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Court: CEO's Compensation Must be Capitalized

Berdon Tax Team 12.28.2015 | eVisor

The Fifth Circuit Court of Appeals recently upheld a decision of the Tax Court regarding the capitalization of costs incurred by a real estate developer.  In Frontier v. Commissioner 1, the taxpayer had deducted the compensation of its CEO on its tax return, and the IRS challenged the deduction under the uniform capitalization (UNICAP) rules of section 263A - which generally apply to real estate developers. The Tax Court upheld the IRS disallowance, and the Fifth Circuit subsequently affirmed the decision that the compensation must be capitalized.

Frontier argued that the UNICAP rules did not apply since they did not provide any production-related services directly because the work was performed by subcontractors. The Court found that the UNICAP rules did apply since the statute provides that a taxpayer is deemed to engage in the production activities of subcontractors.

Frontier also argued that the compensation of its CEO should not be capitalized since his work related solely to management, planning, and marketing.  The Tax Court had found that the CEO was directly involved in designing homes and selecting and managing subcontractors. The Fifth Circuit accepted these findings and held that these activities were related to the development of homes that needed to be capitalized under the UNICAP rules.

The IRS disallowed all of the compensation paid to the CEO. The Fifth Circuit agreed with the taxpayer that much of the CEO's time was spent on management activities - which would have been deductible. However, Frontier could not substantiate the hours spent on management activities, and the CEO did not keep a contemporaneous time record. As a result, the Fifth Circuit upheld the finding of the Tax Court that all of the CEO's compensation related to the development of homes needed to be capitalized.

The lesson from Frontier is that if officers of a company perform more than just traditional management services, a record system should be established to help determine the portion of their time spent on production activities (subject to capitalization under UNICAP) and the portion that is deductible.

1 Frontier Custom Builders Inc. v. Commissioner, 2015 Tax Notes Today 180-14 (5th Cir) (per curiam)

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