                        T.C. Memo. 1996-563




                      UNITED STATES TAX COURT



              SUMMIT SHEET METAL CO., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20131-93.              Filed December 30, 1996.




     Elliott H. Kajan and Steven R. Mather, for petitioner.

     Lisa W. Kuo and T. Elizabeth Stetson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined a deficiency in

petitioner's Federal income tax of $307,671 for 1987.

     Petitioner is an S corporation.   An S corporation is liable

for tax on net recognized built-in gain if that gain exceeds 50

percent of its taxable income for the year in issue.    Sec.
                                - 2 -


1374(a).1   Respondent determined that petitioner is liable for

tax under section 1374(a).

     Petitioner realized capital gains of $929,915 in the year in

issue.    That amount is $12,762 more than 50 percent of the amount

of petitioner's revised taxable income for the year in issue.

Petitioner seeks to increase its taxable income so that its

capital gains are less than 50 percent of its taxable income.

Thus, petitioner has adopted positions which, if successful,

would increase its taxable income.      Petitioner contends (1) that

it paid unreasonable compensation to its officers during the year

at issue, and (2) that it improperly deducted bonuses it paid to

its officers in the year at issue (when petitioner declared the

bonuses) instead of the following year (when petitioner paid the

bonuses).

     We must decide the following issues:

     1.     Whether reasonable compensation for petitioner's

officers for the year in issue is $618,295 as respondent contends

and as petitioner reported on its return, $421,938 as petitioner

contends, or some other amount.    We hold that $618,295 is

reasonable.

     2.     Whether, as respondent contends, petitioner must have

respondent's consent to delay deductions for bonuses from the

     1
      Section references are to the Internal Revenue Code in
effect for the year in issue. Rule references are to the Tax
Court Rules of Practice and Procedure.
                                - 3 -


year petitioner declared the bonuses to the following year when

the bonuses were paid because it is a change in accounting method

under section 446(e).   We hold that it must.

     3.   Whether petitioner's net recognized built-in gain was

more than 50 percent of its taxable income in the year in issue.

We hold that it was.

                          FINDINGS OF FACT

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

A.   Petitioner

     Petitioner is a California corporation which was

incorporated on August 30, 1960.   Its principal place of business

was in Orange County, California, when it filed the petition in

this case.

     Petitioner manufactured and installed flashing, vents,

pipes, and light-gauge sheet metal for housing projects in

southern California.    Ninety percent of petitioner's business was

sheet metal installation, and 10 percent was sheet metal

fabrication.   There were 8 to 10 other companies in Orange County

also doing that work.   Petitioner served a large part of southern

California, including the counties of San Diego, Orange, Los

Angeles, and Riverside.

     Petitioner's fiscal years ended on June 30 in 1964, 1966 to

1975, 1977, 1978, 1980 to 1982, 1984, and 1985.   In 1986,

petitioner changed the end of its fiscal year from June 30 to
                                - 4 -


September 30.    Petitioner's fiscal year ended on September 30 in

1986 and 1987.   In 1987, petitioner changed its fiscal year to

end on December 31.

     Petitioner had an initial capital investment of $65,579 in

1960 and had total assets of $4,183,222 on September 30, 1987.

Petitioner made a profit every year from 1960 to the year in

issue.   Petitioner had more jobs under contract in the year in

issue than in previous years.   The number of petitioner's

employees increased greatly from 1984 to 1990.

     Petitioner's financial situation in fiscal years 1986 and

1987 was as follows:

                                            FY 1986      FY 1987
     Total sales                          $6,666,643   $8,621,838
     Gross profit                          2,746,670    3,560,057
     Ordinary income
          before taxes                       803,997      893,236
     Beginning total assets                3,407,735    3,761,574
     Ending total assets                   3,761,574    4,183,222
     Beginning total equity                1,822,375    2,020,646
     Ending total equity                   2,020,646    3,391,012
     Beginning total capital stock
          and paid-in stock or surplus
          less paid treasury stock            50,446         50,446
     Ending total capital stock
          and paid-in stock or surplus
          less cost of treasury stock         50,446         50,446
     Beginning accumulated
          adjustments account                636,158      824,587
     Ending accumulated
          adjustments account                824,587    2,190,307
     Beginning retained earnings           1,135,771    1,135,771
     Ending retained earnings              1,135,771    1,135,591

     Petitioner's success in the year in issue resulted in part

from an increase in housing construction in southern California.
                                 - 5 -


     Petitioner has used the accrual method of accounting since

1964.     Petitioner paid administrative salaries of $192,079 and

cost of labor of $2,901,375 during the year in issue.

B.   Petitioner's Shareholders and Officers

     1.     Milton J. Chasin

     Milton J. Chasin has a bachelor of science degree in

accounting.     He was licensed as a public accountant in 1948 or

1949.     He was employed as an auditor with the California State

Board of Equalization in the late 1940's.

     Chasin cofounded petitioner in 1960 with Morley Weis (not

otherwise described in the record) and Donald Hanson.       Gale

Searing became a one-third shareholder of petitioner in 1964

after Weis died.     Chasin was responsible for the administration

of petitioner.     He established and was responsible for

petitioner's books and records.     He kept accurate records for

petitioner from 1960 through the year in issue.     He negotiated

loans and bought material and equipment for petitioner.       He

negotiated a line of credit for petitioner with Metropolitan Bank

in the year in issue.     Chasin always had an assistant to help him

with the administrative duties.
                               - 6 -


     Chasin worked about 35 hours per week and took about 5 weeks

of vacation in the year in issue.

     2.   Donald Hanson

     Hanson graduated from high school.     He has no professional

licenses.   He has owned one-third of petitioner since 1960.    He

was petitioner's president in the year in issue.

     Hanson was more directly involved with petitioner's

operations in petitioner's early years than he was during the

year in issue.   His duties in the early years included

fabricating in the shop, installing, and bidding.

     During the year in issue, Hanson was responsible for

estimating jobs, running the production shop, overseeing union

contracts, and supervising petitioner's union employees.     His

primary duty was to get jobs for petitioner.     He was the person

primarily responsible for doing this.     He reviewed the contracts

in which petitioner agreed to provide materials and perform

services.   Petitioner's shop foreman and two estimators reported

to him.   Petitioner had no union problems during the year in

issue.

     Hanson worked for petitioner about 8 hours per day, 50 weeks

per year during the year in issue.     He also worked for Summit

Supply Co., which was owned by Chasin, Hanson, and Searing.     He

took 4 to 5 weeks of vacation each year.
                                 - 7 -


     3.   Gale Searing

     Searing did not have a high school education.    He was a

sheet metal apprentice for 3½ years in the early 1950's, after

which he received a journeyman's card.    He did not have a

professional license.    He was petitioner's field superintendent

during the year in issue.

     In the year in issue, Searing was responsible for

petitioner's metal work installation.    He supervised installers’

supervisors and coordinated installation of petitioner's product.

He was responsible for petitioner's laborers.

     Searing, Chasin, and Hanson knew each other's duties but did

not know how to perform them.    Searing worked 8 hours per day, 50

weeks per year for petitioner and took about 10 days of vacation

during the year in issue.   He also worked for North County

Builders and Summit Supply Co.    Searing received cash

distributions, but not wages, from Summit Supply Co.

     4.    Petitioner's Board of Directors and Officers

     Chasin, Hanson, and Searing were the only members of

petitioner's board of directors from 1964 to the year in issue.

They have each owned one-third of petitioner's stock since 1964.

During the year in issue, Hanson was president, Chasin was vice

president and chief financial officer, and Searing was secretary.

Chasin, Hanson, and Searing consulted with each other before
                               - 8 -


making important decisions for petitioner.   Chasin, Hanson, and

Searing never had a written employment contract with petitioner.

During the year in issue, petitioner paid salaries of $108,575 to

Chasin, $131,360 to Hanson, and $131,360 to Searing.    Petitioner

had a retirement plan for its nonunion employees including

Chasin, Hanson, and Searing.   Petitioner contributed $30,000 to

its retirement plan in the year in issue for each of its three

shareholders.

     Each of the three shareholders had authority to sign

petitioner's checks during the year in issue without having them

cosigned by another shareholder.   Chasin, Hanson, and Searing

reported their income and expenses on a calendar year basis and

used the cash method of accounting.

     Petitioner had a $50,000 group term life insurance policy

for each shareholder.

     5.   Summit Supply Co. and North County Builders

     Chasin, Hanson, and Searing were equal partners of Summit

Supply Co., a California general partnership, in 1986 and 1987.

Summit Supply Co. bought, developed, and sold real estate.

Summit Supply Co. did not pay Chasin, Hanson, or Searing for

their services to Summit Supply Co., which consisted of helping

to buy, develop, and sell real estate.   Chasin, Hanson, and
                                - 9 -


Searing each received equal amounts of the net profits from

Summit Supply Co.

     Chasin, Hanson, and Searing owned North County Builders with

Sherman and Harris (neither of whom is otherwise described in the

record).   North County Builders was developing an apartment house

project in the year in issue.

C.   Bonuses Paid to Chasin, Hanson, and Searing

     1.    Petitioner's Bonus Payment Procedures

     Petitioner authorized bonuses each year for its officers for

their services.   Petitioner's board of directors (Chasin, Hanson

and Searing) authorized the bonuses to be paid when petitioner's

cash position reasonably permitted, but not later than September

15 of each taxable year from 1966 to 1986 except 1971 and 1972.

In taxable years 1971 and 1972, petitioner's board of directors

authorized an approximate amount for a combined salary and bonus

for each officer.

     Chasin, Hanson, and Searing met each year to consider

factors such as petitioner's success, development, profits,

needs, and tax considerations and their own tax considerations in

deciding the amount of the bonuses.     Chasin, Hanson, and Searing

agreed unanimously on the amounts of their bonuses each year,

including the year in issue.    Each year, Chasin, Hanson, and
                             - 10 -


Searing signed a corporate resolution stating what they decided

about their bonuses.

     2.   Timing of Petitioner's Bonus Payments

     Petitioner paid the bonuses after the end of each of its

fiscal years before the year in issue, but not later than

September 15 of each year, except the year in issue.   For those

years, the resolution authorizing the bonuses said:

     NOW, THEREFORE, BE IT RESOLVED, that a bonus of
     [amount for each year for each officer] * * * to each
     of the * * * [officers] be and the same hereby is
     granted and awarded, the same to be paid to said
     persons as soon hereafter as the cash position of the
     corporation reasonably permits, but in any event on or
     before September 15, * * * [year bonuses are
     authorized].

     Petitioner paid the bonuses after the end of its fiscal

years ending on September 30 in 1986 and 1987 and before December

15 of those years.

     Chasin, Hanson and Searing unanimously approved the

following resolution on September 16, 1987:

          WHEREAS, the success and development of the
          business of this corporation during the fiscal
          year to end September 30, 1987 is largely the
          result of the efforts of certain of the key
          personnel of this corporation; and

          WHEREAS, it is deemed to be to the best interests
          of this corporation to provide for a special
          reward for the efforts of said key personnel in
          order that said key personnel be furnished with a
          continuing incentive; and
                             - 11 -


          WHEREAS, DONALD HANSON, President of this
          corporation, MILTON J. CHASIN, Vice President of
          this corporation, GALE SEARING, Secretary of this
          corporation, have each contributed in a special
          degree to the success of this corporation; and

          WHEREAS, PAUL HARDIE, Estimator, HERMAN AUSLANDER,
          Field Superintendent, TOM KRAEMER, Assistant Field
          Superintendent, GEORGE KARSTEN, Shop
          Superintendent, BILL BUSHEY, Estimator, and LINDA
          SANDS, Bookkeeper, are also worthy of special
          recognition;

          NOW, THEREFORE, BE IT RESOLVED, that the following
          bonuses be paid by the corporation on or before
          December 15, 1987:

              Employee                     Amount of Bonus
          Herman Auslander                     $46,000
          Bill Bushey                          $ 7,200
          Paul Hardie                          $47,000
          George Karsten                       $46,000
          Tom Kraemer                          $25,000
          Linda Sands                          $ 6,000

              Officer                      Amount of Bonus
          Milton J. Chasin                     $75,000
          Donald Hanson                        $75,000
          Gale Searing                         $97,000

     The resolution for the year in issue required petitioner to

pay the bonuses by December 15, 1987.   Chasin, Hanson, and

Searing could not have been paid the bonuses in the year in issue

without the consent of all of them.

     3.   Payment of the Bonuses in 1987

     On September 30, 1987, pursuant to the board's resolution,

petitioner debited its payroll expense--officers account by

$247,000 for bonuses it declared that year.   Chasin recorded
                                - 12 -


petitioner’s accrued liability for wages in a document entitled,

"Summit Sheet Metal Company, Inc. Accrued Wages”.    Chasin entered

each officer's bonus on that document on September 30, 1987.

     Petitioner paid the bonuses on December 15, 1987, by paying

Federal and State payroll taxes for its officers in the following

amounts:   $75,000 for Chasin, $75,000 for Hanson, and $97,000 for

Searing.

     4.    Summary of Petitioner's Practices Relating to Bonuses
           It Paid to Its Officers

     Petitioner declared bonuses for its three officers near the

end of each of its fiscal years from 1966 to the year in issue

and paid the bonuses in the first 75 days following the end of

the fiscal year in which they were declared.    Petitioner accrued

the deduction for the bonuses in the year the bonuses were

declared in its fiscal years from 1966 through 1987.2

D.   Building Sale

     Petitioner sold a building on May 1, 1985, and realized a

net capital gain of $1,160,069.    Petitioner reported the gain

under the installment method.    Petitioner received the final




     2
      This fact is established for 1984 to 1987 by petitioner's
tax returns; for 1966 to 1983 we infer that petitioner's practice
was the same because petitioner's practice of declaring and
paying bonuses was consistent from 1966 to 1987, and because
neither party contends otherwise.
                               - 13 -


payment of $1.2 million in the year in issue.   Of that amount,

$929,915 was taxable.




E.   Petitioner's S Corporation Election and Income Tax Returns

     Petitioner was a subchapter C corporation from August 30,

1960, to June 30, 1985.   On July 1, 1985, petitioner elected to

be taxed under subchapter S.

     Petitioner deducted $247,000 for bonuses it paid to its

officers as part of the compensation of $618,295 it paid to the

officers (not counting fringe benefits) for the year in issue.

     Petitioner reported the following on a Schedule K attached

to its S corporation return for the year in issue:

          Ordinary income                 $893,236
          Income from rental real
               estate activity              38,033
          Long term capital gain           929,915
          Charitable contributions          (2,845)
               Total                    $1,858,339

     Petitioner did not include the $929,915 gain on its tax

return for 1987.   However, petitioner reported each officer's

share on his respective Schedule K-1.   Petitioner allocated the

gain to Chasin, Hanson, and Searing, each of whom reported one-

third of the gain on his individual income tax return for 1987.

     Petitioner seeks to delay the year of its deduction of

bonuses for its officers from the year in issue to the following
                                - 14 -


year.     Petitioner did not ask respondent for permission to change

its method of accounting for the year in issue.

         Petitioner overstated its ending inventory on its return

for 1987 by $24,033.

                                OPINION

A.   Background

     Petitioner realized a $1,160,069 net capital gain from the

sale of a building in May 1985.     At that time, petitioner was a C

corporation.     Petitioner reported the gain on the installment

method, thereby postponing recognition of $929,915 of the gain

until 1987 when it was to receive the last installment.     Sec.

453(c).

     On July 1, 1985, petitioner elected to be taxed as an S

corporation.     At that time, petitioner had a realized but

unrecognized capital gain of $929,915 from the sale.     That amount

is $12,762 more than 50 percent of the amount of petitioner's

revised taxable income for the year in issue (before deciding the

issues in dispute here).3    An S corporation must pay tax if its

net recognized built-in gain is more than 50 percent of its

taxable income.     Sec. 1374(a).




     3
      This takes into account petitioner's inadvertent $24,033
understatement of its ending inventory.
                                - 15 -


     Respondent determined a deficiency in petitioner's income

tax of $307,671 for 1987.    Respondent’s determination is presumed

to be correct, and petitioner bears the burden of proving

otherwise.    Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933).

B.   Whether Petitioner Paid Unreasonable Compensation to its
     Officers in the Year in Issue

     Petitioner contends that it deducted an unreasonable amount

for officers’ compensation for the year in issue.     Petitioner

contends that a total of no more than $421,938 is reasonable

compensation for its three officers.     Respondent contends that

the compensation petitioner paid and deducted ($618,295) was

reasonable.

     1.      Whether All of the Compensation Was Paid for Services
             Provided to Petitioner

     A corporation may deduct "a reasonable allowance for

salaries or other compensation for personal services actually

rendered".    Sec. 162(a)(1).   Reasonable compensation must be

purely for services provided to the company which provides the

compensation.     Elliotts, Inc. v. Commissioner, 716 F.2d 1241,

1243 (9th Cir. 1983), revg. and remanding T.C. Memo. 1980-282;

sec. 1.162-7(a), Income Tax Regs.

     Petitioner contends that Searing and Hanson spent a

substantial amount of time in the years in issue working for
                               - 16 -


North County Builders, which were businesses other than

petitioner.   Hanson testified that he worked about 25 hours a

week for petitioner.   Searing testified that he worked for

petitioner from 2 to 10 hours a week.    Respondent contends that

petitioner paid its officers exclusively for services performed

for petitioner.

     We agree with respondent.    Petitioner's interrogatory

answers conflict with Hanson's and Searing's testimony.    In

supplemental interrogatory response for petitioner, Chasin stated

that Searing and Hanson "rendered services for petitioner based

upon an 8-hour day for 50 weeks per year."    The supplemental

response suggests that the officers provided substantial services

for petitioner.   Chasin testified that the supplemental response

included services for business ventures other than petitioner.

Chasin's explanation is contrary to the language in the

supplemental response, which states that the services were for

petitioner.

     North County Builders had five owners, including

petitioner's three officers.     It is implausible that petitioner

would pay salaries that North County Builders owed.

     Petitioner's board of directors adopted written resolutions

which stated that petitioner declared the bonuses because its

officers contributed substantial services to petitioner.
                              - 17 -


Petitioner contends that this language from its resolutions means

nothing because it used the identical language for many years as

boilerplate.   We do not believe that the board of directors took

the decisions to pay the bonuses and the resolutions approving

them as lightly as petitioner suggests.

     We conclude that petitioner paid the compensation at issue

for services performed by its officers for petitioner.

     2.   Whether the Compensation Was Reasonable in Amount

     Whether the amount of compensation is reasonable is a

question of fact.   Botany Worsted Mills v. United States, 278

U.S. 282, 289-290 (1929); Estate of Wallace v. Commissioner, 95

T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992).

Factors to consider in deciding whether compensation is

reasonable include (a) the employee's qualifications; (b) the

nature, extent, and scope of the employee's work; (c) the size

and complexity of the business; (d) a comparison of salaries paid

with sales, net income, gross income, and capital value; (e)

general economic conditions; (f) the taxpayer's salary policy to

all employees; (g) the taxpayer's financial condition; (h)

prevailing rates of compensation for comparable positions in

comparable companies; (i) compensation paid in prior years; and

(j) whether the employee and the taxpayer dealt at arm's length.

Elliotts, Inc. v. Commissioner, supra at 1245-1248; Kennedy v.
                               - 18 -


Commissioner, 671 F.2d 167, 173-174 (6th Cir. 1982), revg. and

remanding 72 T.C. 793 (1979); Mayson Manufacturing Co. v.

Commissioner, 178 F.2d 115, 119 (6th Cir. 1949); R.J. Nicoll Co.

v. Commissioner, 59 T.C. 37, 48 (1972).      No single factor

controls.    Mayson Manufacturing Co. v. Commissioner, supra.

     Petitioner called an expert, Edwin A. Scott, Jr. (Scott), to

testify about the reasonable compensation issue.     Respondent did

not call an expert to testify.   Expert witnesses' opinions may

help the Court understand an area requiring specialized training,

knowledge, or judgment.    Snyder v. Commissioner, 93 T.C. 529, 534

(1989).   We may be selective in deciding what part of an expert's

opinion we will accept.    Helvering v. National Grocery Co., 304

U.S. 282, 295 (1938); Silverman v. Commissioner, 538 F.2d 927,

933 (2d Cir. 1976), affg. T.C. Memo. 1974-285; Parker v.

Commissioner, 86 T.C. 547, 561-562 (1986).

            a.   Employees' Qualifications

     An employee's superior qualifications for a position may

justify high compensation.   See, e.g., Home Interiors & Gifts,

Inc. v. Commissioner, 73 T.C. 1142, 1158 (1980); Dave Fischbein

Manufacturing Co. v. Commissioner, 59 T.C. 338, 352-353 (1972).

     Each of petitioner's officers was well qualified for his

position.    All three officers performed successfully for

petitioner.
                              - 19 -


     Petitioner contends that a suitable replacement could

perform the job of each officer.   Petitioner’s point does not

establish much because it does not address how difficult it would

be or what amount of pay would have been required to find someone

suitable.

     This factor tends to show that the compensation at issue was

reasonable.

            b.   Nature, Extent, and Scope of Duties

     The position held by the employee, hours worked, and duties

performed may justify high compensation.    Mayson Manufacturing

Co. v. Commissioner, supra; see, e.g., Elliotts, Inc. v.

Commissioner, supra at 1245-1246; 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); Home Interiors &

Gifts, Inc. v. Commissioner, supra at 1158.

     Petitioner contends that its officers had minimal

responsibilities.   We disagree.   Each officer was responsible for

an important part of petitioner's operations.    Petitioner's

officers did not know how to perform each other's jobs.    This

made each of them less valuable to petitioner.    By the year in

issue, petitioner was a well-established and stable business.

Petitioner's officers were no doubt required to work less than if

petitioner had been a new business.
                               - 20 -


     On balance, this factor tends slightly to show that the

compensation at issue was reasonable.

          c.     Size and Complexity of Taxpayer

     The size and complexity of a taxpayer's business can

indicate whether compensation is reasonable.     Elliotts, Inc. v.

Commissioner, 716 F.2d at 1246; Pepsi-Cola Bottling Co. v.

Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), affg. 61 T.C.

564 (1974); Mayson Manufacturing Co. v. Commissioner, supra.

Petitioner's witnesses testified that petitioner's business was

straightforward and routine.    However, petitioner had sales in

the year in issue of more than $8.6 million.    It had assets of

$3.8 million at the start of the year in issue and $4.2 million

at the end.    Petitioner served a large part of Southern

California, including the counties of San Diego, Orange, Los

Angeles, and Riverside.

     Considering both the testimony and the other evidence of

petitioner's business, we conclude that this factor tends to show

that the compensation at issue was reasonable.

          d.     Comparison of Salaries Paid With Sales, Net
                 Income, Gross Income, and Capital Value

     Courts have compared compensation to sales and gross and net

income in deciding whether compensation is reasonable.      Elliotts,

Inc. v. Commissioner, supra at 1246; Mayson Manufacturing Co. v.

Commissioner, supra.
                                - 21 -


     Petitioner's compensation of officers was 7.2 percent of

sales.     In Mayson Manufacturing Co., the Court found compensation

that was more than 25 percent of sales to be reasonable.     Mayson

Manufacturing Co. v. Commissioner, supra at 120.     Petitioner's

officers' compensation was 41 percent of petitioner's ordinary

income before taxes and deduction of officers' compensation.     We

have found that compensation equal to 43 percent of gross profit

is reasonable for a company comparable in size to petitioner.

L & B Pipe & Supply Co. v. Commissioner, T.C. Memo. 1994-187.

         This factor tends to show that the compensation at issue

was reasonable.

             e.   General Economic Conditions

     General economic conditions may affect a company's

performance and, thus, show the extent, if any, of an employee's

effect on the company.     Elliotts, Inc. v. Commissioner, supra;

Mayson Manufacturing Co. v. Commissioner, supra.

     Petitioner's sales increased more than 70 percent in the 2

years before the year in issue.     Petitioner's officers testified

that petitioner succeeded because there was an economic boom in

Southern California before and during the year in issue.

Respondent did not effectively challenge their testimony on this

point.     This factor tends to show that the compensation at issue

was unreasonable.
                             - 22 -


          f.   Taxpayer's Salary Policy to All Employees

     Courts have considered the taxpayer's salary policy for its

other employees in deciding whether compensation is reasonable.

Home Interiors & Gifts, Inc. v. Commissioner, supra at 1159.

There is no evidence that petitioner has a formal policy for

setting salaries for its officers or other employees.   Because

the record is not clear on this point, we do not apply this

factor.

          g.   Taxpayer's Financial Condition

     The past and present financial condition of the company is

relevant to deciding whether compensation is reasonable.    Id. at

1157-1158.

     Petitioner grew from total equity (capital stock and paid-in

surplus) of $65,579 to $2,020,646 for the year in issue.

Petitioner always made a profit.   For the year in issue,

petitioner's gross profit was 41 percent of gross income, return

on sales was 10.3 percent, return on assets was 22.5 percent, and

return on equity was 33 percent.   Petitioner's officers'

compensation decreased 16.3 percent as a percentage of net sales

from the year before the year in issue to the year in issue while

its sales and gross profit increased nearly 30 percent.

     Petitioner points out that a survey by the Sheet Metal and

Air-Conditioning Contractors' National Association (SMACNA) dated
                              - 23 -


October 26, 1988, shows that petitioner's compensation of its

officers exceeds the average amount paid by similar firms.

However, this does not establish that the compensation of

petitioner's officers was unreasonable because the SMACNA survey

also shows petitioner performed considerably better financially

than the SMACNA survey respondents.

     SMACNA sent each member a questionnaire asking for financial

information, such as gross profit, gross sales, and executive

compensation.   Forty-one SMACNA survey respondents had sales of

more than $8.2 million.   The following chart compares the SMACNA

survey results for these respondents with data for petitioner for

the year in issue.

                      SMACNA survey respondents
                     with sales over $8.2 Million

        Net income                     SMACNA
     before tax as a --                average      Petitioner

     Percent of sales                    3.5           10.3
     Percent of assets                   9.3           22.5
     Percent of net worth               25.0           33.0

     The 41 respondents had an average gross profit margin of

18.8 percent of sales; petitioner had 41 percent in the year in

issue.   Petitioner's financial performance was superior to that

of SMACNA survey respondents which had sales exceeding $8.2

million.
                                - 24 -


     This factor tends to show that the compensation at issue was

reasonable.

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

     In deciding whether compensation is reasonable, we compare

it to compensation paid for comparable positions in comparable

companies.     Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th

Cir. 1983); Mayson Manufacturing Co. v. Commissioner, 178 F.2d

115 (6th Cir. 1949).    Scott points out that petitioner's officers

were paid more than the average paid to officers of companies

that responded to the SMACNA and Contractor magazine surveys.

While both surveys have flaws for our purposes, respondent

offered no evidence on salary comparability.    We conclude that

this factor tends to show that the compensation was unreasonable.

          i.      Compensation Paid in Prior Years

     An employer may deduct compensation paid in a year even

though the employee performed the services in a prior year.

Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); R.J.

Nicoll Co. v. Commissioner, 59 T.C. at 50-51.

     Petitioner's officers testified that petitioner may have

underpaid them in the early years, but that petitioner caught up

at least 10 years before the years in issue.    Respondent points

out that petitioner offered no documentary evidence on this

factor; however, respondent offered no evidence that contradicts
                                - 25 -


the testimony of petitioner's officers.    Their testimony was

credible on this point.    We conclude that none of the

compensation in the year at issue was paid for services performed

in prior years.    This factor tends to show that the compensation

was unreasonable.

          j.      Whether the Employee and Employer Dealt at Arm's
                  Length

      We closely scrutinize compensation if the employee controls

the employer to see whether it is unreasonable in amount or

payment for something other than the employee's services.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1322-

1324 (5th Cir. 1987), affg. T.C. Memo. 1985-267; Elliotts, Inc.

v. Commissioner, supra at 1246; Charles Schneider & Co. v.

Commissioner, 500 F.2d 148, 152-154 (8th Cir. 1974), affg. T.C.

Memo. 1973-130.

     Chasin, Hanson, and Searing owned 100 percent of

petitioner's stock.    That leads us to consider whether an

independent investor would have approved the compensation in view

of the nature and quality of the services performed and the

effect of those services on the investor's return on his or her

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

1326-1327; Elliotts, Inc. v. Commissioner, supra at 1246-1247.

An independent investor would have received a 33-percent return

on equity.     We believe that an independent investor would approve
                               - 26 -


petitioner's officers' compensation because of the officers'

successful leadership of petitioner.

     This factor tends to show that the compensation at issue for

services to petitioner was reasonable.

     3.   Conclusion

     We conclude that the compensation of petitioner's officers

in the year in issue was reasonable because of their

qualifications and the scope of their duties, petitioner's size,

growth, and financial success, the officers' compensation in

relation to petitioner's sales, and the fact that, according to

the SMACNA survey, the taxpayer performed well compared to other

reasonably comparable firms.

C.   Whether Petitioner May Change the Year It Deducts Bonuses
     Without Respondent's Consent

     1.   Contentions of the Parties

     Petitioner seeks to change the year it deducts its officers'

bonuses from the year it authorized them, as petitioner reported

on its return, to the following taxable year, in which the

officers received and reported the bonuses.

     Respondent contends that petitioner needed but did not have

respondent's permission to change the year it deducted its

officers' bonuses.4    Sec. 446(e).


     4
      Petitioner contends that respondent’s contention that
                                                   (continued...)
                              - 27 -


     Petitioner contends that changing the year it deducts its

officers' bonuses is not a change of accounting method, and that

it is a correction required to comply with section 267(a).

Section 267(a)(2), which was enacted in 1984, bars a taxpayer

from deducting a payment to a related taxpayer before the related

taxpayer includes the payment in income.   Petitioner contends

that its accrual of a deduction for the bonuses in the year they

are awarded (before they are paid) violates section 267(a)(2)

because petitioner's officers included the bonuses in income in a

later year.   Petitioner contends that it does not need

respondent's consent to change to comply with section 267(a)(2).


     4
      (...continued)
petitioner must have consent under sec. 446(e) is new matter on
which respondent bears the burden of proof. We agree.
Respondent first raised this issue in the amended answer. A new
theory that is presented to sustain a deficiency is treated as a
new matter when it either increases the original deficiency or
requires the taxpayer to present different evidence. Wayne Bolt
& Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989); Achiro v.
Commissioner, 77 T.C. 881, 890-891 (1981). This issue is a new
matter because the evidence relevant to it differs from that
relevant to the original determination. Respondent bears the
burden of proof for any new matter. Rule 142(a).
     Petitioner contends that respondent failed to carry the
burden of proof. We disagree. The parties do not dispute that
petitioner had a longstanding practice of deducting the bonuses
in the year it authorized them and paying them in the following
year, that petitioner seeks to change the year it deducts the
bonuses for its officers from the year in issue to the next
taxable year to comply with sec. 267(a) several years after the
law changed, and that petitioner does not have respondent's
consent to do so. We decide this issue based on those facts.
Thus, the burden of proof does not affect our decision on this
issue.
                             - 28 -


Similarly, petitioner contends that it does not need respondent's

consent to change from treating the bonuses incorrectly to

treating them correctly.5

     Respondent does not dispute that Chasin, Hanson, and Searing

are related for purposes of section 267(a).   However, even if

section 267(a) applies, we conclude for reasons discussed next

that petitioner would need respondent's consent to change the

year it deducts the officers' bonuses.

     2.   Whether Changing the Year Petitioner Deducts Bonuses Is
          a Change of a Material Item for Purposes of Section
          446(e)

     We first decide whether changing the year petitioner deducts

its officers' bonuses is a change in the treatment of a material

item for purposes of section 446(e).

     A taxpayer generally must have the consent of the Secretary

to change the method of accounting it uses for material items.

Sec. 446(e); Pacific Enters. & Subs. v. Commissioner, 101 T.C. 1,

18 (1993); Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 509

(1989); Standard Oil Co. v. Commissioner, 77 T.C. 349, 380

(1981); secs. 1.446-1(e)(2)(ii)(a), 1.481-1(a)(1), Income Tax


     5
      Respondent alternatively contends that petitioner complied
with sec. 267(a)(2) because petitioner's officers constructively
received their bonuses in the year in issue. We need not decide
this issue because we conclude that sec. 267(a) does not apply,
and if it did, petitioner requires respondent's consent to change
the year it deducts its officers' bonuses.
                                - 29 -


Regs.     An item is material for purposes of section 446(e) if the

time for including it in income or deducting it is at issue.

Knight-Ridder Newspapers v. United States, 743 F.2d 781, 798

(11th Cir. 1984); Wayne Bolt & Nut Co. v. Commissioner, supra at

510; sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.

        Petitioner's officers' bonuses are material items for

purposes of section 446(e) because petitioner seeks to change the

year it deducts the bonuses from the year it declared them to the

following year.     Wayne Bolt & Nut Co. v. Commissioner, supra at

509-510; H.F. Campbell Co. v. Commissioner, 53 T.C. 439, 447

(1969), affd. 443 F.2d 965 (6th Cir. 1971); Fruehauf Trailer Co.

v. Commissioner, 42 T.C. 83, 103 (1964), affd. 356 F.2d 975 (6th

Cir. 1966); sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.

        3.   Whether Petitioner May Change Its Accounting Method
             Without Respondent's Consent Based on a Change in Law

        Before raising the section 267(a)(2) issue here, petitioner

had consistently deducted its officers' bonuses in the year it

authorized them.     A change in the consistent treatment of a

material item generally requires the Commissioner's consent under

section 446(e).     Witte v. Commissioner, 513 F.2d 391, 393-394

(D.C. Cir. 1975), revg. T.C. Memo. 1972-232; H.F. Campbell Co. v.

Commissioner, supra; Fruehauf Trailer Co. v. Commissioner, supra.

     Petitioner contends that an accounting change made to comply

with section 267(a)(2) does not require respondent's consent.
                               - 30 -


Petitioner relies on Douthit v. United States, 299 F. Supp. 397

(W.D. Tenn. 1969), revd. on other grounds 432 F.2d 83 (6th Cir.

1970).    On May 13, 1960, Congress enacted the Dealer Reserve

Adjustment Act of 1960, Pub. L. 86-459, 74 Stat. 124.      That act

required the taxpayers in Douthit to change their method of

accounting.    The taxpayers in Douthit sought to comply with the

new law on their tax return for 1961.

       The court in Douthit said:   "Section 446(e) requiring

consent of the Commissioner is not applicable to a change in

accounting required by law."    Douthit v. United States, supra at

403.    In Douthit, the taxpayers changed their treatment of an

item in the tax return they filed for the first year in which the

law was effective.    Id. at 400.   In the instant case, the change

in law on which petitioner relies occurred in 1984 and was

effective for taxable years beginning after December 31, 1983.

Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 174(a)(1) and

(b)(2)(A), 98 Stat. 494, 704, 708.      Petitioner first cited

section 267(a) in this case in 1994 after the audit of its 1987

return and while this case was pending.      Petitioner does not

contend that it raised this issue with respondent before that

time.    The rationale for allowing a taxpayer to change an

accounting method immediately after the law is changed, e.g., to

simplify prompt compliance by a large number of taxpayers, is
                              - 31 -


missing when a taxpayer does not act for several years, and acts

only after being audited and commencing a Tax court case for the

year at issue.   Douthit is not controlling authority for

petitioner.

     In United States v. Kleifgen, 557 F.2d 1293, 1297 n.9 (9th

Cir. 1977), a case decided by the U.S. Court of Appeals for the

Ninth Circuit, the court to which this case is appealable, the

court said:

          The Commissioner’s consent to a change in
     accounting methods is required regardless of whether
     the change is from one proper method to another proper
     method or from an improper method to a proper one.
     Witte v. Commissioner, * * * 513 F.2d 391 (1975). See
     Treas Reg. §1.446-1(e)(2).

     In   Southern Pac. Transp. Co. v. Commissioner, 75 T.C. 497,

682 (1980), supplemented by 82 T.C. 122 (1984), we said:

          In addition, consent is required when a taxpayer,
     in a court proceeding, retroactively attempts to alter
     the manner in which he accounted for an item on his tax
     return. If the alteration constitutes a change in the
     taxpayer's method of accounting, the taxpayer cannot
     prevail if consent for the change has not been secured.
     [Citations omitted.6]



     6
      In dicta, the Court in Southern Pac. Transp. Co. v.
Commissioner, 75 T.C. 497, 685 (1980), said that it was not a
case in which the taxpayer was changing from an incorrect to a
correct method, but that if it were, it might be inclined, under
some decisions of this Court, to not require the Commissioner's
consent. We need not consider those dicta further in light of
the position of the U.S. Court of Appeals for the Ninth Circuit
in United States v. Kleifgen, 557 F.2d 1293, 1297 n.9 (9th Cir.
1977).
                                - 32 -


      Petitioner points out that a taxpayer may recharacterize

interest or salary as dividends without being considered to have

changed its method of accounting.    Section 1.446-1(e)(2)(ii)(b),

Income Tax Regs., does not apply here because the issue here is

the timing, not the character, of the deduction.

      Petitioner relies on Evans v. Commissioner, T.C. Memo. 1988-

228, and Gimbel Bros., Inc. v. United States, 210 Ct. Cl. 17, 535

F.2d 14, 23 (1976).    Both cases held that the taxpayer may

correct the treatment of an item without the Commissioner's

consent.   Unlike those in the instant case, the taxpayers and the

corporation in Evans made the correction on their returns for the

year in issue.

      In Gimbel Bros., Inc. v. United States, supra, the taxpayer

elected to use the installment method of accounting to report

income from installment sales but applied it erroneously.      Id. at

15.   The taxpayer filed amended returns to correct the error

apparently before the Commissioner audited the year in issue.

Unlike the taxpayers in Evans and Gimbel Bros., petitioner did

not seek to change how it treats the bonuses on a tax return or

an amended return.    Rather, petitioner did so as part of this

case after respondent's audit.

      Petitioner has cited other cases relating to a taxpayer's

change in accounting methods.    We have considered all of those
                              - 33 -


cases; the cases discussed above are those that most closely

resemble the instant case.

D.   Conclusion

     We hold that petitioner must have respondent's consent under

section 446(e) to change the year it reports payment of the

bonuses.   Petitioner does not have respondent's consent.   Thus,

petitioner may deduct its officers' bonuses only in the year in

issue as it reported on its return.

     For the foregoing reasons, we conclude that petitioner is

liable for the tax under section 1374(a) on the $929,915 net

capital gain because the net capital gain is more than 50 percent

of petitioner's taxable income.

     To reflect the foregoing and concessions,

                                              Decision will be

                                       entered under Rule 155.
