No. 17-1 ___________________________________________________________________________

In the Supreme Court of the United States

___________________

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

v.

STUMP, INCORPORATED, Respondent.

___________________

On Writ of Certiorari to the United States Court of Appeals

for the Second Circuit ____________________

BRIEF FOR THE PETITIONER

______________________

TEAM NO. 5

Counsel for Petitioner ______________________________________________________________________________

i

TABLE OF CONTENTS

Page

TABLE OF CONTENTS i

TABLE OF AUTHORITIES iii

STATEMENT OF ISSUES 1

STATEMENT OF THE CASE 2

SUMMARY OF THE ARGUMENT 5

ARGUMENT 7

I. THIS COURT SHOULD REVERSE THE SECOND CIRCUIT’S RULING AND DISALLOW RESPONDENT’S BUSINESS ENTERTAINMENT DEDUCTION BECAUSE RESPONDENT FAILED TO SATISFY INTERNAL REVENUE CODE § 274 AND THE SECOND CIRCUIT’S RULING CONTRAVENE CONGRESSIONAL INTENT 7

A. Standard of Review 9

B. This Court should reverse the Second Circuit’s allowance of Respondent’s business entertainment deduction because the entertainment expenditure was not incurred in a “clear business setting” as defined in Treasury Regulation § 1.274-2(c)(4) 9

C. This Court should reverse the Second Circuit’s allowance of Respondent’s business entertainment deduction because the allowance contravenes Congress’s intent for enacting Internal Revenue Code § 274 14

III. II. THIS COURT SHOULD REVERSE THE SECOND CIRCUIT’S RULING AND DISALLOW THE RESPONDENT’S DEDUCTION UNDER INTERNAL REVENUE CODE § 162(A)(1) BECAUSE THE COMPENSATION WAS UNREASONABLE UNDER BOTH THE “INDEPENDENT INVESTOR” AND “TOTALITY OF THE CIRCUMSTANCES” TESTS. 17

A. Standard of Review 18

ii

B. This Court should adopt the “independent investor” test in determining the reasonableness of the Respondent’s payments to its officers for the purchases of deductibility under I.R.C. § 162(a)(1). 19

C. The Respondent’s payments are unreasonable even under the “totality of the circumstances” test and therefore cannot be deducted. 22

CONCLUSION 26

iii

TABLE OF AUTHORITIES

CASES

Alpha Medical, Inc. v. Commissioner, 172 F.3d 942, 946 (6th Cir. 1999) 18 Berkley Machine Works & Foundry Co. v. Commissioner, 623 F.2d 898 (4th Cir. 1980) passim Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) 15, 16 Commissioner v. Sullivan, 356 U.S. 27 (1958) 15 Commissioner v. Tellier, 383 U.S. 687 (1966) 15 D.A. Foster Trenching Co. v. United States, 200 Ct. Cl. (Ct. Cl. 1973) 8, 10, 11 Deputy v. du Pont, 308 U.S. 488 (1940) 15 Dexsil Corp. v. Commissioner, 147 F.3d 96 (2nd Cir. 1998) 18, 19, 20, 23 Dowell v. United States, 522 F.2d 708 (5th Cir. 1975) 18 Eberl’s Claim Serv. v. Commissioner, 249 F.3d 994 (10th Cir. 2001) 18, 19, 24 Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983) 17, 18, 19, 24 Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999) passim Feldman v. Commissioner, 86 T.C. 458 (1986) 14 Good Chevrolet v. Commissioner, 36 T.C.M. 1157 (1977) 26 Handelman v. Commissioner, 509 F.2d 1067 (2d Cir. 1975) 7, 13 Hippodrome Oldsmobile, Inc. v. United States, 474 F.2d 959 (6th Cir. 1973) 16 Kelley v. Commissioner, 45 F.3d 348 (9th Cir. 1995) 9 Kennedy v. Commissioner, 671 F.2d 167 (6th Cir. 1982) 19, 25 LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091 (9th Cir. 2001) 19, 20 LaForge v. Commissioner, 434 F.2d 370 (2d Cir. 1970) 13 Mays v. United States, 763 F.2d 1295 (11th Cir. 1985) 12 Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949) 17 Owensby & Kritikos, Inc. v. Commissioner, 819 F2d 1315, (5th Cir. 1987) 19, 26 Pacific Grains, Inc. v. Commissioner, 399 F.2d 603 (9th Cir. 1968) 27 Rapco, Inc. v. Commissioner, 85 F.3d 950, 954–55 (2d Cir. 1996) 19, 22 Reynolds v. Commissioner, 296 F.3d 607 (7th Cir. 2002) 9 Schoppe v. Commissioner, 711 F.3d 1190 (10th Cir. 2013) 12 St. Petersburg Bank & Trust Co. v. United States, 362 F. Supp. 674 (M.D. Fla. 1973) 10, 11, 15 Commissioner v. Stump, Inc., 123 F.4th. 1 (2nd Cir. 2016) passim United States v. United States Gypsum Co., 333 U.S. 364 (1948) 19 Walliser v. Commissioner, 72 T.C. 433 (1979) 12, 16 Welch v. Helvering, 290 U.S. 111 (1933) 7 Yoon v. Commissioner, 135 F.3d 1007 (5th Cir. 1998) 9

STATUTES

iv

26 U.S.C. Internal Revenue Code § 162 7, 8 § 162(a)(1) passim § 274 passim § 274(a)(1)(A) 8, 10 § 274(d) 7

§ 7941 7 § 7941(a) 16 § 7941(a)(2) 7

RULES AND REGULATIONS

Treas. Reg. 26 (C.F.R.) § 1.162-7(b)(1) 21, 23 § 1.274-2(b)(1)(i) 9, 10 § 1.274-2(b)(1)(ii) 10 § 1.274-2(c)(3) 11, 12 § 1.274-2(c)(4) 5,7,8,9 § 1.274-2(c)(7) 12 § 1.274-2(c)(7)(ii) 12 § 1.274-2(c)(7)(ii)(a) 8, 9

1

STATEMENT OF ISSUES

I. Whether the Commissioner properly disallowed Respondent’s deduction of

hockey tickets as a business entertainment expense under Internal Revenue

Code § 274(a)(1).

II. Whether the Commissioner properly disallowed Respondent’s deduction of

the compensation paid to its corporate officers under Internal Revenue Code §

162(a)(1).

2

STATEMENT OF THE CASE

I. Procedure

Respondent brought suit to challenge the Commissioner’s assessment for tax

deficiencies for the 2013 Tax Year based on disallowed business entertainment and

compensation deductions. The Tax Court issued an opinion agreeing with the

Commissioner and found Respondent liable for deficiencies. Respondent timely appealed

to the Second Circuit, which reversed the Tax Court’s ruling. This Court granted the

Commissioner’s writ of certiorari.

II. Facts

J. Ronald Stump and his three adult children, Oak, Maple and Willow are the

shareholders and employees of the Respondent, Stump, Inc. Commissioner v. Stump, 123

F.4th 1, 1–2 (2016). Ronald founded the company in 1985 using money obtained from

his father, a developer in Buffalo, New York. Id. at 1. Ronald owns 97% of the stock,

while Oak, Maple and Willow each own a single share. Id. at 2. Currently, Ronald is the

president of Stump, Inc., and Oak, Maple and Willow occupy officer positions in the

corporation as vice-president, corporate treasurer and corporate secretary, respectively.

Id. at 1-2. In 2013, Ronald and his three children made $1,000,000 each in salary.

Ronald’s role in the company began through his involvement in real estate deals

throughout Western New York. Id. at 2. Stump, Inc. elicited testimony from an expert

during the Tax Court hearing that Ronald was the “most savvy” business man he had ever

met, and had unique expertise. Id. at 2. Ronald along with children provide advice,

guidance and oversight to developers associated with the Stump name. Id. at 2. To

maintain interest in the Stump name, Ronald and his children attend public events and

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regularly appear in the social pages of local and national print media. Id. at 2, 3. The

expert testified that the Stump family’s effort to be “seen” is key to the Stump brand, and

helps portray Stump, Inc. “as a company with cache.” Id. at 3.

Though Stump, Inc. is known as a real estate development company, in 2013,

Stump, Inc. generated revenue solely from licensing the “Stump” name to various

business ventures. Id. at 2, 3. The Stump name appears on many buildings in Buffalo and

on consumer goods. Id. at 2, 3. Stump, Inc. does not own equity in any of the companies

that bear the Stump name. Id. at 3. Rather, Stump, Inc. receives a substantial licensing fee

for use of the Stump name. Id. at 3. Ronald testified before the Tax Court that his name

on a project creates “buzz,” which encourages others to invest and promotes the business

venture. Id. at 2. Before the Tax Court, the expert stated that the reason for Stump, Inc.’s

successful licensing business was because of the Stump name itself, which “has

developed a connotation of luxury, success, and privilege.” Id. at 3. Accordingly, the

expert’s subjective opinion is that people see the Stumps and want to be them, which

results in people being more likely to visit properties bearing the Stump name. Id. at 3.

The Respondent has offered evidence that shows licensing the Stump name may have

improved the sales for a failing company. Id. at 4.

In 2013, Stump Inc. only reported a total of $5,000,000 in revenue generated

solely from licensing the Stump name. Id. at 3. The Respondent took out deductions of

$4,000,000 for compensation–$1,000,000 to each shareholder-employee— and

$1,000,000 for business deductions including $100,000 for Buffalo Sabres season tickets.

Id. at 4. The Respondent showed, after all deductions were taken, $0 in tax liability for

the 2013 tax year. Id. at 5.

4

Stump, Inc. deducted as a business entertainment expense, the cost of four season

tickets to the Buffalo Sabres, which cost $25,000 per seat. Id. at 5. The seats are located

directly behind the Sabres’ bench, which allows members of the Stump family to be seen

throughout the game. Id. Ronald attends every home game while the children attend

when possible. Id. If all the children are unavailable, Ronald will often invite a local

celebrity or dignitary to sit with him. Id. In 2013, the comedian Carrot Top attended six

games with Ronald. Id.

The Commissioner of the Internal Revenue Service assessed a deficiency on the

Respondent, claiming the compensation to employees and the hockey tickets were

improper. Id. The Respondent challenged the Commissioner’s assessment in Tax Court.

The Tax Court sided with the Commissioner and the Respondent appealed to the Second

Circuit Court of Appeals. The Second Circuit reversed the Tax Court and allowed both

the business entertainment deduction and the compensation deductions.

5

SUMMARY OF ARGUMENT

There are two issues on appeal. Concerning Respondent’s business entertainment

deduction of the Buffalo Sabres hockey tickets, Respondent failed to satisfy the stringent

requirements of I.R.C. § 274 and the applicable Treasury Regulations. Specifically,

Respondent failed to demonstrate that the hockey games constituted a “clear business

setting” under Treasury Regulation § 1.274-2(c)(4). The subjective, self-serving

testimonies of Respondent, Respondent’s daughter, and the expert are of no bearing and

must be discredited. The Second Circuit improperly concluded that such subjective

evidence satisfies the objective standard set forth in Treasury Regulation § 1.274-2(c)(4).

Further, the Second Circuit’s ruling clearly contravenes Congress’s intent and purpose for

enacting I.R.C. § 274: to eliminate the tax abuses that developed under the less stringent

I.R.C. § 162, and substantially narrow the class of deductible business entertainment

expenses.

The Respondent’s compensation deduction under I.R.C. § 162(a)(1) is also

problematic because the compensation deduction is not reasonable. In determining

reasonableness, the Courts have used the “independent investor test” or the “totality of

the circumstance test” and the Respondent has not provided enough evidence show the

deduction was reasonable under either tests. The Second Circuit failed to adhere to the

standard set forth in Treasury Regulation § 1.162-7(b)(1) that compensation deductions

can only be deducted for service actually rendered. This Court is asked to resolve the

current split of authorities in using either the “independent investor test” or the “totality

of the circumstance test” in determining “reasonableness” of compensation deduction.

For public policy and the most objective test, the independent investor test should be the

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standard in addressing reasonableness in compensation deductions.

7

ARGUMENT

I. THIS COURT SHOULD REVERSE THE SECOND CIRCUIT’S RULING AND DISALLOW THE RESPONDENT’S BUSINESS ENTERTAINMENT DEDUCTION BECAUSE RESPONDENT FAILED TO SATISFY INTERNAL REVENUE CODE § 274 AND THE SECOND CIRCUIT’S RULING CONTRAVENES CONGRESSIONAL INTENT.

This Court should reverse the Second Circuit’s ruling and disallow the

Respondent’s entertainment deduction because Respondent’s subjective, self-supporting

evidence does not satisfy the “clear business setting” objective test set forth in Treasury

Regulation § 1.274-(c)(4). Further, the Second Circuit’s ruling contravenes Congress’s

intent for enacting I.R.C. § 274 by broadening the class of deductible entertainment

expenses.

As a general rule, the Commissioner’s determination in a notice of deficiency are

presumed correct, and the taxpayer bears the burden of proving otherwise by a

preponderance of the evidence. Welch v. Helvering, 290 U.S. 111, 115 (1933).1 Section

274 of the Internal Revenue Code is strictly a disallowance provision, the terms of which

must be met in addition to I.R.C. § 162, for a business to deduct entertainment expenses.

Handelman v. Commissioner, 509 F.2d 1067, 1072 (2d Cir. 1975). Congress enacted

I.R.C. § 274 to eliminate the tax abuses developed under I.R.C. § 162 by substantially

narrowing the class of deductible entertainment expenses. See Berkley Machine Works &

Foundry Co. v. Commissioner, 623 F.2d 898, 902 (4th Cir. 1980).

As opposed to I.R.C. § 162, I.R.C. § 274 requires businesses to meet a more 1 I.R.C. § 7941(a) provides for a shifting of the burden of proof to the Commissioner in limited circumstances. Section 7941(a) does not apply, however, unless the taxpayer complies with all the substantiation requirements under the Internal Revenue Code and has maintained all the records required by the Code. I.R.C. § 7941(a)(2). In the instant case, Respondent did not comply with the substantiation requirements of I.R.C. § 247(d) and also failed to maintain required records regarding the attendance of the games at issue in this case. Accordingly, § 7491 is inapplicable to shift the burden of proof to the Commissioner.

8

stringent standard of business-relatedness and adhere to strict substantiation

requirements. Id. Section 274(a)(1)(A), the specific provision that applies in the present

case, states no deduction shall be allowed for any item “[w]ith respect to an activity

which is of a type generally considered to constitute entertainment . . . unless the taxpayer

establishes that the item was directly related to, or . . . that such item was associated with,

the active conduct of the taxpayer’s trade or business.” Thus, the taxpayer bears the

burden of proof that a business entertainment deduction satisfies both I.R.C. §§ 162 and

274.

Here, this Court should reverse the Second Circuit and disallow Respondent’s

entertainment deduction because attending Buffalo Sabres hockey games does not

constitute a “clear business setting,” and Respondent failed to provide objective evidence

to clearly establish otherwise. In contrast, Respondent urges this Court to affirm the

Second Circuit’s ruling, but doing so would violate the plain language of I.R.C. § 274

and the relative Treasury Regulation §§ 1.274-(c)(4) and (7)(ii)(a). Other courts presented

with similar arguments to that of Respondent’s have explicitly rejected such arguments

and, instead, determined that settings with substantial distractions coupled with a

taxpayer’s failure to provide objective evidence shall not constitute a “clear business

setting.” See Berkley Machine Works & Foundry Co., 623 F.2d at 905 n. 8; see also D.A.

Foster Trenching Co. v. United States, 200 Ct. Cl. 526, 533-35 (Ct. Cl. 1973).

Therefore, because Respondent’s entertainment expenditure was not incurred in a

“clear business setting,” and because the Second Circuit’s ruling contravenes

Congressional intent, this Court should reverse the Second Circuit and disallow

Respondent’s business entertainment deduction.

9

A. Standard of Review

The Tax Court’s conclusions of law are reviewed de novo and findings of facts

are reviewed for clear error. Kelley v. Commissioner, 45 F.3d 348, 350 (9th Cir. 1995).

Thus, whether a taxpayer has satisfied the requirements of I.R.C. § 274 is a finding a fact

that this Court reviews for clear error. Reynolds v. Commissioner, 296 F.3d 607, 612 (7th

Cir. 2002); Yoon v. Commissioner, 135 F.3d 1007, 1016 (5th Cir. 1998).

B. This Court should reverse the Second Circuit’s allowance of

Respondent’s business entertainment deduction because the entertainment expenditure was not incurred in a “clear business setting” as defined in Treasury Regulation § 1.274-2(c)(4).

The Second Circuit improperly allowed Respondent to deduct the Buffalo Sabres

hockey tickets as a business entertainment expense because Respondent’s season ticket

expenditure was not for entertainment occurring in a clear business setting to directly

further Respondent’s business. This finding accords with the plain language of Treasury

Regulation §§ 1.274-2(c)(4) and (7)(ii)(a).

This Court should reverse the Second Circuit’s ruling because the court

unquestionably misapplied I.R.C. § 274 and the relevant governing Treasury Regulations.

Treasury Regulation § 1.274-2(b)(1)(i) defines “entertainment” as “any activity which is

of a type generally considered to constitute entertainment, amusement, or recreation, such

as . . . sporting events . . . .” Further, the objective test set forth under subparagraph (ii) of

the same Treasury Regulation establishes that “if an activity is generally considered to be

entertainment, it will constitute entertainment . . . regardless of whether the expenditure

can also be described otherwise . . . .” This objective test prohibits a taxpayer from

arguing that an entertainment expenditure “. . . should be characterized as an expenditure

10

for advertising or public relations.” Treas. Reg. § 1.274-2(b)(1)(ii). However, applying

this test requires considering the taxpayer’s trade or business. Id. (illustrating this point

by stating, “although attending a theatrical performance would generally be considered

entertainment, it would not be so considered in the case of a professional theater critic,

attending in his professional capacity”). In the present case, the Buffalo Sabres games are

clearly entertainment as defined in Treasury Regulation § 1.274-2(b)(1)(i). Additionally,

Respondent was not attending the hockey games in a professional manner and, as such,

Respondent’s attending the Buffalo Sabres hockey games constitutes entertainment.

Therefore, Respondent must satisfy I.R.C. § 274(a)(1)(A).

The plain language of Section 274(a)(1)(A) creates two classes of entertainment

expenses: a general class, and a specific class. St. Petersburg Bank & Trust Co. v. United

States, 362 F. Supp. 674, 677 (M.D. Fla. 1973). “Entertainment expense in general must

be ‘directly related’ to ‘the active conduct of the taxpayer’s trade or business’” to qualify

for deduction. Id. Though, “an expense incurred for entertainment ‘directly preceding or

following a substantial and bona fide business discussion’” only needs to be “associated

with” a taxpayer’s trade or business to qualify for deduction. Id.

Nonetheless, the “associated with” test is an exception, and is to be “examined in

juxtaposition with the ‘directly related’ test as the basic standard.” Id. at 681. Expenses

for events that are normally regarded as fundamentally social or entertaining in nature are

permitted deduction only if the more stringent “directly related” test is met. Id. “The mere

purpose of fostering good will is insufficient to show a direct relationship to the

business.” Id. However, when such events are held in conjunction with meetings or

conferences where substantial and bona fide business discussions take place, the

11

entertainment costs will be deductible as “associated with” the business. Id. An

illustrative example that qualifies for the “associated with” exception is when business

conferences are conducted during the day and participants are entertained at night. Id.

Further, as noted in Berkley Machine Works & Foundry Co., business discussions that

“take place during the course of a combined social/business function” do not qualify for

deduction under the “associated with” test. 623 F.2d at 906; see also St. Petersburg Bank

& Trust Co., 362 F. Supp. at 681. Thus, in the present case, the “associated with” test is

clearly inapplicable because Respondent provided no evidence that substantial bona fide

business discussions took place directly before or after the Buffalo Sabres hockey games.

Additionally, Respondent conceded that no active business discussions even took place

during the hockey games. Stump, 123 F.4th at 6.

Treasury Regulation § 1.274-2(c)(3) illustrates the requirements needed for a

business entertainment expenditure to satisfy the “directly related” test. However, if a

taxpayer establishes that the entertainment occurred in a “clear business setting” then the

expenditure “shall be considered directly related to the active conduct of the taxpayer’s

trade or business.” Treas. Reg. § 1.274-2(c)(4). Treasury Regulation § 1.274-2(c)(4) acts

as a safe harbor and does not require an analysis of the directly related test set forth in

Treasury Regulation § 1.274-2(c)(3). D.A. Foster Trenching Co., 473 F.2d at 533-34. To

determine if an entertainment expenditure occurred in a “clear business setting,” the

Treasury Regulation institutes an objective test, and subjective evidence is discredited

and non-determinative. See id; see also Treas. Reg. § 1.274-2(c)(4).

Treasury Regulation § 1.274-2(c)(4) states “entertainment shall not be considered

to have occurred in a clear business setting unless the taxpayer clearly establishes that

12

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.” Under this objective test, it is irrelevant if a taxpayer does not enjoy the

entertainment. See Walliser v. Commissioner, 72 T.C. 433, 441 (1979). Furthermore, both

Treasury Regulation §§ 1.274-2(c)(3), and (4) direct to subparagraph (7) of the same

paragraph, which illustrates circumstances when a taxpayer’s entertainment expenditures

are considered not directly related, even if such entertainment is connected with the

taxpayer’s trade or business because of “little or no possibility of engaging in the active

conduct of a [taxpayer’s] trade or business.” Treas. Reg. § 1.274-2(c)(7).

Treasury Regulation § 1.274-2(c)(7)(ii) describes instances that are presumed as

not occurring in a “clear business setting” because of substantial distractions. Sporting

events are explicitly recognized as not being a “clear business setting,” and as such, not

considered directly related to the active conduct of a taxpayer’s trade or business. Treas.

Reg. § 1.274-2(c)(7)(ii)(a). A taxpayer bears the burden to rebut this presumption by

providing objective evidence that clearly establishes to the contrary. Id. A taxpayer’s bald

assertions that expenses were incurred for business purposes are insufficient to carry this

burden. See Schoppe v. Commissioner, 711 F.3d 1190, 1193 (10th Cir. 2013)

(“unsubstantiated testimony is insufficient to meet [taxpayer’s] burden of proof”); Mays

v. United States, 763 F.2d 1295, 1297 (11th Cir. 1985) (claim must be substantiated by

something other than “uncorroborated oral testimony” or “self-serving statements”).

Further, even if a taxpayer clearly establishes that an entertainment expenditure

was directly related to the active conduct of taxpayer’s trade or business, a taxpayer must

then satisfy the substantiation and recordkeeping requirements of I.R.C. § 274(d). See

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Berkley Machine Works & Foundry Co., 623 F.2d at 906; see also Handelman, 509 F.2d

at 1072. A court is required to do a stringent analysis to determine that the entertainment

deductions were properly substantiated and satisfy the amount, time, business purpose,

and business relationship of the expenditures with precision and particularity. See

LaForge v. Commissioner, 434 F.2d 370, 372 (2d Cir. 1970). If a taxpayer lacks the

required substantiation, then the deduction must be disallowed entirely. Dowell v. United

States, 522 F.2d 708, 714 (5th Cir. 1975).

Here, Respondent failed to supply objective evidence to rebut the unambiguous

presumption that a sporting event is not a “clear business setting.” The Second Circuit

recognized that subjective perceptions are not determinative of whether business

entertainment expenses were incurred in a clear business setting. Stump, 123 F.4th at 8.

However, rather than applying the objective standard set forth in the plain language of

I.R.C § 274 and the relevant Treasury Regulations, the Second Circuit determined that

Expert’s subjective testimony was determinative solely because “the Commissioner

failed to give the Court any reason to believe that the perceptions of [Expert] were

anything other than reasonable.” Id. This is an egregious error by the Second Circuit

because, under I.R.C. § 274 and the applicable Treasury Regulations, the Commissioner

has no burden to disprove subjective testimony. See Dowell, 522 F.2d at 712 (reasoning

that I.R.C. § 274 places the risk of inadequate proof entirely on the taxpayer).

The Second Circuit further improperly supported its finding that Respondent’s

clear purpose was to obtain publicity as opposed to maintaining goodwill because the

court credited and relied upon the self-serving, subjective testimony of both Respondent

and Respondent’s daughter. Stump, 123 F.4th at 8. Respondent testified that “his sole

14

motivation in attending games was to promote his business,” but “would much rather stay

home at night, reading Jane Austen.” Id. Respondent’s daughter subjectively

corroborated Respondent’s self-serving statements by stating “[Respondent] often

groused about attending games.” Id. However, as iterated in Walliser, it is irrelevant that

Respondent did not enjoy attending Buffalo Sabres hockey games. 72 T.C. at 441.

Additionally, the Second Circuit performed no substantiation analysis as required by

I.R.C. § 274(d), and Respondent presented no evidence that the Buffalo Sabres tickets

were properly substantiated.

Therefore, because Respondent provided no objective evidence to establish the

Buffalo Sabres hockey games constituted a “clear business setting” and were properly

substantiated, this Court should overturn the Second Circuit’s decision and disallow

Respondent’s entertainment deduction.

C. This Court should reverse the Second Circuit’s allowance of Respondent’s business entertainment deduction because the allowance contravenes Congress’s intent for enacting Internal Revenue Code § 274.

The Second Circuit improperly allowed Respondent to deduct the Buffalo Sabres

hockey tickets as a business entertainment expense because the deduction conflicts with

Congress’s intent to narrow the class of deductible entertainment expenses. The purpose

and history of I.R.C. § 274 underscore the plain meaning of its language.

Under I.R.C. § 162, a taxpayer’s “ordinary” and “necessary” expenses in carrying

on a trade or business are allowable deductions. Feldman v. Commissioner, 86 T.C. 458,

465 (1986). “Ordinary” and “necessary” are terms of art. An expense is considered

“ordinary” if of a kind that is “common and accepted” or “normal, usual, or customary,”

15

at least in some circumstances, in the type of business carried on by the taxpayer. Welch

v. Helvering, 290 U.S. 111, 114 (1933); Deputy v. du Pont, 308 U.S. 488, 495 (1940). To

be “necessary,” an expense must be at least “appropriate and helpful” to the development

of the taxpayer’s business. Welch, 290 U.S. at 113; see Commissioner v. Tellier, 383 U.S.

687, 689 (1966). Thus, due to the relatively loose business connection required under

I.R.C. § 162, the broad judicial interpretation afforded to “ordinary and necessary,” and

the approximation rule established in Cohan v. Commissioner, 39 F.2d 540 (2d Cir.

1930), rampant abuses developed among businesses deducting entertainment

expenditures. St. Petersburg Bank & Trust Co., 362 F. Supp. at 676. These tax abuses

prompted Congress to enact I.R.C. § 274 to substantially narrow the class of deductible

entertainment expenses, and eliminate the Cohan rule. Id; see also Dowell, 522 F.2d at

712.

Deductions “are a matter of grace and Congress can, of course, disallow them as it

chooses.” Commissioner v. Sullivan, 356 U.S. 27, 28 (1958). Recognizing the

government’s pre-eminent need to assess and collect tax revenues, Congress enacted

I.R.C. § 274 to eliminate tax abuses with respect to entertainment expense deductions that

developed under I.R.C. § 162. See St. Petersburg Bank & Trust Co., 362 F. Supp. at 677.

Section 274 of the Internal Revenue Code evidences a clear congressional intent “to limit

the types of business entertainment expenditures otherwise deductible under § 162 by

requiring [entertainment expenditures] to meet a more stringent standard of business-

relatedness than had theretofore obtained.” Berkley Machine Works & Foundry Co., 623

F.2d at 902. Further, the legislative history of § 274 “indicate[s] a clear Congressional

intent that general goodwill entertainment could no longer be deducted as a business

16

expense.” Hippodrome Oldsmobile, Inc. v. United States, 474 F.2d 959, 961 (6th Cir.

1973).

Lastly, Congress established the substantiation requirements under I.R.C. §

274(d) “to disallow entertainment deductions based solely on a taxpayer’s ‘own

unsupported self-serving testimony,’” Dowell, 522 F.2d at 712, allow the Government “to

double-check the amount and true business character of the deduction.” Berkley Machine

Works & Foundry Co., 623 F.2d at 906, and eliminate the Cohan rule, which “permitted

an approximation of expenses actually incurred . . . .” Handelman, 509 F.2d at 1074.

In the present case, the Second Circuit’s ruling to allow Respondent’s

entertainment deduction severely undermines Congress’s purpose for enacting I.R.C §

274. The Second Circuit’s failure to adhere to the plain language and precise

requirements of I.R.C § 274 reinstitutes the exact type of tax abuse Congress intended to

eliminate with I.R.C. § 274. The Second Circuit’s ruling essentially establishes that any

individual of fame or notoriety can deduct season tickets as a business entertainment

expense because attending sporting events contributes to that individual’s “brand” and

“reputation for fame, glitz, and celebrity.” Stump, 123 F.4th at 12. However, this type of

deduction is barred, not only by the clear, express language of I.R.C. § 274, but also

because Congress intended, by means of the more stringent standard set forth in I.R.C. §

274, to disallow this entertainment deductions incurred merely for the promotion of

goodwill in a social setting. Walliser, 72 T.C. at 442.

Thus, this Court should reverse the Second Circuit and disallow Respondent’s

entertainment deduction because attending Buffalo Sabres hockey games simply allowed

Respondent to obtain and/or maintain his brand’s goodwill. With this ruling, the Second

17

Circuit substantially broadened the class of deductible business entertainment expenses,

which expressly contradicts Congress’s intent for enacting I.R.C. § 274.

II. THIS COURT SHOULD REVERSE THE SECOND CIRCUIT’S RULING AND DISALLOW THE RESPONDENT’S DEDUCTION UNDER INTERNAL REVENUE CODE § 162(A)(1) BECAUSE THE COMPENSATION WAS UNREASONABLE UNDER BOTH THE “INDEPENDENT INVESTOR” AND “TOTALITY OF THE CIRCUMSTANCES” TESTS.

This Court should reverse the District Court’s decision that allowed the

Respondent to take the deduction of the compensation paid to its corporate officers.

Section 162(a)(1) of the Internal Revenue Code allows corporations to deduct ordinary

and necessary expenses, of which reasonable allowances for compensation for personal

services actually rendered. The Respondent has failed to provide the facts necessary to

establish that the compensation is reasonable under existing case law. See Mayson Mfg.

Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949).

A corporation is permitted to deduct “a reasonable allowance for . . .

compensation for personal service actually rendered.” I.R.C. § 162(a)(1). For

compensation to be deductible, salaries must satisfy two prongs under Treasury

Regulations 167(a): (1) the amount of the compensation must be reasonable and (2) the

payments must be purely for services rendered. In Elliotts, Inc. v. Commissioner, the

Ninth Circuit commented that the analysis has generally focused on whether the

purported compensation payments were reasonable. 716 F.2d 1241, 1244–45 (9th Cir.

1983).

In determining “reasonableness,” there is a circuit split of authorities, where the

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Seventh Circuit uses the more objective “independent investor’s test,” while Second

Circuit and the rest adopt a “totality of the circumstances” test that is subjective and

standardless. Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999); contra

Dexsil Corp. v. Commissioner, 147 F.3d 96 (2nd Cir. 1998). This Court should adopt the

bright-line and concise test from the Seventh Circuit to safeguard in the event of

taxpayers improperly deducting dividends disguised as salary.

This Court should resolve the circuit split adopt the more objective “independent

investor” legal test in determining “reasonableness” under I.R.C. § 162(a)(1). However,

even under the subjective test applied by the Second Circuit, this Court should find the

Second Circuit have incorrectly decided based on the totality of the circumstances test.

A. Standard of Review

This Court is faced with an issue of first impression as to which test to apply in

determining reasonableness under I.R.C. § 162(a), therefore this Court should use the de

novo standard. See MedChem (P.R.). Inc. v. Commissioner, 295 F.3d 118, 122 (1st Cir.

2002). The Court is not obligated to give deference to findings under the incorrect

standards. See Exacto Spring, 196 F.3d at 838. However, if the Court finds the “totality of

the circumstances test” to be the controlling legal test, then the issue is reviewed under

the clearly erroneous standard. Dexsil Corp, 147 F.3d at 100. Under the clearly erroneous

standard, this Court must review the entire record and determine “with the definite and

firm conviction” that a mistake has been made. United States v. United States Gypsum

Co., 333 U.S. 364 (1948).

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B. This Court should adopt the “independent investor” test in determining the reasonableness of the Respondent’s payments to its officers for the purchases of deductibility under I.R.C. § 162(a)(1).

The “independent investor” test is an improvement upon the “totality of the

circumstance” tests and should be adopted in the interest of uniformity and justice when

considering deductibility under I.R.C. § 162(a)(1). The number of factors examined

under the totally of the circumstance test has ranged from as little has five to as many as

twenty-one; this exemplifies the subjectivity across the country when it comes to

determining the deductibility of reasonable salary.2

The subjectivity of the totality of the circumstance tests have been called “more

nearly an art than a science.” Kennedy v. Commissioner, 671 F.2d 167, 173 (6th Cir.

1982). Some circuits have adopted the independent investor as part of their totality of the

circumstances test. LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091, 1095 (9th Cir.

2001) (using the “perspective of a hypothetical independent investor test” while

conducting the reasonableness inquiry); Dexsil, 147 F.3d at 100; Rapco, Inc. v.

Commissioner, 85 F.3d 950, 954–55 (2d Cir. 1996).

Using the independent investor test, would resolve the conflict of interest of a

shareholder-employee. For the shareholder-employee, there is an incentive to distribute

earnings in the form of compensation than dividends to avoid the two-tier system of

taxation. Eberl’s Claim Serv., Inc. v. Commissioner, 249 F.3d 994, 998 (10th Cir. 2001).

The independent investor fills the void left when there is not a third-party who can limit

compensation for the sake of profitability. Id.

2 E.g. LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091, 1095 (9th Cir. 2001) (listing five factors); Eberl’s Claim Serv. v. Commissioner, 249 F.3d 994, 999 (10th Cir. 2001) (listing twelve factors); Alpha Medical, Inc. v. Commissioner, 172 F.3d 942, 946 (6th Cir. 1999) (listing nine factors); Owensby & Kritikos, Inc. v. Commissioner, 819 F2d 1315, 1323 & n. 18 (5th Cir. 1987) (nine factors).

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i. Application of the Independent Investor Test

Under the independent investor test, the inquiry is whether “an inactive,

independent investor would be willing to compensate the employee as he was

compensated.” The employee’s salary is directly related to the employee’s work to

increase the value of assets. The higher the rate of return to the owner’s investment, the

higher the worth the manager is to the company. There is an inherent correlation between

the company’s worth and the officer’s salary. Exacto Spring, 196 F.3d at 838.

In a closely held corporation, the situation becomes problematic when the same

individual occupy shareholder and employee roles. In a situation like this, the corporation

are not dealing with its shareholders and employees at arm’s length. Elliots, 716 F.2d at

1243. The shareholder-employees and the corporation would like to characterize the

payments to the shareholder-employees as compensation instead of dividends. The

Respondent’s characterization of compensation must be carefully scrutinized to ensure

that the payments are not disguised dividends. Treas. Reg. § 1.162-7(b)(1).

According to the Treasury Regulations, when the salaries are in excess of those

ordinarily paid for similar services, the excessive payments are a distribution of earnings

upon the stock. Id. The evidence presented in the lower court proceedings fail to

demonstrate the stockholder-employees were paid purely for their services. The

hypothetical independent investor would resolve the conflict of interest of a shareholder-

employee.

The Second Circuit considers return of equity as part of their analysis into Stump,

Inc. It was determined that the return on equity was at least 1000%. The court also

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deemed the returns to be “far in excess of the return on equity.” However, the court used

the wrong standard in comparing the case at hand. First, the Second Circuit took note of

the Respondent’s expert witness that the return was justified given the riskiness of

investment in real estate development. However, the only source of revenue for the

Respondent in Tax Year 2013 was from licensing the “Stump” name. Due to the

reputation of the Stump name, the value of the name is not as volatile as investment in

real estate development.

Second, the Second Circuit compared Stump Inc., a closely held corporation, to a

large publicly traded corporation. In a closely-held corporation, there is an inherent

conflict of interest when the shareholder is also an employee. To avoid double taxation,

the shareholder would opt to categorize the payment as a compensation deduction not a

distribution of dividend. In a publicly traded corporation, the determination of salaries is

subject to approval by neutral third parties.

ii. It is in the Court’s interest to adopt the “independent investor” test to ensure

uniformity across all circuits.

In Exacto Spring, the totality of the circumstances test is criticized for two main

reasons. The test has factors that are vague and incomparable to any metric, and also the

several factors bear no clear relation to the primary purpose of I.R.C § 162(a)(1). Exacto

Spring, 196 F.3d at 835. The primary purpose of I.R.C. § 162(a)(1) is to prevent

dividends which are not deductible from corporate income be disguised as salary. Rapco,

85 F.3d at 952 n. 2.

Having the judges weigh the factors in the totality of the circumstances test puts

judges in the position in determining what the reasonable salary should be in relation to

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comparable jobs in various industries. Exacto Spring, 196 F.3d at 835. Judge Posner

underscores that judges are ill-equipped to make these determinations of reasonableness

and to know what types of business should pay abnormally high (or low) salaries. Id.

Similar to the chief executive officer of the Petitioner in Exacto Spring, Ronald has the

job title of “president” but also takes on various other roles within the corporation such as

marketing and negotiator. It would be difficult for judges to make a determination that

Ronald is being adequately compensated in his various roles.

Further, using the totality of the circumstances test leads to arbitrary decisions

based on “unprincipled rules of thumb.” Id. Finally, because the unpredictability of the

Tax Court to challenge the deduction of compensation, especially in the context of

closely-held corporations, corporations are at legal risk in determining a level of

compensation that may hurt their chance at success. Id. In this case, the Respondent

deducted 80% of their revenue in salary deductions and made other deductions to make

the corporation’s taxable income zero.

To avoid arbitrariness and to ensure the proper compensation deduction is taken,

this Court should follow the Seventh Circuit and adopt the independent investor test as

the appropriate test to analyze the deductibility of reasonable compensation under I.R.C.

§ 162(a)(1).

C. The Respondent’s payments are unreasonable even under the “totality of the circumstances” test and therefore cannot be deducted.

Under I.R.C. § 162(a)(1), the Respondent may deduct a “reasonable allowance for

salaries… for services actually rendered.” In addressing this question, there is a circuit

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split of authorities, where the Second Circuit and the rest adopt a “totality of the

circumstances” test. See generally Dexsil, 147 F.3d at 100. Though this Court should

adopt the bright-line and concise “independent investor test” for the above reasons, the

Court could also find that the Second Circuit erred in allowing the Respondent’s

deduction to be taken.

The lower court in Stump looked at only four factors in determining

reasonableness of compensation: (1) shareholders as employees; (2) The employee’s role

in the company and the economic climate surrounding company; (3) Return on gross and

net income; (4) Company’s dividend practices and return on equity. Though no single

factor is decisive of reasonableness, the Court must consider and weight the totality of the

facts and circumstances. Pacific Grains, Inc. v. Commissioner, 399 F.2d 603, 606 (9th

Cir. 1968). The fourth factor is the independent investor test discussed in the section

above.

However, Second Circuit Court of Appeals erred in finding Respondent’s

payment deductions to be reasonable under the totality of the circumstances test. The

Second Circuit erred in two ways. First, the Second Circuit erred by failing to apply the

correct legal standard in adjudicating the relevant factors. Second, there is insufficient

evidence to support a finding of reasonableness under the totality of circumstances test.

i. Shareholders as Employees

The first factor is examining the deductions of a company where the shareholders

are also employees. The burden is on the Respondent, to show it is entitled to a deduction

allowed by the Commissioner. See Treas. Reg. § 1.162-7(b)(1). The Second Circuit

looked at the correlation between the payments and the shareholder-employee’s

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stockholdings. In the current case, the Second Circuit found that when the payments of

compensation are “unquestionably high,” the correlation between stockholdings and

payments is necessary for the courts to consider that the payments are disguised

dividends. Stump, 123 F.4th at 15. The Respondent’s shareholder-employees are J.

Ronald, Oak, Maple and Willow Stump. The four officers are also the shareholders of the

company; Ronald owns 97%, while his three children own each 1%. The payments did

not correlate to the stockholdings, because in 2013, each corporate officer was paid

$1,000,000 regardless of stock holdings.

Though it is entirely possible that a portion of the payments represent

compensation for services, it is also possible that the remainder of the payments is a

disguised dividend. It is the incentive for the shareholder-employees to categorize

payments as compensation because it can be deducted from the corporation’s income.

The Second Circuit erred when concluding that it is “not unreasonable for a court to

conclude that a portion of the payments represent compensation for serves and the

remainder represents a disguised dividend.” Stump at 15. Per Elliots Inc., the payments

must be purely for services, and this proposition must be construed narrowly to prevent

abuse. 716 F.2d at 1244-45. Therefore, the Respondents can only deduct the amount

attributed to services. The evidence from the lower court fail to substantiate the roles and

responsibilities of the Respondent’s shareholder-employees. See Kennedy v.

Commissioner, 671 F.2d 167, 168 (6th Cir. 1982) (describing the roles of a employee

through a compensation agreement). As in Exacto Spring, the judiciary is ill-equipped to

make the determination of salaries that is “ordinary paid for similar services.” Treas. Reg.

§ 1.162-7(b)(1).

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ii. The employee’s role in the company and the economic climate surrounding company

The lower court in Stump concluded that the employees are “highly motivated,

uniquely and extremely productive individuals” and occupy a variety of roles within the

company and therefore should be compensated “handsomely.” Stump at 16. The Second

Circuit pointed to favorable economic climate towards the success of the company, and

therefore the employee should be compensated for their services. Id. Courts have used

past history of compensation to illustrate allowable compensation deductions in previous

years. E.g. Eberl’s Claim Serv., 249 F.3d at 997.

This factor relies on many subjective determinations and not enough evidence is

available to make the determination that the success of the company can be attributed

solely to the employees’ services. The unique business of the Respondent makes it

difficult to find similar companies to make the determination that the salaries are

reasonable. Per Treasury Regulations, the compensation to employees must be made in

purely for services. Furthermore, evidence offered in the record only show the

compensation for 2013, and no evidence of compensation received in previous year was

used a reference point to show past allowable compensation deductions.

iii. Return on Percentage of Gross and Net Income

The Second Circuit took note of the trial court’s finding that the Respondent had

made distributions of its taxable income as compensation to its shareholder-employees.

Courts have noted that compensation was reasonable to shareholder-employees when it

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was approximately 60% of net income. Good Chevrolet v. Commissioner, 36 T.C.M.

1157 (1977). However, in Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th

Cir. 1987), the Fifth Circuit did not agree with Good Chevrolet in finding that 60% of net

income was reasonable compensation for shareholder-employees.

In the Respondent’s case, the return on net income was 100% of net income, well

passed the benchmark set by Good Chevrolet and rejected by Owensby & Kritikos,

because the benchmark was too high. Therefore, this Court should follow the Fifth

Circuit’s ruling in Owensby & Kritikos, and find that deducting 100% of taxable income

is unreasonable. Furthermore, the Court should also consider policy arguments against

this factor, the judiciary is ill-equipped to make determination of what percentage of

taxable income a corporation should allocate to compensation. Corporations should be

free to make their business decisions without the limitations of an arbitrary standard.

CONCLUSION

The Second Circuit’s Order in allowing the Respondent to take the business

entertainment expense deduction and compensation deductions should be reversed for the

aforementioned reasons.

Dated at Buffalo, New York, Feb. 15, 2017. Respectfully submitted, COMMISSIONER OF INTERAL REVENUE, Petitioner