Harolds Club v. Commissioner

Brief Fact Summary. Harolds Club was a gaming operation owned by Raymond Smiths’ two sons. His two sons agreed to pay him $10,000 a year plus 20% of the profits for Smith to manage the operation. Harolds Club attempted to deduct the compensation from its income.

Synopsis of Rule of Law. Contingent compensation may be allowed as a deduction if it is the result of a free bargain between employer and the individual and if the contract for compensation was reasonable under the circumstances.

Facts. Harolds Club was an incorporated gaming establishment in Nevada. Raymond Smith was paid an annual salary of $350,000 to $560,000. Smith’s two sons owned all the stock in the corporation. The business was essentially a continuation of an illegal operation that Smith ran in California. Smith eventually took over managing the Club and he and his sons agreed to pay him 20% of the profits on top of an annual salary of $10,000 per year. His two sons received salaries of $60,000 to $75,000 per year.

Issue. Were the amounts paid by Petitioner to Smith reasonable salaries and the result of a free bargain, and thus allowable deductions?

Held. Circuit Judge Hamley issued the opinion for the United States Ninth Circuit Court of Appeals in holding that the salary was not the result of a free bargain and should not be allowed to be deducted.

Discussion. The facts showed that while the two sons were adults, they were always under the control of their father. The Tax Court found that the sons were dominated by their father, thus, there could be no “free bargain.”