                          T.C. Memo. 1999-211



                        UNITED STATES TAX COURT



             EBERL'S CLAIM SERVICE, INC., Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12385-97.                         Filed June 25, 1999.



     John D. Moats, for petitioner.

     David J. Mungo, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:     Respondent determined deficiencies in

petitioner's Federal income tax and penalties as follows:

                                            Penalty
          FY1    Deficiency               Sec. 6662(d)
         1992    $1,374,783                $274,957
         1993       637,712                 127,542
     1
      Petitioner's 1992 fiscal year ended on May 31, 1993, and
its 1993 fiscal year ended on May 31, 1994.
                                 -2-

     After concessions, the issues for decision are:

     1.     Whether petitioner may deduct as compensation for Kirk

Eberl $4,340,000 for fiscal year 1992 and $2,080,000 for fiscal

year 1993, as petitioner contends; $500,000 for fiscal year 1992

and $400,000 for fiscal year 1993, as respondent contends; or

some other amount.    We hold that petitioner may deduct $2,340,000

for fiscal year 1992 and $1,080,000 for fiscal year 1993.

     2.     Whether petitioner is liable for the accuracy-related

penalty for substantial understatement under section 6662 for

fiscal years 1992 and 1993.    We hold that it is not.

     Section references are to the Internal Revenue Code in

effect during the years at issue.      Rule references are to the Tax

Court Rules of Practice and Procedure.

                        I.   FINDINGS OF FACT

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

     Petitioner is a Colorado corporation that had its mailing

address in Lakewood, Colorado, when it filed the petition.

A.   Kirk Eberl

     1.     General

     Kirk J. Eberl (Eberl) is petitioner's founder, sole

shareholder, and president.    Grace and Kirk Eberl have been

married since 1975.

     Eberl's father, Gene Eberl, was a catastrophic claims

adjuster.    Catastrophic claims adjusting is the process of
                                -3-

determining the amount of damages suffered by an insured property

owner as the result of natural or man-made disasters such as

hurricanes, earthquakes, and fires.   Catastrophic claims

adjusters inspect property for insurance companies after a

disaster and determine whether the property was damaged by the

catastrophe and the monetary amount of the damage.   As a young

man, Eberl sometimes helped his father in catastrophic claims

adjusting activities.

     2.    Employment

     In 1975, Eberl was 18 years old and bought his first house.

He repaired it and sold it for about twice the amount he had paid

for it.   From 1975 to about 1985, Kirk and Grace Eberl bought,

lived in, repaired, and sold about 17 houses.   Eberl also built

houses, self-storage units, and condominiums.

     Before 1986, Eberl occasionally worked as a claims adjuster

for independent catastrophic claims adjusting companies.    In

1986, Eberl began working full time as a catastrophic claims

adjuster for several independent catastrophic claims adjusting

companies.

B.   Petitioner

     1.    Formation

     In 1987, Eberl started an independent claims adjusting

business, which he operated as a sole proprietorship.   Eberl knew

many claims adjusters before he formed petitioner.   In 1988, he

incorporated petitioner.   Eberl's only capital investment in

petitioner was $500.
                                  -4-

     Eberl was the only member of petitioner's board of directors

from June 8, 1988, through the years in issue.   Grace Eberl has

been petitioner's corporate secretary and treasurer since it was

incorporated.

     2.   Petitioner's Business

     Petitioner provides the temporary services of independent

catastrophic claims adjusters to client insurance companies.

Petitioner has provided independent claims adjusters for several

major insurance companies, including State Farm Insurance Co.

(State Farm), Safeco, Aetna Travelers, USAA, Nationwide,

Prudential, National Farmers Union, and American Family.

     Insurance companies pay independent claims adjusting

companies a negotiated fee for each claim adjusted by the

independent company.   Independent companies subcontract the

adjusting work to individual claims adjusters.

     Most major insurance companies have in-house claims

adjusters.   They use independent adjusters only when major

disasters occur.    In 1990, State Farm decided to use only its own

claims adjusters.   However, 10 days after Hurricane Andrew struck

in 1992, State Farm decided to use independent adjusters because

its own adjusters could not handle all of the claims.   State Farm

accounted for 60-70 percent of petitioner's business in fiscal

years 1992 and 1993.   The rest of petitioner's work was

distributed fairly evenly among other companies.   Insurance
                                -5-

companies' in-house claims adjusters performed about 70 percent

of all claims adjusting in 1993 and more than half in 1994.

     Petitioner contracted with independent claims adjusters to

work as needed from time to time.     Petitioner contracted with 192

claims adjusters in calendar year 1992, 170 in 1993, and 199 in

1994.   Catastrophic claims adjusters travel extensively and are

frequently away from home for long periods of time.    Adjusters

could decline calls to work for petitioner if they so chose.

     Petitioner contracted with individuals and insurance

companies which were located throughout the United States.    Once

petitioner was hired, it was required to have claims adjusters at

the site of the catastrophe immediately after it occurred.

     Independent claims adjusting companies typically paid their

claims adjusters 60-65 percent of the fee they received from the

insurance company for each claim adjusted.    In contrast,

petitioner paid its claims adjusters 70 percent of the fee it

received for each claim adjusted.     This helped petitioner obtain

and keep the services of high-quality claims adjusters.

     Petitioner issued to its independent claims adjusters Forms

1099 totaling $15,589,041 for fiscal year 1992 and $6,510,745 for

fiscal year 1993.   Petitioner paid 76.2 percent of its gross

receipts to claims adjusters in fiscal year 1992 and 71 percent

in fiscal year 1993.

     Petitioner's supervisors coordinated the adjusting

activities at each work site and were liaisons between petitioner
                                 -6-

and the insurance companies.    Petitioner's supervisors did not

direct the day-to-day work of its independent claims adjusters or

review a significant number of the claims files handled by

petitioner's independent adjusters.

     Petitioner's claims adjusters usually returned the claim

file to the insurance company when they finished adjusting a

claim.    They did not send the file to petitioner.   The adjuster

completed a billing sheet showing how much petitioner was to

receive for the claim.    The claims adjuster gave the billing

sheet to the insurance company and sent a copy to petitioner.

     After the insurance companies received a completed claim

file, they issued one check to petitioner and one to the

policyholder.    Petitioner usually paid its adjusters 2 weeks

after it received payments from the insurance companies.

     3.     Eberl's Duties

     Eberl has always made all of petitioner's business decisions

and supervised or performed substantially all of its managerial

functions, except accounting.    He was solely responsible for

marketing petitioner's services to insurance companies and

negotiating petitioner's contracts with insurance companies and

individual claims adjusters.

     From 1990 to 1994, Eberl solicited business from six to

eight insurance companies, and petitioner did work for about

four. Eberl spent a substantial amount of time maintaining

relationships with his insurance company contacts because
                                 -7-

petitioner's successful performance for an insurance company in

one disaster did not guarantee that that company would use its

services in the future.

     Eberl traveled extensively to meet with insurance industry

officials.   In 1986 and 1987, he traveled by car because he could

not afford to fly.   He was away from home for months at a time in

1987 and 1988.   In 1992, 1993, and 1994, Eberl was away from home

about 75 percent of the time.    Eberl worked long hours, often

from 4:30 a.m. until midnight.

     Eberl's work schedule was the most hectic right after a

catastrophe.   When a catastrophe occurred, he coordinated

petitioner's work with the insurance companies and petitioner's

claims adjusters.    He discussed with the insurance companies the

types and number of anticipated claims, determined which

adjusters to use for which jobs, and, with the help of

petitioner's office staff, contacted adjusters and coordinated

the logistics of getting them to the disaster site.
                                 -8-

     4.     Petitioner's Employees

     Eberl signed an employment agreement with petitioner on July

19, 1988.    The agreement provided that petitioner would pay Eberl

a base salary and, if the board of directors approved, a bonus.

The contract did not specify the amount of the base salary.

Eberl's salary and bonus were set at the annual meeting of

petitioner's board of directors near the end of each taxable

year.

     Grace Eberl was petitioner's office manager, bookkeeper, and

secretary beginning in 1987.    Her employment agreement with

petitioner did not specify how much she would be paid.    Her

annual salary was set for the next fiscal year at each annual

meeting of petitioner's board of directors.    Petitioner paid no

bonuses to Grace Eberl.

     Before fiscal year 1991, Kirk and Grace Eberl were

petitioner's only employees.    Beginning in fiscal year 1991,

petitioner employed Grace Eberl's mother, Carol Soucie (Soucie),

as office manager, and some part-time clerical staff.    Soucie

began to work full time around 1992.    Petitioner did not pay a

bonus to Soucie in fiscal years 1992 and 1993.

     5.     Compensation Paid by Petitioner

     In 1988, petitioner sought the advice of its attorney,

Richard Elrod (Elrod), certified public accountant, Mark Lehrner

(Lehrner), and a financial adviser, George Volland (Volland),

concerning its compensation for Eberl.    Elrod, Lehrner, Volland,
                                  -9-

and Eberl met two or three times a year thereafter.    Among other

things, at those meetings they discussed Eberl's desire to have

petitioner pay Eberl 20-25 percent of its revenues.    Based on

these discussions, Eberl believed that they thought compensation

equal to 20-25 percent of petitioner's gross receipts would be

reasonable.

     Petitioner paid salaries and bonuses (excluding pension and

profit-sharing contributions) to its officers and employees as

follows:

                    Kirk         Grace                 Other
Fiscal year         Eberl        Eberl      Soucie   employees

    1988            $40,000        -0-        --        --
    1989            608,000     $122,0001     --        --
    1990            300,000      120,000    $6,560      -0-
    1991            190,000      120,000    16,530      -0-
    1992          4,340,000      120,000    21,980     $861
    1993          2,080,000      120,000    26,190    6,394
1
  This includes $2,000 paid in November 1989 for fiscal year
1988.

     Petitioner has provided health and accident insurance for

Eberl since 1988.    Effective May 28, 1990, petitioner started a

pension plan and a profit-sharing plan for its employees.

Petitioner contributed to the plan only if petitioner had

profits.    Petitioner contributed a total of $30,000 each year to

its pension and profit-sharing plans for Eberl and for Grace

Eberl.     It contributed a total of $5,495 in fiscal year 1992 and

$6,437 in fiscal year 1993 to its pension and profit-sharing

plans for Soucie.
                               -10-

     Petitioner and Eberl entered into a deferred compensation

agreement, effective June 1, 1992, under which petitioner agreed

to establish a reserve of $500,000 for each year of Eberl's

service to petitioner (payable at his death, disability, or

retirement) unless his total annual compensation (including

salary and bonus) exceeded $1 million.    Payments under this

agreement were in addition to payments made under his employment

agreement with petitioner.   Petitioner made no contributions

under the deferred compensation agreement.

     Eberl's compensation, as a percentage of petitioner's total

income (gross receipts less cost of goods sold plus interest

income) and net income (before tax, net operating loss, and

Eberl's compensation) was as follows:

                  Eberl's                            Comp. as
     Fiscal        total              Total         % of total
      year      compensation          income          income

      1988        $40,000           $72,943            54.8%
      1989        638,000           942,552            67.7
      1990        330,000           558,178            59.1
      1991        220,000           517,332            42.5
      1992      4,370,000         4,862,456            89.9
      1993      2,110,000         2,658,025            79.4
                                        -11-

                                        Comp. as %      Eberl's salary
                                 1
     Fiscal            NIBTNOL          of NIBTNOL         as % of
      year             & comp.           & comp.        gross receipts

         1988          $36,391            110.0%             14.1%
         1989          638,000            100.0              14.7
         1990          293,767            112.3              13.7
         1991          222,861             98.7               8.7
         1992        4,392,439             99.5              21.2
         1993        2,151,935             98.0              22.7
     1
         NIBTNOL is petitioner's net income before tax and net operating
loss.

     6.         Petitioner's Gross Receipts and Taxable Income

     Petitioner's taxable income was as follows:

                          Fiscal          Taxable
                           year           income

                           1988           ($3,609)
                           1989            (3,609)
                           1990           (39,842)
                           1991           (36,981)
                           1992           (14,542)
                           1993            27,393

     Petitioner has never paid dividends.

     Petitioner's net profits (i.e., profits before tax and net

operating loss) as a percentage of gross receipts were as

follows:

Fiscal          Net profits before                     Net profit as %
 year              tax and NOL       Gross receipts   of gross receipts

 1988               ($3,609)            $282,682           (1.28%)
 1989                  -0-             4,141,872            0.00
 1990               (36,233)           2,190,835           (1.65)
 1991                 2,861            2,193,708            0.13
 1992                22,439           20,438,803            0.11
 1993                41,935            9,168,585            0.46

     Petitioner's net profits as a percentage of total income and

equity were as follows:
                                   -12-

                                    Net profits
     Fiscal                          as % of
      year         Total income     total income         Equity

      1988               $72,943      (4.95%)             $500
      1989               942,552       0.00                500
      1990               558,178       6.49                500
      1991               517,332       0.55                500
      1992             4,862,456       0.46                500
      1993             2,658,025       1.58                500

     Petitioner's annual and cumulative retained earnings were as

follows:

             Fiscal Year            Annual          Cumulative

                1988               ($4,655)           ($4,655)
                1989                (5,750)           (10,405)
                1990               (41,276)           (51,681)
                1991                 4,650            (47,031)
                1992                16,748            (30,283)
                1993                37,098              6,815

     7.      General Economic Conditions

     There was more work for catastrophic claims adjusters during

the years in issue than in prior years because of the large

number of catastrophes in 1992 and 1994.        U.S. insured

catastrophic losses (approximate) from 1971 to 1995 were:


              Calendar year               Amount (billions of $)
                  1971                              <1
                  1972                              <1
                  1973                               1
                  1974                               2
                  1975                             1.5
                  1976                              <1
                  1977                              <1
                  1978                             1.5
                  1979                               3
                  1980                               2
                  1981                               1
                  1982                               2
                                -13-

               1983                             3
               1984                             2
               1985                           3.5
               1986                             1
               1987                             1
               1988                           1.5
               1989                           8.5
               1990                             3
               1991                           4.5
               1992                            23
               1993                             6
               1994                            17
               1995                          17.7

     Five of the 10 most costly insured U.S. catastrophes, as of

May 2, 1996, occurred in petitioner's tax years at issue, shown

as follows:

                                                      Occurred in
                                                      petitioner's
                                         Amount       fiscal year
          Event               Date     (billions)     1992 or 1993
Hurricane Andrew              8/92       $15.5              x
Northridge (CA) earthquake    1/94        12.5              x
Hurricane Hugo                9/89         4.2
Hurricane Opal                10/95        2.1
Winter storms (20 States)     3/93         1.3              x
Oakland fire                  10/91        1.7
Hurricane Iniki               9/92         1.6              x
Texas hail storms             5/95         1.1
Loma Prieta (CA) earthquake   10/89        1.0
California brush fires        11/93        1.0              x

     8.   Petitioner's Federal Income Tax Returns

     Lehrner prepared and signed each of petitioner's returns for

fiscal years 1988 to 1993.    Petitioner deducted as compensation

it paid to Eberl $4,340,000 in fiscal year 1992 and $2,080,000 in

fiscal year 1993.
                                    -14-

                              II.   OPINION

A.   Positions of the Parties

     Respondent determined that it was unreasonable for

petitioner to pay Eberl more than $286,815 for services rendered

in fiscal year 1992 and $234,227 in fiscal year 1993.        Respondent

now contends that the amounts petitioner paid in excess of

$500,000 for fiscal year 1992 and $400,000 for fiscal year 1993

were unreasonable compensation, disguised dividends, and not for

services to petitioner.    Petitioner contends that the amounts it

paid Eberl in fiscal years 1992 ($4,340,000) and 1993

($2,080,000) were reasonable and were for services Eberl provided

to petitioner.

     A taxpayer may deduct payments for compensation if the

amount paid is reasonable in amount and for services actually

rendered.   Sec. 162(a)(1).    Petitioner bears the burden of

proving the reasonableness of compensation it paid in excess of

what respondent contends was reasonable.      Rule 142(a).

B.   Controlling Factors

     Courts have considered several factors in deciding whether

compensation is reasonable in amount, such as:      (1) The

employee's qualifications; (2) the nature and scope of the

employee's work; (3) the size and complexity of the business; (4)

general economic conditions; (5) the employer's financial

condition; (6) a comparison of salaries paid with sales and net

income; (7) distributions to shareholders and retained earnings;
                               -15-

(8) whether the employee and employer dealt at arm's length, and

if not, whether an independent investor would have approved the

compensation; (9) the employer's compensation policy for all

employees; (10) the prevailing rates of compensation for

comparable positions in comparable companies; (11) compensation

paid in prior years; and (12) whether the employee guaranteed the

employer's debt.   Rutter v. Commissioner, 853 F.2d 1267, 1271

(5th Cir. 1988), affg. T.C. Memo. 1986-407; Owensby & Kritikos,

Inc. v. Commissioner, 819 F.2d 1315, 1322-1323 (5th Cir. 1987),

affg. T.C. Memo. 1985-267; Pepsi-Cola Bottling Co. of Salina,

Inc. v. Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), affg.

61 T.C. 564 (1974); Mayson Manufacturing Co. v. Commissioner, 178

F.2d 115, 119 (6th Cir. 1949), revg. and remanding a Memorandum

Opinion of this Court dated Nov. 16, 1948; R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 51 (1972).   No single factor controls.

Mayson Manufacturing Co. v. Commissioner, supra.

     Both parties called experts to testify about whether

compensation paid to Eberl was reasonable.   Petitioner's expert

was Albert S. Williams (Williams), and respondent's was James F.

Carey (Carey).

     We next apply the factors listed above in deciding whether

compensation petitioner paid to Eberl was reasonable.
                                 -16-

     1.    Employee's Qualifications

     An employee's superior qualifications for his or her

position with the business may justify high compensation.       Home

Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1158

(1980).   Eberl was highly qualified for his position with

petitioner.   This factor favors petitioner.

     2.    Nature and Scope of Employee's Work

     An employee's position, duties performed, hours worked, and

general importance to the success of the company may justify high

compensation.     Rutter v. Commissioner, supra; American Foundry v.

Commissioner, 536 F.2d 289, 291-292 (9th Cir. 1976), affg. in

part and revg. in part 59 T.C. 231 (1972); Mayson Manufacturing

Co. v. Commissioner, supra.

     Eberl was responsible for the rapid growth in petitioner's

gross receipts.    Gerald Underwood, a catastrophe operations

supervisor for State Farm during the years at issue, testified

that State Farm would not have hired petitioner to adjust claims

resulting from Hurricane Andrew if not for Eberl.

     Eberl has at times performed or overseen virtually every

task for petitioner except accounting.    He made virtually every

important business decision for petitioner before and during the

years at issue.

     Respondent contends that it is common for a CEO to work long

hours, suggesting that Eberl's schedule was nothing out of the
                                 -17-

ordinary.     We believe respondent understates Eberl's level of

effort.

     Michael Lawrence Melvin (Melvin) and K.D. Nunn have been

catastrophic claims adjusters for more than 20 years.     They

testified that many people have tried to start a business like

petitioner, but they do not know anyone who has been as

successful as Eberl.     Melvin formed an independent catastrophic

claims adjusting company similar to petitioner, but his company

went out of business in 1987 or 1988.

     This factor favors petitioner.

     3.     Size and Complexity of Business

     We consider the size and complexity of a taxpayer's business

in deciding whether compensation is reasonable.     Rutter v.

Commissioner, supra; Pepsi-Cola Bottling Co. v. Commissioner,

supra; Mayson Manufacturing Co. v. Commissioner, supra.      A

company's size is measured by its sales, net income, gross

receipts, or capital value.     Elliotts, Inc. v. Commissioner, 716

F.2d 1241, 1246 (9th Cir. 1983), revg. and remanding T.C. Memo.

1980-282; E. Wagner & Son v. Commissioner, 93 F.2d 816, 819 (9th

Cir. 1937).

     Respondent contends that petitioner's business was simple

because it sold only one service and performed few functions,

none of which were complex.    Respondent points out that:   (a)

Petitioner generally contracted with experienced claims adjusters

who needed little or no day-to-day supervision, (b) petitioner
                                 -18-

had few employees because its claims adjusters were independent

contractors, (c) petitioner’s billing and collection process was

simple, and (d) petitioner solicited business from only six to

eight companies from 1990 to 1994.      However, respondent concedes

that Eberl’s excellent performance in obtaining and retaining

clients for petitioner offsets the relative simplicity of its

business.

     Petitioner had gross receipts of more than $20 million in

fiscal year 1992, and more than $9 million in fiscal year 1993.

It arranged for the services of almost 200 claims adjusters

during the years in issue.    Petitioner's business required

expertise in catastrophic claims adjusting, bidding, marketing,

and management.    Petitioner was responsible for getting a large

number of claims adjusters located throughout the United States

to disaster sites immediately.    This was logistically complex.

It is easy to say that founding and running petitioner was

simple, but we do not think anyone who accomplished what Eberl

did would find that characterization to be fair.     This factor

favors petitioner.

     4.     General Economic Conditions

     General economic conditions may affect a company's

performance and thus show the extent of the employee's effect on

the company.    Rutter v. Commissioner, supra; Mayson Manufacturing

Co. v. Commissioner, supra.
                                -19-

     Petitioner contends that it grew even though other

independent claims adjusting companies failed.        Nonetheless,

petitioner benefited tremendously from the large amount of

catastrophes (5 of the 10 largest in history) during its fiscal

years 1992 and 1993.   This factor favors respondent.

     5.     Petitioner's Financial Condition

     The past and present financial condition of a company is

relevant to deciding whether compensation was reasonable.        Home

Interiors & Gifts, Inc. v. Commissioner, supra at 1157-1158.

     Petitioner contends that the fact that its gross receipts

increased from $282,682 in fiscal year 1988 to $20,438,803 in

fiscal year 1992 and $9,168,585 in fiscal year 1993 shows that

its financial condition was good.      We disagree.

     Petitioner's financial condition (in contrast to Eberl's)

was poor.   Despite having a large increase in gross receipts from

fiscal year 1988 to fiscal years 1992 and 1993, petitioner had a

tiny amount of profits in fiscal years 1992 and 1993, negative

taxable income from fiscal years 1988 to 1992, and taxable income

of only $27,393 in fiscal year 1993.      Petitioner's profits in

fiscal years 1992 and 1993 were substantially lower than those of

comparably sized service companies.

     In Alpha Med., Inc. v. Commissioner, 172 F.3d 942 (6th Cir.

1999), revg. T.C. Memo. 1997-464, the taxpayer was a medical

management corporation that paid its president and sole

shareholder compensation of $4,439,180.      The U.S. Court of
                               -20-

Appeals for the Sixth Circuit held that the compensation was

reasonable.   However, unlike petitioner, the taxpayer in Alpha

Med., Inc. was financially successful; its taxable income

increased by a factor of 18, and its net worth increased by a

factor of 35 in 4 years.   In contrast, petitioner had negative

taxable income in all years except fiscal year 1993, negative

accumulated retained earnings in all years except fiscal year

1993, and low profits in fiscal years 1992 and 1993.

     This factor favors respondent.

     6.   Comparison of Salaries Paid With Gross and Net Income

     A comparison of compensation to net income can indicate

whether a corporation is disguising dividends as compensation.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1325-1326;

Mayson Manufacturing Co. v. Commissioner, supra.

     Eberl's compensation was 99.5 percent of petitioner's net

income1 for fiscal year 1992, and 98 percent of its net income

for fiscal year 1993.   Petitioner's pattern of distributing the

vast majority of its net income as compensation to Eberl at the

end of each year suggests that the amount of compensation paid

was unreasonable.   Owensby & Kritikos, Inc. v. Commissioner,

supra at 1326.

     Petitioner contends that Eberl's compensation was reasonable

because it had agreed to pay Eberl 20 percent of its gross


     1
       Net income is income before tax, net operating loss, and
compensation.
                                -21-

receipts under a contingent compensation formula.    We disagree.

Petitioner's purported compensation formula was at best vague.

Eberl wanted compensation equal to 20-25 percent of petitioner's

gross receipts,2 and he told petitioner's tax advisers of his

wish.    However, this purported formula was not in petitioner's

corporate minutes.    While we give little or no weight to the

absence of formal board resolutions in closely held corporations,

Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 713-714

(1977); Reub Isaacs & Co. v. Commissioner, 1 B.T.A. 45, 48

(1924), it is noteworthy here that the purported agreement was

not in writing, despite the fact that petitioner’s employment and

deferred compensation agreements were in writing.    Petitioner did

not pay Eberl 20 percent of its gross receipts during any of its

fiscal years from 1988 to 1993.    Eberl's compensation increased

from 14.2 percent of petitioner's gross receipts in fiscal year

1988 to 23 percent in fiscal year 1993.    Petitioner consistently

paid Eberl almost all of the income left after it paid its claims

adjusters and overhead expenses.




     2
       Petitioner's reliance on Boca Constr., Inc. v.
Commissioner, T.C. Memo. 1995-5, for the proposition that its
compensation formula was reasonable is misplaced. In Boca, the
taxpayer consistently applied a bonus formula each year. The
bonus could not exceed the lesser of 25 percent of gross receipts
or 67 percent of profits. In contrast to the instant case, the
formula in Boca ensured that the owners' compensation would not
deprive the taxpayer of all of its net profits. Here, Eberl's
compensation caused petitioner to have no taxable income from
fiscal years 1988 to 1992.
                                -22-

     Petitioner contends that it set the amount of Eberl's pay at

the end of the fiscal year because of the contingent compensation

formula.   We disagree.   We believe Eberl decided the amount of

his compensation late in fiscal years 1992 and 1993 so he could

receive virtually all of petitioner's net profits as

compensation.   See Petro-Chem Mktg. Co. v. United States, 221 Ct.

Cl. 211, 602 F.2d 959, 968 (1979) (Court inferred that bonuses

paid to shareholder-employees near the end of the year which

absorbed nearly all of the taxpayer's earnings were at least in

part a distribution of profits); Builders Steel Co. v.

Commissioner, 197 F.2d 263, 264 (8th Cir. 1952); Owensby &

Kritikos, Inc. v. Commissioner, T.C. Memo. 1985-267, affd. 819

F.2d 1315 (5th Cir. 1987); see e.g., Rich Plan, Inc. v.

Commissioner, T.C. Memo. 1978-514.     The fact that petitioner made

lump-sum payments to Eberl that were not allocated between salary

and bonus also suggests that the payments to Eberl were in part

disguised dividends.   See Nor-Cal Adjusters v. Commissioner, T.C.

Memo. 1971-200, affd. 503 F.2d 359 (9th Cir. 1974) (bonuses paid

to officer-stockholders that were computed based on the

availability of funds were distributions of earnings and thus not

deductible by the taxpayer).

     This factor favors respondent.
                                -23-

     7.     Comparison of Salary to Distributions to Shareholders
            and Retained Earnings

     If salaries paid to controlling shareholders are large

compared to salaries paid to nonowner managers who have similar

responsibilities, the salaries suggest that the amount of

compensation is a function of ownership.      Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247.

     The failure to pay more than a minimal amount of dividends

may suggest that some of the amounts paid as compensation to the

shareholder-employee is a dividend.      Edwin's, Inc. v. United

States, 501 F.2d 675, 677 n.5 (7th Cir. 1974); Charles Schneider

& Co. v. Commissioner, 500 F.2d 148, 152-153 (8th Cir. 1974),

affg. T.C. Memo. 1973-130; Owensby & Kritikos, Inc. v.

Commissioner, supra at 1322-1323.      However, corporations are not

required to pay dividends; shareholders may be equally content

with the appreciation of their stock if the company retains

earnings.   Owensby & Kritikos, Inc. v. Commissioner, supra at

1326-1327; Elliotts, Inc. v. Commissioner, supra; Home Interiors

& Gifts, Inc. v. Commissioner, 73 T.C. at 1161.

     Petitioner has never paid dividends.     Nonpayment of

dividends in conjunction with paying contingent compensation to

controlling shareholders, such as Eberl, suggests that

unreasonable and excessive compensation is being paid.

Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 528 F.2d
                              -24-

at 182-183; Perlmutter v. Commissioner, 373 F.2d 45, 48 (10th

Cir. 1967), affg. 44 T.C. 382 (1965).

     Petitioner contends that it had no need to retain earnings

and that it was reasonable for it not to do so.   We are not

convinced that petitioner had no need to retain earnings to help

it survive if Eberl retired or became disabled or if there was

less work for independent catastrophe claims adjusters.   See

Pulsar Components Intl., Inc. v. Commissioner, T.C. Memo. 1996-

129 (Court found that corporation paid reasonable compensation to

two of its officer/shareholders because an independent investor

would have been satisfied with corporation's payment of $65,000

of dividends and additional retention of earnings as cushion for

possible less profitable periods).

     The prime indicator of the return a corporation is earning

for its investors is its return on equity.   Owensby & Kritikos,

Inc. v. Commissioner, supra at 1324.

     Petitioner contends that petitioner's return on equity

should be based on Eberl's $500 investment, that petitioner had a

return on equity for fiscal year 1992 of 3,350 percent and 1,363

percent for fiscal year 1993, and that this return on equity

would satisfy an independent investor.   Petitioner also contends

that it did not need to pay dividends because a hypothetical

shareholder would be satisfied with the appreciation in value of

his or her stock due to petitioner's retention of earnings and

the growth in petitioner's annual sales.
                                -25-

     Petitioner cites no case in which the court gave significant

weight to a high return on equity based on a founding

shareholder's small initial investment.    Courts have relied on

other financial factors when a shareholder's capital contribution

is small.   See, e.g., Alpha Medical, Inc. v. Commissioner, 172

F.3d 942 (6th Cir. 1999), revg. T.C. Memo. 1997-464 (Court

derived return on equity by comparing retained earnings for the

year at issue plus the shareholder's $1,000 capital investment to

retained earnings for the prior year plus the shareholder's

capital investment); Labelgraphics, Inc. v. Commissioner, supra

(annual return on equity may be skewed in years in which the

taxpayer's equity is low); H&A Intl. Jewelry, Ltd. v.

Commissioner, T.C. Memo. 1997-467.     We give petitioner's method

for calculating return on equity3 for fiscal year 1993 based on

Eberl's $500 investment little weight in view of petitioner's

small amount of accumulated retained earnings, taxable income,

profits, and lack of dividends.   Finally, petitioner did not

retain earnings in fiscal years 1988 to 1990 and had negative

cumulative retained earnings in fiscal years 1988 to 1992; there

is no evidence that the value of petitioner's stock appreciated

during the years in issue; and petitioner offered no reason for

its failure to pay dividends.   See Owensby & Kritikos, Inc. v.


     3
       The parties disagree as to whether we compute return on
equity using current or accumulated retained earnings.
Resolution of this dispute does not affect the outcome of this
case.
                               -26-

Commissioner, supra at 1326 (in deciding the reasonableness of

compensation, a court may consider the absence of dividends if a

profitable corporation has offered no reasons for its failure to

pay dividends).

     This factor favors respondent.

     8.   Whether Employee and Employer Dealt at Arm's Length

     The failure of the employee and employer to deal at arm's

length, such as if the employee is the employer's sole or

controlling shareholder, suggests that the amount of compensation

paid may be unreasonable.   Elliotts, Inc. v. Commissioner, 716

F.2d at 1246; Owensby & Kritikos, Inc. v. Commissioner, supra at

1322-1324.   We closely scrutinize compensation if the employee

controls the employer to see whether it is something other than

the purchase price of the employee's services.   Charles Schneider

& Co. v. Commissioner, 500 F.2d at 152; see also Dielectric

Matls. Co. v. Commissioner, 57 T.C. 587, 591 (1972).

     Eberl has been petitioner's sole shareholder and president

at all times since he founded petitioner.   He set his own salary

and bonus.   Eberl and petitioner did not deal at arm's length.

See Estate of Wallace v. Commissioner, 95 T.C. 525, 555 (1990),

affd. 965 F.2d 1038 (11th Cir. 1992); cf. Mayson Manufacturing

Co. v. Commissioner, 178 F.2d at 121 (bonus plan established by

board of directors for minority shareholders was an arm's-length

transaction).

     This factor favors respondent.
                                 -27-

        9.   Petitioner's Compensation Policy for All Employees

     Courts have considered the taxpayer's compensation policy

for its other employees in deciding whether compensation is

reasonable.     Mayson Manufacturing Co. v. Commissioner, 178 F.2d

at 119; Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at

1159.    This factor focuses on whether the entity pays top dollar

to all of its employees, including both shareholders and

nonshareholders.     Owensby & Kritikos, Inc. v. Commissioner, supra

at 1329-1330.

     Petitioner offered no evidence that its other employees

(Eberl's wife and mother-in-law) were paid at or near the high

end of the compensation range.    Although petitioner's adjusters

were not its employees, we recognize that petitioner paid them 70

percent of the fee it received from the insurance company,

compared to an industry norm of 60-65 percent.     However, the

adjusters did not share in the large distribution of profits

petitioner made to Eberl at the end of the fiscal year.     Thus,

petitioner's payment policy for its adjusters is not similar to

petitioner's payment policy for Eberl.    Cf. Home Interiors &

Gifts, Inc. v. Commissioner, supra (compensation paid to the

taxpayer's shareholder-employees was reasonable in part because

the taxpayer had longstanding practice of paying all of its key

employees on the basis of commissions).

     This factor favors respondent.
                               -28-

     10.   Prevailing Rates of Compensation for Comparable
           Positions in Comparable Companies

     In deciding whether pay is reasonable, we compare it to

compensation paid to persons holding comparable positions in

comparable companies.   Rutter v. Commissioner, 853 F.2d at 1271;

Mayson Manufacturing Co. v. Commissioner, supra at 119.

     Neither respondent's expert, Carey, nor petitioner's expert,

Williams, had data from businesses that are similar to petitioner

or executives whose performance was shown to be similar to

Eberl's.   Pulsar Components Intl., Inc. v. Commissioner, supra

(Court not persuaded by expert testimony that did not compare

prevailing rates of compensation for comparable positions in

comparable companies); Mad Auto Wrecking, Inc. v. Commissioner,

T.C. Memo. 1995-153 (same).

     Respondent contends that petitioner could have hired someone

to perform all of Eberl's services for $500,000 per year.

Respondent's contention is speculative.

     This factor is neutral because neither respondent's nor

petitioner's experts had persuasive comparative pay data.
                               -29-

     11.   Compensation Paid in Prior Years

     An employer may deduct compensation paid in a year for

services rendered in prior years.     Lucas v. Ox Fibre Brush Co.,

281 U.S. 115, 119 (1930); R.J. Nicoll Co. v. Commissioner, 59

T.C. at 50-51.   To currently deduct amounts paid as compensation

for past undercompensation, a taxpayer must show:    (a) That it

intended to compensate employees for past services from current

payments, and (b) the amount of past undercompensation.    Pacific

Grains, Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968),

affg. T.C. Memo. 1967-7; Estate of Wallace v. Commissioner, supra

at 553-554.

     Petitioner's records show that Eberl's compensation in

fiscal years 1992 and 1993 was not catchup pay.    The minutes for

the annual board meetings authorizing petitioner to pay Eberl's

salary and bonus for fiscal years 1992 and 1993 state that Eberl

was paid "for the current year" and do not indicate that any of

the payment was for prior years.    See Pacific Grains, Inc. v.

Commissioner, supra (corporate president was not underpaid in

part because taxpayer's board did not state that some part of the

payments were for his prior services); H&A Intl. Jewelry, Ltd. v.

Commissioner, T.C. Memo. 1997-467 (pay was not catchup pay where

minutes from shareholder meetings showed that the compensation

for the current year was not intended to reward the employee's

efforts for prior years).
                                 -30-

      Petitioner paid Eberl less than 20 percent of its gross

receipts in fiscal years 1988 to 1991 and more than 20 percent in

fiscal years 1992 and 1993.     Petitioner contends that its

payments to Eberl in fiscal years 1992 and 1993 in excess of 20

percent of its gross receipts were intended to compensate him for

services in petitioner's early years.     We disagree.    We do not

believe that Eberl was underpaid in prior years.     The fact that

Eberl received less than he wanted from fiscal years 1988 to 1991

does not establish that he was underpaid.     Cf. Alpha Medical,

Inc. v. Commissioner, supra (the shareholder had been underpaid

for past services because he had received but rejected an offer

paying more than $1 million annually); Comtec Systems, Inc. v.

Commissioner, T.C. Memo. 1995-4 (corporation's president and vice

president were underpaid for past services where both had

accepted low wages (and the vice president received no pay for 6

years) until the corporation was successful).

      We conclude that none of the 1992 and 1993 compensation in

issue was catchup pay.    This factor favors respondent.

      12.   Whether Employee Guaranteed Taxpayer's Debt

      In deciding whether compensation is reasonable, courts have

considered whether the employee personally guaranteed the

employer's debt.    See R.J. Nicoll Co. v. Commissioner, supra at

51.   Petitioner had no debt.   This factor does not apply here.
                                 -31-

     13.    Conclusion

     Petitioner's increase in gross receipts resulted not only

from the huge volume of catastrophic claims work during the years

in issue, but also from Eberl's long hours, personal contacts,

and his knowledge of the catastrophic claims business.    It would

be reasonable for petitioner to compensate him well for that

work.    However, the problem from petitioner's stand point is that

Eberl chose to leave petitioner with virtually nothing to show

for his work.    Carey testified that it would be reasonable to

expect petitioner to have pretax earnings of about $2 million for

fiscal year 1992 and about $1 million for fiscal year 1993.

Carey acknowledged that if petitioner had retained earnings of $2

million in fiscal year 1992, it would still have had $2,340,0004

to pay Eberl, and that compensation to Eberl of $2,340,000 in

that year might be reasonable.    Carey did not change his

conclusion that it would be unreasonable to pay Eberl more than

$500,000 in fiscal year 1992 and $400,000 in fiscal year 1993,

but neither Carey nor respondent gave any convincing reason why

petitioner should have retained more than $2 million in earnings.

This suggests that reasonable compensation to Eberl for fiscal

year 1992 could be as much as $2,340,000, the difference between

the amount paid to Eberl ($4,340,000) and the amount of retained



     4
       Carey said $2,200,000, not $2,340,000. However, the
record shows that $2,340,000 is the correct amount ($4,340,000 -
$2,000,000 = $2,340,000).
                                -32-

earnings Carey said it would have been reasonable for petitioner

to have ($2 million).   Applying Carey's analysis to fiscal year

1993, reasonable compensation to Eberl could be as much as

$1,080,000 (the difference between the amount petitioner paid

Eberl ($2,080,000) and the amount of retained earnings Carey said

would have been reasonable for petitioner to have ($1 million)).

     Other facts present here support a finding that compensation

to Eberl in excess of those amounts would be unreasonable.   Eberl

set his own compensation, which was not the result of an arm's-

length agreement; petitioner retained a minimal amount of

earnings and distributed almost all of its profits to Eberl at

the end of the year; and petitioner's other employees and

independent adjusters did not receive yearend bonuses.   These

facts suggest that a substantial part of Eberl's compensation was

a disguised dividend and not purely for services.   We conclude

that $2,340,000 for fiscal year 1992 and $1,080,000 for fiscal

year 1993 constituted reasonable compensation to Eberl for those

years.    See Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. at

568 (the Court must decide the amount of reasonable compensation

where the taxpayer proves the Commissioner's determination to be

wrong).
                                -33-

C.   Whether Petitioner Is Liable for the Penalty Under Section
     6662 for Substantial Understatement

     Respondent determined that petitioner is liable for the

accuracy-related penalty for substantial understatement for

fiscal years 1992 and 1993 under section 6662.

     Taxpayers are liable for a penalty equal to 20 percent of

the part of the underpayment attributable to negligence or

substantial understatement of tax.     Sec. 6662(a), (b)(1) and (2).

A substantial understatement of income tax occurs when the amount

of the understatement for a taxable year exceeds the greater of

10 percent of the tax required to be shown on the return or

$10,000 in the case of a corporation.     Sec. 6662(d)(1)(A).   The

accuracy-related penalty does not apply to any part of an

underpayment if the taxpayer shows that there was reasonable

cause and that the taxpayer acted in good faith.     Sec.

6664(c)(1).   Reliance on the advice of a professional, such as an

accountant, may constitute reasonable cause if, under all the

facts and circumstances, that reliance is reasonable and the

taxpayer acted in good faith.   Sec. 1.6664-4(c), Income Tax Regs.

     Respondent contends that petitioner did not have substantial

authority or reasonable cause for deducting the compensation paid

to Eberl because petitioner's tax advisers were not executive

compensation specialists and because they did not advise

petitioner that the amounts it actually paid Eberl were

reasonable compensation.   We disagree.
                                -34-

     Based on his discussions with petitioner's advisers, Eberl

reasonably believed that compensation equal to 20-25 percent of

petitioner's gross receipts would be reasonable.     Lehrner signed

petitioner's tax returns for the years in issue, which suggests

that Eberl believed Lehrner thought Eberl's compensation was

reasonable.    See Bokum v. Commissioner, 94 T.C. 126, 148 (1990)

(accountant's failure to sign the tax return should have put the

taxpayer on notice that he was not backing the advice embodied in

the return).   We hold that petitioner's reliance was reasonable

cause for deducting the compensation it paid to Eberl.5

     To reflect the foregoing and concessions,


                                            Decision will be entered

                                       under Rule 155.




     5
       Also, petitioner is not liable for the substantial
understatement penalty for fiscal year 1992 because it adequately
disclosed the facts relating to Eberl's compensation on its 1992
return. Sec. 6662(d)(2)(B)(ii). Rev. Proc. 92-23, 1992-1 C.B.
737, sec. 4(b)(4), 1992-1 C.B. 738, provides that, for purposes
of reducing the understatement of income tax under sec. 6662(d),
additional disclosure of facts relating to an issue involving
reasonable compensation is unnecessary, if the Form 1120,
Schedule E, Compensation of Officers, has been properly
completed. Petitioner included a properly completed Schedule E
concerning Eberl's compensation in its 1992 return.
