## Facts

- Harolds Club, a Nevada corporation operating a Reno gaming establishment, was owned by Harold and Raymond A. Smith, but was managed by their father, Raymond I. Smith.
- In 1941 the corporation adopted a compensation arrangement under which Raymond I. Smith would receive $10,000 annually plus 20% of the club’s net profits; the percentage was proposed by Raymond I. Smith.
- For tax years 1952–1956, the club’s profits were high and Raymond I. Smith’s total annual compensation ranged from about $350,201 to $557,560.
- The corporation deducted the full amounts as business expenses under § 23(a)(1)(A) of the 1939 Code and § 162(a)(1) of the 1954 Code.
- The Commissioner disallowed deductions above $100,000 per year as unreasonable compensation.
- The Tax Court found the 20%-of-profits arrangement was not the product of arm’s-length dealing due to Raymond I. Smith’s domination of his sons, and held that $10,000 plus 15% of net profits was reasonable compensation.
- Harolds Club sought appellate review, relying heavily on testimony from executives of competing gaming establishments who stated the 20% arrangement was reasonable in the industry.

## Issues

1. Whether amounts paid under a contract providing $10,000 plus 20% of net profits constituted fully deductible “reasonable compensation for personal services actually rendered” under § 23(a)(1)(A) (1939 Code) and § 162(a)(1) (1954 Code).
2. Whether the Tax Court applied an incorrect standard by limiting the deduction to $10,000 plus 15% of net profits despite largely uniform expert testimony supporting the 20% arrangement.
3. Whether disallowing part of the corporate deduction was improper because the employee had reported and paid income tax on the full amounts received, allegedly resulting in double taxation.

## Decision

- The Ninth Circuit affirmed the Tax Court.
- It held that limiting the deductible compensation to $10,000 plus 15% of net profits for each year 1952–1956 was supported by the record and not clearly erroneous.
- It accepted the Tax Court’s finding that the compensation contract was not the result of arm’s-length bargaining in light of the family-control and domination evidence.
- It rejected the argument that the employee’s payment of income tax on the full amount required the corporation to receive a matching deduction.

## Legal Principles

- Under § 162(a)(1) and its predecessor, deductible compensation must be for services actually rendered and reasonable in amount.
- Contingent, profit-based compensation may be deductible, but courts scrutinize whether it reflects an arm’s-length bargain rather than a distribution of profits labeled as salary, especially in closely held family corporations.
- The reasonableness of compensation is a fact question; appellate review is limited to whether the Tax Court’s findings are clearly erroneous, and the Tax Court is not required to accept opinion testimony on reasonableness even if uncontradicted.
- Taxability to the recipient and deductibility to the payor are separate; the Commissioner may tax the full receipt as income to the employee while disallowing the payor’s deduction for amounts deemed unreasonable.

## Conclusion

The Ninth Circuit upheld the Tax Court’s limitation of Harolds Club’s salary deduction because the profit-percentage arrangement with a dominant family member lacked arm’s-length characteristics and produced compensation exceeding what the Tax Court reasonably found allowable under § 162(a)(1), notwithstanding industry testimony and the employee’s reporting of the full payments as income.


Harolds Club v. Commissioner, 340 F.2d 861 (9th Cir. 1965)