 97 (1952). In the instant case, Congress specifically

enacted 26 U.S.C. § 274(a) to supplement § 162 to eliminate what was perceived as

widespread abuse of expense accounts and business entertainment expenses. See

Hippodrome Oldsmobile, Inc. v. United States, 474 F.2dc 959, 961 (6th Cir. 1973); see

also Danville Plywood Corp. v. United States, 899 F.2d 3, 7 (Fed. Cir. 1990). As a result,

claimed deductions for business entertainment expenses are subject to a more stringent

standard with respect to the proximate relationship of the expense to the active conduct of

the business. See D. A. Foster Trenching Co., v. United States, 473 F.2d 1398, 1400

(Ct.Cl. 1973).

The Commissioner’s asserts that Taxpayer failed to sufficiently overcome the

Commission’s presumption of correctness regarding application of both the four-factor

“directly related test” and the “clear business setting” test for the deductions claimed. See

generally Welch v. Helvering, 290 U.S. 111, 115 (1933) (citing Wickwire v. Reinecke,

275 U.S. 101 (1927); providing that the rulings of the Commissioner have the

presumption of correctness and the petitioner has the burden of proving it to be wrong)).

In addition, Taxpayer has failed to properly substantiate the claimed deductions, as

required by § 274(d). The court below incorrectly applies the statutes, regulations, case

law, and legislative history to the record provided in determining that the hockey games

constitute a “directly related” expense in a “clear business setting,” and thus giving rise to

an appropriate deduction. See Treas. Reg. §§ 1.274-2(c)(3), (4). In so doing, in addition

to improperly granting the deduction, the ruling below, as a matter of law, creates an

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absurd result, eviscerating the efficacy and countermanding the legislative intent of the

federal statute as applied to Taxpayer, creating problematic enforcement inefficiencies

for similarly situated cases. As a result of the foregoing, this Court should reverse the

court below and uphold the determination of the Commissioner, as found by the Tax

Court.

A. The court below failed to thoroughly examine the threshold issue of establishing the expenses as both “necessary” and “ordinary,” as required by § 162 and interpreted by this Court’s jurisprudence.

Prior to approaching the “directly related” or “associated with” standards,

allowable business expense deductions must be established as “ordinary and necessary.”

IRC § 162. This Court has established the parameters of a “necessary” expense as those

that are appropriate and helpful to the development of the petitioner’s business. See

Welch, 290 U.S. at 113. The Government does not dispute this contention as applied to

Taxpayer’s claim for the deduction; however, the elements require the expenses to also

be “ordinary.” IRC § 162. This Court has examined the meaning of “ordinary” in the

statute, identifying that there must always be a strain of constancy within it, which can be

affected by time, place, and circumstance. Id.

The Welch court provided that expenses are ordinary when examined in

accordance with the ways and conduct and forms of speech prevailing in the business

world. Id. at 114. To do so, the record must evince that the expense is not unique in the

life of similar businesses such that the court can “stabilize its judgment, making it certain

and effective.” Id. at 114. In said case, a business owner – in order to establish and

solidify reputations with his customers – expended sums to eliminate prior debts. Id.

There, we stated – in a ruling ultimately upheld by this Court – that the payments were

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not deductible from income as ordinary and necessary expenses, but rather were in the

nature of capital expenditures, an expenditure for the development of reputation and good

will. Id. (emphasis added). The Welch court stated directly:

“Reputation…[is] akin to capital assets, like the good will of an old partnership. For many they are the only tools with which to hew a pathway to success. The money spent in acquiring them is well and widely spent. It is not an ordinary expense of the operation of the business.” Id. at 116. (emphasis added). In the instant case, based on the record, the

petitioner failed to establish and, inexplicably, the court below failed to thoroughly

examine this threshold question. Here, as in Welsh, the record similarly fails to provide

any substantiation of these expenses being ordinary within the business world with

similar businesses akin to Taxpayer. Moreover, the record poignantly chronicles this and

other similar expenses by the Taxpayer as pointed to and motivated by increasing

reputational value. R. 2-4 ¶¶ 8, 9, 13, 22. This Court spoke authoritatively and should

accordingly reaffirm the notion that these expenses are not “ordinary” within the meaning

of IRC ¶ 162.

B. Taxpayer failed to properly and sufficiently establish that the hockey games, for which the tickets were purchased, qualify as “directly related to” or “associated with” the active conduct of the taxpayer’s trade or business.

Courts, in reviewing the Internal Revenue Code, have reaffirmed IRC § 162,

providing that “ordinary and necessary” business expenses of a taxpayer are generally

deductible, but will be disallowed if they fail to adhere to both the “directly related”

standards of § 274(a) and the substantiation requirements of § 274(d). Berkley Machine

Works and Foundry Co. v. Commissioner of Internal Revenue, 623 F.2d 898, 901 (4th

Cir. 1980). Specifically, the Internal Revenue Code categorically disallows deductions

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for business entertainment expenses unless the expenses are “directly related to” the

active conduct of Taxpayer’s trade or business. See I.R.C. § 274(a)(1)(A). In the case of

entertainment directly preceding or following a substantial and bona fide business

discussion, the expenses must be “associated with” the active conduct of a taxpayer’s

trade or business. Id; see Treas. Reg. § 1-274-2(a)(1).

The Treasury Regulations are designed to effectuate the intent of its authorizing

statute, IRC § 274, namely to have the taxpayer illustrate a closer nexus between the

entertainment expenditure and the taxpayer’s trade or business than was required under §

162. See St. Petersburg Bank & Trust Co. v. United States, 362 F. Supp 674, 677-9

(1973) (citing H.R.Rep 1447, 1962-3 Cum.Bul. at 424). In so doing, they set up four

requirements which must be met by a claimant Taxpayer:

(1) at the time of the entertainment expense, the taxpayer had more than a

general expectation of deriving some income or other specific business

benefit other than good will from the person(s) entertain at some indefinite

future time from the making of the expenditure,

(2) during the entertainment period related to the expenditure, the taxpayer

actively engaged in a business meeting, discussion, negotiation, or other bona

fide business transaction for the purpose of obtaining such income or other

specific trade or business benefit,

(3) in light of the facts and circumstances of the case, the principal character

or aspect of the combined business and entertainment to which the

expenditure was related was the active conduct of the taxpayer’s trade or

business, and

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(4) the expenditure was allocable to the taxpayer and person(s) with whom

the taxpayer engaged in the active conduct of trade or business.

See Treas. Reg. § 1-274-2(c)(3); see also St. Petersburg, 362 F. Supp at 679-80.

Under the record provided, Taxpayer meets none of the provided requirements,

despite the fact that, under the regulation, one must meet all of the requirements of Treas.

Reg. § 1-274-2(c)(3). The opinion of the court below provides that the Taxpayer does not

contend that any business discussions took place during these sporting events, which

alone disqualifies any compliance with the requirements; however, we address

specifically Treas. Reg. § 1-274-2(c)(3)(i).

Courts hold that taxpayers, in claiming entertainment expenses, cannot simply

have a general expectation of deriving some income at some indefinite future time.

Handelman v. Commissioner of Internal Revenue, 509 F.2d 1067 (2d Cir. 1975). The

record, here, indicates the expenditure for seats at the game, with the intention of

attending home games, provides no specific, active conduct of Taxpayers trade or

business. The creation of publicity and reputation value for the brand is built with the

expectation that potential customers are, in the future, drawn to and partner with the

Taxpayer’s brand. R. 2-4 ¶¶ 8, 9, 13, 22. As such, such expenses are impermissible as

“directly related” and thus, our determination should be upheld.

C. Taxpayer failed to properly establish that the hockey games, for which the tickets were purchased, qualify as a “clear business setting.”

Treasury Regulations, in execution of 26 U.S.C. § 274, generally establish that

“no deduction shall be allowed for any expenditure for entertainment unless the taxpayer

establishes that the expenditure was directly related to the active conduct of his trade or

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business.” See Treas. Reg. § 1.274-2(c)(1). Taxpayer can show that entertainment

occurred in a clear business setting by “clearly establishing that any recipient of the

entertainment would have reasonably known that the taxpayer had no significant motive,

in incurring the expenditure, other than directly furthering his trade or business.” See

Moore v. United States, 943 F. Supp. 603, 618 (E.D. Va. 1996) (citing Treas. Reg. §

1.274-2(c)(4)). In evaluating the clear business setting standard, the regulation establishes

a nexus between the recipient(s) of the entertainment and their reasonable knowledge and

understanding that the purpose of the entertainment to which they were subjected or

invited had any other significant motive other than the advancement of the taxpayer’s

business. This becomes an objective, fact-based inquiry as to a simple question: whether

for the reasonable attendee, the facts, in sum, point to an objective and obvious

subordination of entertainment activities to furthering a clear business purpose, as defined

by the Treasury Regulations.

Moore v. United States provides a correct example of the analysis necessary to

properly establish the clear business setting standard. There, the court reviewed the

Government’s determination that a party hosted by the petitioner, Moore, did not

constitute a clear business setting and, consequently, was not deductible as defined by

Treas. Reg. § 1.274-2(c)(4). The court noted that the petitioners averred that the attendees

at their event all knew that the only reason the Moores incurred the expense of the party

was to promote their realty business, despite substantial distractions alleged by the

Government under Treas. Reg. § 1.274-7. See Moore, 943 F. Supp at 619. The court

agreed with the Moores that the expense of their party was incurred in a clear business

setting. In the case, the court noted two ways in which the petitioner satisfied the

26

requirements of the Treasury Regulations. First, through testimony from attendees at the

party, the court established that any attendee at the party would have reasonably known

that the expense of the party was incurred only to further the Moores’ business. Id.

Secondly, petitioners in the case established the lack of meaningful personal or social

relationships between the Moores and the recipients of the entertainment. Both of these

evidentiary items together led the court to find that the party was akin to one of the

illustrations of entertainment expenses occurring in a clear business setting, per Treas.

Reg. § 1.274-2(c)(4).

In this wise, the court below fails to properly follow the standard set forth by

Treas. Reg. § 1.274-2(c)(4) in that its analysis erroneously focuses on Taxpayer’s self-

averred motivation rather than establishing that any recipient of the entertainment would

have reasonably known that the taxpayer had no significant motive, in incurring the

expenditure, other than directly furthering his trade or business. Further, of those known

to attend the hockey games, namely his children, they fall outside of both the objective

evidentiary standard required to be determinative for establishing motive, as well the

necessary lack of meaningful personal or social relationship between the taxpayer and the

recipients of the entertainment. Cf. Moore, 943 F. Supp at 619. The only other guidance

provided by the Official Record are the expert opinions of Prof. Harold Hill, who does

not allege or otherwise infer that he was a recipient of the entertainment in question and,

therefore, would be unable to properly establish the standard provided by Treas. Reg. §

1.274-2(c)(4). See. R. 5 ¶ 30.

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CONCLUSION

This Court should reverse the Second Circuits decision and reaffirm the Tax

Court’s decision because Tax court’s decision was not clearly erroneous since the

independent investor test is at most a rebuttable presumption and the $4,000,000

deduction exceeded even the most liberal net income threshold. exceeded the taxable

income by 100% exceeded the gross receipts by 80%. In addition, the Taxpayer has

failed to provide evidence to meet the requirements of §§ 274(a), 274(d), or Treas. Reg. §

1-274-2(c)(3) in claiming his expenses as being in a “clear business setting” so as to

properly claim a deduction. The result of the court below is contrary to the public policy

pronouncements made by Congress and should be overturned. We, therefore, respectfully

request the reversal of the Court below.

Respectfully submitted,

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