Appeal from a Decision of the United States Tax Court
Julian I. Jacobs, Tax Court Judge, Presiding Argued and Submitted March 12, 1998 San Francisco, California
Before: Byron R. White,*fn* Justice, and John T. Noonan and Sidney R. Thomas, Circuit Judges
The opinion of the court was delivered by: Noonan, Circuit Judge:
Leonard Pipeline Contractors, Ltd. (the Taxpayer) appeals the judgment of the United States Tax Court limiting the deduction of reasonable compensation to its president, Richard L. Leonard, for the tax year 1987 to $700,000. The case involves the meaning of "reasonable" in the familiar and fundamental statute, 26 U.S. S 162, governing the deduction of compensation as an expense of doing business. Holding that the Tax Court has not furnished an adequate explanation of what it finds reasonable, we reverse and remand.
Richard L. Leonard is a forty-year veteran of the pipeline industry. He formed the Taxpayer in 1977. At all relevant times he was its president, chief operating officer and chief financial officer. Its board of directors consisted of him and his son. Its stock was wholly owned by R.L. Leonard Holdings, Limited, whose stock in turn was wholly owned by him.
In the period 1978 through 1987 the Taxpayer had gross revenues of $123,124,905 and net income for the period of $1,750,958. In the years 1985 through 1986 the Taxpayer was involved in coating, insulating and wrapping 325 miles of pipeline in Texas, Arizona and California (the All American Pipeline project), which was the major source of its income during these years. In 1991 Leonard pleaded guilty to an information charging him with the federal felony of mail fraud in making payments to Ronald L. Hinn, the president of All American Pipeline Company, in order to secure contracts with All American Pipeline, a scheme which involved the setting up of a shell corporation, Consulting Technologists, Inc. and the furnishing of false invoices to Leonard and his payment of these false invoices to Consulting Technologists, Inc., which forwarded the payments to Hinn and other officers of All American Pipeline.
In 1987 the All American Pipeline project was completed and the sole activity of the Taxpayer was receiving payments on that contract. Leonard decided to retire. As early as February 1987 he had consulted an accountant, who in turn consulted Arthur Andersen and Co., as to what would be an appropriate bonus. On September 28, 1987 the board of directors of the Taxpayer adopted a resolution noting that it was through Leonard's efforts that the Taxpayer had been "placed on the bidding list for All American Pipeline Co."; that Leonard had developed a new insulation process "which process was ultimately successful in securing the All American contract"; that Leonard had secured a joint venturer for the project; that Leonard had personally guaranteed the bank financing of the project; and that in 1985 and 1986 Leonard had received no compensation from the Taxpayer due to credit restrictions placed by the bank financing the project. In the light of these considerations the board voted to pay Leonard a bonus of $1,680,000. His salary was $97,800, so his total compensation came to $1,777,800.
Another relevant event in 1987 was that Leonard and his wife were divorced. They entered into a property settlement by which Leonard agreed to provide her money ...