                        T.C. Memo. 1997-300



                      UNITED STATES TAX COURT



                O.S.C. & ASSOCIATES, INC. d.b.a.
              OLYMPIC SCREEN CRAFTS, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3522-95.            Filed June 30, 1997.



     Daniel L. Casas, Diana T. Gendotti, and Sheila M. Riley, for

petitioner.

     Paul J. Krug and Virginia J. Coffre, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:   By notice of deficiency dated December 5,

1994, respondent determined the following deficiencies and

accuracy-related penalties:
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                                               Penalty
     Year            Deficiency              Sec. 6662(a)

     1990             $130,182                 $26,036
     1991              544,877                 108,975
     1992              413,649                  82,730

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

     The issues we must decide are as follows:

     1.   Whether petitioner, pursuant to section 162, is entitled

to deduct certain compensation payments to shareholders in

amounts in excess of the amounts determined by respondent.       We

hold that petitioner is not so entitled.

     2.   Whether petitioner, pursuant to section 6662(a), is

liable for accuracy-related penalties for negligence.       We hold

that petitioner is liable.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

O.S.C. & Associates, Inc. d.b.a. Olympic Screen Crafts was

incorporated under California law in 1982.    During the years in

issue, petitioner's principal place of business was in Fremont,

California.   Allen Blazick is petitioner's chief executive

officer, Janette Blazick (Allen Blazick's wife) is petitioner's
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secretary and treasurer, and Steven Richter (Mrs. Blazick's

brother) is petitioner's vice president.    Together the three

constituted petitioner's board of directors.

     Mr. Blazick is a resident of Fremont, California.    He

attended Armstrong College, where he received a bachelor's degree

in business management and a master's degree in business

administration.   In January of 1970, while attending college, he

purchased a silk-screen printing business.    From 1970 through

1972, he and his wife, Janette, conducted the business from their

residence.   He had no previous experience in the printing

business but learned quickly.    In 1982, Mr. Blazick incorporated

the business under the name "O.S.C. & Associates, Inc."    During

the years in issue, Mr. Blazick owned 90 percent of petitioner's

stock and Mr. Richter owned 10 percent.    Mr. Blazick expanded the

business to include numerous printing processes and other

services.    During the years in issue, petitioner employed between

179 and 235 employees, including numerous managerial and

supervisory personnel.

     Leo Rosi was petitioner's accountant.    Messrs. Rosi and

Blazick were classmates at Armstrong College, and in the late

1970's, Mr. Blazick became Mr. Rosi's client.    In 1988 or 1989,

Mr. Rosi advised Messrs. Blazick and Richter that petitioner

should pay dividends.    Their response to Mr. Rosi's advice

discouraged Mr. Rosi from raising the issue in subsequent years.

Petitioner has never declared or paid dividends.
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     In 1985, Mr. Rosi drafted an incentive compensation plan

(the plan), applicable only to Messrs. Blazick and Richter, which

was approved by the board of directors on October 7, 1985.    The

plan provided for the payment, after the close of the fiscal

year, of compensation in cash and/or promissory notes.

     Pursuant to the terms of the plan, the first step is to

calculate the "Adjusted Industry Gross Margin".   The adjusted

industry gross margin, or hypothetical gross profit, is the gross

profit petitioner would have made on its sales if its gross

profit margin had equaled the printing industry's average gross

profit margin (i.e., petitioner's sales x industry average gross

profit percentage = hypothetical gross profit).   This

hypothetical gross profit is then compared to petitioner's actual

gross profit for the year.   The amount by which petitioner's

actual gross profit exceeds the hypothetical gross profit

constitutes the incentive compensation pool.   The plan allocates

the incentive compensation pool to Messrs. Blazick and Richter

"According to Stock Ownership" (i.e., 90 percent to Mr. Blazick

and 10 percent to Mr. Richter).

     Under the plan, each allocation is reduced if certain

contingencies occur.   Mr. Blazick's allocation is reduced by

inventory shortages in excess of $100,000 and by bad debts.     Mr.

Richter's allocation is reduced by inventory spoilage in excess

of $100,000 and production rerun costs in excess of $100,000.
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     Petitioner operated on a fiscal year ending on October 31.

Petitioner's financial statements for the years in issue

delineated the following figures:




     FYE 1990

     Sales/revenue                     $10,271,148.12
     Cost of goods sold                 (5,978,195.24)
     Gross profit                        4,292,952.88

     Net income                            192,865.38

     Yearend net worth                     194,490.31

     FYE 1991

     Sales/revenue                     $13,115,588.55
     Cost of goods sold                 (7,324,963.44)
     Gross profit                        5,790,625.11

     Net income                            134,160.16

     Yearend net worth                     328,650.47

     FYE 1992

     Sales/revenue                     $12,310,770.53
     Cost of goods sold                 (5,981,916.36)
     Gross profit                        6,328,854.17

     Net income                            143,809.07

     Yearend net worth                     472,459.54

     Mr. Rosi calculated the compensation due under the plan.   In

calculating the compensation, he referred to information

published annually in a survey of small businesses (the Survey).

For the 1990 calculation, he used 32.189 percent as the industry

average gross profit margin.   For that year, the Survey reported
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a 34.93-percent industry average.    For the 1991 calculation, he

again used the 1990 industry average (i.e., 32.189 percent)

rather than the 1991 industry average.         In the 1990 and 1991

calculations, he used figures from a sample of printing companies

categorized according to the amount of their sales.         In 1992,

however, he used figures from a sample of printing companies

categorized according to the value of their assets.         In addition,

he used a chart applicable to companies with assets under $1

million when petitioner had assets in excess of that amount.

Also in 1992, petitioner incurred bad debts of $166,700.          Before

adjusting Mr. Blazick's allocation, however, Mr. Rosi reduced the

bad debts figure to $112,403.

     During the years in issue, petitioner paid, in the form of

cash and promissory notes, the following amounts to Messrs.

Blazick and Richter:

                       1990             1991             1992

Allen Blazick
     Salary      $155,372.00      $175,845.00          $173,372
     Incentive    490,859.92     1,651,145.76         1,324,608
     Total        646,231.92     1,826,990.76         1,497,980

Steven Richter
     Salary       $57,791.00        $64,616.00          $60,000
     Incentive     98,035.62        183,460.64          149,179
     Total        155,826.62        248,076.64          209,179

     For each year in issue, petitioner filed a Form 1120 (U.S.

Corporation Income Tax Return) and claimed a deduction for the

compensation paid to Messrs. Blazick and Richter.         Respondent, in

the notice of deficiency, disallowed $357,453 of petitioner's
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1990 deduction, $1,580,631 of petitioner's 1991 deduction, and

$1,198,677 of petitioner's 1992 deduction.    The petition in this

case was filed on March 6, 1995.

                               OPINION

I.   Deductibility of Plan Payments

      Section 162(a) provides that a taxpayer may deduct all

"ordinary and necessary expenses paid or incurred during the

taxable year in carrying on any trade or business".    Such

expenses may include "a reasonable allowance for salaries or

other compensation for personal services actually rendered".

Sec. 162(a)(1); sec. 1.162-7(a), Income Tax Regs.    For such an

expense to be deductible, two elements must be present:    (1) The

amount must be reasonable, and (2) the expense must relate to

compensation for services actually rendered.    Elliotts, Inc. v.

Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), revg. T.C.

Memo. 1980-282.    Where there is evidence that an otherwise

reasonable compensation payment contains a disguised dividend, we

may expand our inquiry into the existence or nonexistence of

compensatory intent.    Id. at 1244; see also Ruf v. Commissioner,

T.C. Memo. 1993-81, affd. without published opinion 57 F.3d 1078

(9th Cir. 1995).

      Numerous factors in the present case lead us to conclude

that the plan allocations were not intended as compensation for

services rendered.    First, in 1990, 1991, and 1992, petitioner

paid Messrs. Blazick and Richter salaries and bonuses totaling
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approximately 81 percent, 94 percent, and 92 percent,

respectively, of petitioner's net income (i.e., calculated by

adding back compensation).   Such high percentages are consistent

with the existence of disguised dividends.    See Pacific Grains,

Inc. v. Commissioner, 399 F.2d 603 (9th Cir. 1968), affg. T.C.

Memo. 1967-7.

     Second, petitioner has never declared or paid a dividend.

While the U.S. Court of Appeals for the Ninth Circuit has

indicated that this fact is not dispositive, Elliotts, Inc. v.

Commissioner, supra at 1246, it is a relevant consideration,

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1324

(5th Cir. 1987), affg. T.C. Memo. 1985-267; Nor-Cal Adjusters v.

Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), affg. T.C. Memo.

1971-200.   Mr. Rosi testified that in 1988 or 1989 he advised

petitioner to pay dividends and that Messrs. Blazick and

Richter's response discouraged him from offering such advice

during the years in issue.   Mr. Blazick, however, when asked why

petitioner did not pay dividends, testified that dividends were

not paid "Because Mr. Rosi prepared a procedure for us to follow

and we did."

     Third, Mr. Rosi's implementation of the plan had the effect

of arbitrarily increasing allocations above the amounts the plan

authorized.    This occurred in 1990 and 1991 when Mr. Rosi

utilized industry average gross profit margins lower than those

published in the Survey, and in 1992 when Mr. Rosi reduced the
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bad debts adjustment to Mr. Blazick's 1992 allocation.    Mr. Rosi

offered no explanation for these apparent manipulations.

     Finally, the most persuasive evidence of petitioner's lack

of compensatory intent is the plan itself.   Consistent with the

existence of disguised dividends, the plan applied only to

petitioner's shareholders, Messrs. Blazick and Richter, and

payments were expressly calculated with reference to their

proportion of stock ownership.    See Elliotts, Inc. v.

Commissioner, supra at 1246-1247 & nn. 4, 7.     Moreover, the plan

does not use the value of services rendered as the basis for

calculating the amount of compensation, but merely distributes

excess profits to Messrs. Blazick and Richter.

     Generally, incentive compensation plans are designed to

increase the compensation to employees by some fraction of the

benefit the corporation derives from the employees' efforts.    See

Elliotts, Inc. v. Commissioner, supra at 1248 (stating that

"Incentive payment plans are designed to encourage and compensate

that extra effort and dedication which can be so valuable to a

corporation."); cf. Kennedy v. Commissioner, 671 F.2d 167 (6th

Cir. 1982), revg. 72 T.C. 793 (1979) (concerning incentive

compensation equal to 52 percent of net profits); PMT, Inc. v.

Commissioner, T.C. Memo. 1996-303 (concerning incentive

compensation equal to 10 percent of the increase in sales over

the previous year's sales).   As the benefit to the corporation

increases, the compensation to the employee increases.
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Dividends, on the other hand, are merely distributions of excess

earnings to shareholders in proportion to their stock holdings.

      Petitioner's plan provides that every dollar of gross

profits in excess of the hypothetical gross profit goes directly

to Messrs. Blazick and Richter while petitioner receives nothing.

The allocations are measured by the amount of petitioner's excess

gross profits and not by the value of Messrs. Blazick's and

Richter's contributions to petitioner.    We also note that the

adjustments (i.e., relating to bad debts, inventory spoilage,

production rerun costs, and inventory shortages) made to the

allocations merely reduce the distributions to Messrs. Blazick

and Richter without direct relation to the value of their

services.

      Accordingly, we conclude that the plan allocations were not

made with compensatory intent and thus did not constitute

compensation for services.   As a result, we sustain respondent's

determination for each year.

II.   Negligence Penalty

      Section 6662(a) imposes an accuracy-related penalty in an

amount equal to 20 percent of the portion of any underpayment to

which the section applies.   The section applies to, among other

items, the portion of an underpayment attributable to negligence

or disregard of rules or regulations.    Sec. 6662(b)(1).

Negligence has been defined as the lack of due care or failure to

do what a reasonable and ordinarily prudent person would do under
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the circumstances.    Neely v. Commissioner, 85 T.C. 934, 947

(1985).    It includes the failure to make a reasonable attempt to

comply with the Internal Revenue Code.    Sec. 6662(c).   In

determining whether a corporation is liable for the negligence

penalty, the acts of officers on behalf of the corporation are

imputed to the corporation.    DiLeo v. Commissioner, 96 T.C. 858,

875 (1991), affd. 959 F.2d 16 (2d Cir. 1992); Auerbach Shoe Co.

v. Commissioner, 21 T.C. 191, 194 (1953), affd. 216 F.2d 693 (1st

Cir. 1954); Ibabao Med. Corp. v. Commissioner, T.C. Memo. 1988-

285.

       We conclude that petitioner failed to exercise ordinary

care.    The record establishes that the plan was both designed and

manipulated to direct the flow of corporate earnings to Messrs.

Blazick and Richter and to disguise such payments as

compensation.

       We have considered all other arguments made by the parties

and found them to be either irrelevant or without merit.

       To reflect the foregoing,


                                          Decision will be entered

                                     for respondent.
