## Facts

- Elliotts, Inc. was an Idaho corporation engaged in selling agricultural and industrial equipment manufactured by John Deere and servicing Deere equipment and equipment made by other manufacturers.
- The company began with roughly eight employees and about $500,000 in sales, but by 1975 it had grown to about 40 employees and annual gross sales exceeding $5 million, with locations including Burley and Idaho Falls, Idaho.
- Edward G. Elliott had been the company’s chief executive officer since incorporation and had been its sole shareholder since 1954.
- Elliott had total managerial responsibility for the business and performed duties commonly handled by multiple executives at similar dealerships, including functions usually assigned to a general manager, sales manager, and credit manager.
- Elliott worked about 80 hours per week.
- For several years, the company paid Elliott a fixed salary of $2,000 per month plus a year-end bonus.
- Since incorporation, the bonus formula was set at 50% of net profits (before subtracting taxes and management bonuses).
- For the fiscal year ending February 28, 1975, the company deducted $181,074 as total compensation paid to Elliott; for the fiscal year ending February 28, 1976, it deducted $191,663.
- After paying Elliott’s compensation, the company reported strong returns on equity: approximately 21% in 1975 and 19% in 1976.
- The Commissioner of Internal Revenue determined the claimed deductions were excessive and issued a notice of deficiency, asserting that part of the payments were nondeductible dividends rather than deductible compensation.
- The United States Tax Court sustained the deficiency in part by fixing “reasonable” compensation at $120,000 for 1975 and $125,000 for 1976, treating the excess as dividends.
- Elliotts, Inc. appealed the Tax Court’s decision to the United States Court of Appeals for the Ninth Circuit.

## Issues

1. Whether amounts paid by a closely held corporation to its CEO and sole shareholder were deductible under I.R.C. § 162(a)(1) as reasonable compensation for services actually rendered, or partly nondeductible as disguised dividends.
2. What method should be used to determine “reasonable” compensation when the employee controls the corporation and can influence the form of profit distributions.

## Decision

- The Ninth Circuit reversed the Tax Court.
- The court held that the Tax Court used an improper approach to evaluate reasonableness and that, under the correct analysis, the compensation paid to Elliott in 1975 and 1976 was deductible as reasonable compensation under § 162(a)(1).
- The case was remanded to the Tax Court for further proceedings consistent with the Ninth Circuit’s opinion.

## Legal Principles

- Under I.R.C. § 162(a)(1), a corporation may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered”; amounts exceeding reasonable compensation may be recharacterized as dividends and are not deductible.
- When the payee is a controlling shareholder, courts scrutinize compensation because the parties may label profit distributions as “salary” to obtain a deduction.
- Reasonableness is evaluated by considering a group of factors rather than any single item, including:
  - The employee’s role in the company (position, duties, hours, and contributions).
  - Compensation paid by similar companies for similar services (market comparison).
  - The character and condition of the company (size, complexity, and financial results).
  - Potential conflicts of interest created by shareholder control (including whether compensation operates as a substitute for dividends).
  - Internal consistency of the compensation policy (whether the compensation arrangement is structured and applied in a consistent way).
- The analysis is informed by the “independent investor” approach: if, after paying the challenged compensation, the corporation still earns a return on equity that would satisfy a hypothetical outside investor, that fact supports a finding that the compensation is reasonable rather than a disguised dividend.
- The presence of a profit-based bonus or the lack of formal dividends may raise suspicion, but those facts do not by themselves establish that the payments were dividends; the controlling question remains whether the total amount paid was reasonable for the services actually provided.

## Conclusion

Elliotts, Inc. v. Commissioner holds that determining reasonable compensation under § 162(a)(1) in a close corporation requires a structured, multi-factor inquiry, tested against whether an outside investor would still receive an acceptable return after the compensation is paid; applying that approach to an Idaho John Deere dealer whose CEO/sole shareholder worked extraordinary hours and produced strong returns on equity, the Ninth Circuit reversed the Tax Court and treated the full compensation amounts as deductible.


Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (1983)