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

  • Smith's sons owned a corporation (Harolds Club) that operated a number of casinos in Nevada. Smith ran the casinos but didn't own any stock in the company.
    • Smith was working under a contract that paid him a fixed salary, plus a percentage of the casino's profits.
  • Harolds Club deducted Smith's salary as a business expense on their taxes.
    • In general, payments to employees as salary are a legitimate business expense under 26 U.S.C. 162(a).
  • The IRS denied the deduction. Harolds Club appealed.
    • The IRS argued that under 162(a)(1) Harolds Club could only deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered."
    • Harolds Club argued that while Smith's salary was high, it was only because the casino made a lot of money under Smith's leadership and his contract gave him a percentage.
      • Harolds Club argued that in previous years, the casino made less money, so Smith made less money and the IRS didn't have a problem with them deducting his salary. So the IRS must have implicitly found that Smith's compensation structure was reasonable.
  • The Tax Court found for the IRS. Harolds Club appealed.
    • The Tax Court found that Smith's salary wasn't reasonable compensation for his work, and was just given to him by his sons because of their familial relationship.
  • The Appellate Court affirmed.
    • The Appellate Court found that salary must be the result of a 'free bargain'. The Court basically said that Smith's sons were only paying as much as they were because he was their dad, not because he was awesome at running a casino.
      • The reason why this was such an issue is that if the family was all in cahoots, they could dodge paying taxes by simply 'paying' each other very large sums of money and then deducting all of it as a business expense.
        • This is especially true if dad was in a much lower tax bracket than the sons were in.
  • The basic reason for 162(a)(1) is that compensation payments made to employees for salary are deductible as a business expense, while payments made to shareholders as a dividend are not deductible. Sometimes, a company will try to call something salary when it is really a dividend just to get the deduction, and 162(a)(1) is an attempt to stop that.