                        T.C. Memo. 2010-139



                      UNITED STATES TAX COURT



              MULTI-PAK CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21597-08.               Filed June 22, 2010.



     Kenneth G. Gordon, for petitioner.

     Laura J. Mullin, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   Petitioner petitioned the Court to

redetermine the following deficiencies in Federal income taxes

and related section 6662(a) accuracy-related penalties:1


     1
      Section references, unless otherwise indicated, are to the
applicable versions of the Internal Revenue Code (Code). Rule
references are to the Tax Court Rules of Practice and Procedure.
                                 - 2 -

                                              Accuracy-Related Penalty
            Year            Deficiency             Sec. 6662(a)

            2001            $123,339                 $24,668
            2002             482,325                 113,095
            2003             395,663                  79,133

     The first issue for decision is whether petitioner may

deduct officer compensation of $2,020,000 and $2,058,000 claimed

on its 2002 and 2003 Federal income tax returns, respectively.

The 2001 deficiency is a computational adjustment resulting from

a net operating loss carryback from 2002 and 2003.2       Respondent

determined in the notice of deficiency that petitioner may deduct

only $655,000 and $660,000 for 2002 and 2003, respectively,

because petitioner has not shown that any greater amount was

reasonable and paid for services.      We hold that petitioner may

deduct all of the claimed amount for 2002 but only $1,284,104 for

2003.    The second issue for decision is whether petitioner is

liable for the accuracy-related penalty attributable to taxable

(calendar) years 2002 and 2003.    We hold petitioner is not.

                          FINDINGS OF FACT

     The parties’ stipulation of facts is incorporated herein by

this reference, and the facts stipulated are so found.         At the

time the petition was filed, petitioner maintained its business

office in Chatsworth, California.        Petitioner filed tax returns

on a calendar year basis.

     2
      For all purposes hereafter, the term “years at issue”
refers to 2002 and 2003.
                               - 3 -

A.   Multi-Pak’s Business

     Petitioner, Multi-Pak Corp. (Multi-Pak, the company, or

petitioner) provides a packaging service called flexible wet

materials.   Customers bring their products to Multi-Pak, which in

turn packages them according to the customers’ specifications and

returns them as finished goods which can then be sold to end

users.   Multi-Pak constructs all the equipment it uses; it

operates as a packaging service primarily for nutritional and

pharmaceutical products in the form of pills or capsules.

     Multi-Pak was incorporated in 1955 as a C corporation by

Ralph Unthank.   Upon his death in 1972 his son, Randall Unthank

(Mr. Unthank), became the sole shareholder of the company.    At

the time, Multi-Pak’s earnings were down and the company

considered filing for bankruptcy protection.   Mr. Unthank bought

new equipment and attracted new accounts to help prevent the

company from filing for bankruptcy.

     Mr. Unthank has been Multi-Pak’s president, CEO, and COO

from 1972 through the years at issue, and he controls all aspects

of Multi-Pak’s operations.3   Since 1972 Mr. Unthank has performed

all of Multi-Pak’s managerial duties and has made all personnel

decisions.   During the years at issue Mr. Unthank was in charge




     3
      Mr. Unthank received stock ownership of Multi-Pak after his
father passed away in 1972.
                                 - 4 -

of Multi-Pak’s price negotiations, product design, machine design

and functionality, and administration.

B.   Multi-Pak’s Financial Condition

     For 2000 through 2003 petitioner’s total assets; revenue;

earnings before interest, taxes, depreciation, and amortization

(EBITDA); net income; and total equity were as follows:

                      2000        2001           2002           2003

Total assets      $2,714,100   $3,166,800     $3,320,900   $3,134,000
Revenue            5,929,500    7,947,300      9,483,800    8,770,900
EBITDA                92,200      449,600        508,500     (120,500)
Net income            24,600      246,800        140,700     (474,000)
Total equity       2,522,000    2,792,000      3,181,300    2,994,200

     For 2002 and 2003, petitioner paid its payables currently

and was essentially debt free.

     C.     Multi-Pak’s Employee Compensation

     Mr. Unthank’s salary and bonuses for 1996 through 2003 were

as follows:

     Year         Salary             Bonus              Total

     1996        $150,000           $96,000          $246,000
     1997         150,000           464,000           614,000
     1998         150,000           712,000           862,000
     1999         150,000         1,063,398         1,213,398
     2000         150,000           988,900         1,138,900
     2001         150,000         1,086,000         1,236,000
     2002         150,000         1,870,000         2,020,000
     2003         353,000         1,705,000         2,058,000

     From 1996 to 2000 Mr. Unthank’s total compensation was

based in part on annual sales.    Although he received a flat

salary, his bonus varied year to year depending on sales and

performance.
                                  - 5 -

     Petitioner deducted the compensation paid to Mr. Unthank as

officer compensation on its Forms 1120, U.S. Corporation Income

Tax Return.   In 2001 petitioner’s business improved, and sales

and revenue increased by 20 percent over the year 2000.

     In 2002 and 2003 petitioner employed approximately 100

employees who were paid hourly.       Petitioner also employed three

sons of Mr. Unthank, who were executives and were each paid a

base salary and a monthly bonus.

     Mr. Unthank’s sons’ compensation for the years 2002 and 2003

was as follows:

                      2002                              2003
            Salary            Bonus           Salary            Bonus

Erik       $100,000          $465,000        $102,000          $330,000
Darin        80,000           425,000          81,000           295,000
Alan         60,000           270,000          61,000           235,000

The deductibility of the compensation paid to his sons is not an

issue in this case.4

     At trial Mr. Unthank testified that he decided the amounts

of bonuses for himself and his sons at the end of every month.

He would decide the amounts on the basis of his and his sons’

performance during the month and on the profitability of the

company.




     4
      Respondent did not call the sons as witnesses or seek to
introduce evidence of their services.
                               - 6 -

D.   Nu-Skin

     In 1996 petitioner acquired a new client, Nu-Skin Corp. (Nu-

Skin), a producer of skin-care products.   Nu-Skin’s business

needs caused an increase in petitioner’s revenue from 1996 to

2000.   During 2001 Nu-Skin informed Multi-Pak that it anticipated

a need to increase its packaging requirements.   To meet Nu-Skin’s

needs, Multi-Pak rebuilt a packaging machine that was capable of

producing, before it was rebuilt, 4 packages per cycle at a rate

of 80 cycles per minute (a total capacity of 320 packages per

minute).   After the extensive retooling, the machine’s capacity

was nearly doubled to 6 packages per cycle at 100 cycles per

minute (or a total capacity of 600 packages per minute).

     The packaging requirements for Nu-Skin’s international

markets increased approximately 30 percent between 2001 and 2002.

The retooling efforts allowed Multi-Pak to meet Nu-Skin’s

increased demand without requiring Nu-Skin to find additional

packaging vendors.

     Petitioner’s regular production schedule consisted of four

10-hour days for 51 weeks in each calendar year.   The production

hours were extended in 2002 and 2003 to 56-plus hours per week to

accommodate customer needs, particularly those of Nu-Skin.

E.   Expansion of Multi-Pak’s Office and Warehouse

     From 1991 through 2000 Multi-Pak’s manufacturing operations,

inventory, storage facilities, and corporate headquarters were
                               - 7 -

maintained in a 17,000-square-foot facility in Chatsworth,

California, purchased by Mr. Unthank and leased to the company at

market rates.   In 2000 Multi-Pak began leasing a portion of a

35,000-square-foot adjoining building for storage.    This building

became available for purchase in October 2001 and was acquired by

a partnership owned by the Unthank family and was leased in its

entirety to Multi-Pak, nearly tripling Multi-Pak’s space.

     The building acquired by Mr. Unthank for Multi-Pak’s use was

not initially suitable for Multi-Pak’s packaging operations and

did not conform to the Food and Drug Administration’s (FDA’s)

standards for Good Manufacturing Practices (GMP).    During the

first half of 2002, the building was extensively redesigned,

upgraded, and renovated to meet Multi-Pak’s and the FDA’s

requirements.   The renovations included:   (1) Developing a flow

pattern for receiving, storing, packaging, inspecting, and

shipping the finished goods to customers; (2) partitioning the

plant into different packaging rooms to prevent contamination and

product mixup; (3) designing gowning areas and “air/vacuum”

showers to further prevent contamination; (4) determining and

designing the heating and cooling loads and electrical

requirements and distribution in the various packaging rooms; and

(5) developing a compressed air system to serve the needs of the

packaging machinery throughout the plant.   Mr. Unthank was
                                    - 8 -

directly and significantly involved in all phases of the design

and renovation of the facility.

     On February 1, 2003, petitioner timely filed a Form 1120 for

2002 and reported $2,020,000 of compensation to Mr. Unthank.               On

February 10, 2004, petitioner timely filed a Form 1120 for 2003

and reported $2,058,000 of compensation to Mr. Unthank.              Scott

Brown (Mr. Brown) prepared Multi-Pak’s Forms 1120 for 2000, 2001,

2002, and 2003.     Mr. Brown is a certified public accountant at

Roger A. Brown & Co. (Brown & Co.), which has been preparing

petitioner’s tax returns since 1965.           Mr. Brown advised Mr.

Unthank and Multi-Pak on their compensation regularly.              Mr. Brown

and his firm evaluated Mr. Unthank’s compensation and determined

it was reasonable for the years at issue.

     Mr. Brown provided to the Court a written analysis of

petitioner’s finances as follows:

                             2000              2001        2002        2003

Net income                   $31,684         $370,183    $140,651   ($474,124)
Interest                       -0-                210         137         349
Taxes--Federal                 7,044          123,339      47,649      -0-
Taxes--California              2,553           34,529      41,489         800
Depreciation                  61,336           79,842     367,686     353,235
Depreciation--Schedule A     240,140          226,229     247,242     275,426
Amortization                   -0-              -0-         -0-        -0-
EBITDA                       342,757          834,332     844,854     155,686
Total equity               2,522,024        2,791,979   3,229,065   2,994,232
Return on equity              13.6%            29.9%      26.2%        5.2%

     On June 19, 2008, respondent issued to petitioner a notice

of deficiency disallowing a portion of the deduction it claimed

for compensation paid to Mr. Unthank for each of the years 2002

and 2003.    Petitioner timely filed its petition on September 2,
                                 - 9 -

2008.   A trial was held on September 15, 2009, in Los Angeles,

California.

                               OPINION

I.   Reasonable Compensation

     Section 162(a)(1) permits a taxpayer to deduct ordinary and

necessary business expenses, including “a reasonable allowance

for salaries or other compensation for personal services actually

rendered”.    A taxpayer is entitled to a deduction for

compensation if the payments were reasonable in amount and in

fact paid purely for services.    Sec. 1.162-7(a), Income Tax Regs.

Although framed as a two-prong test, the inquiry under section

162(a)(1) generally turns on whether the amounts of the purported

compensation payments were reasonable.    Elliotts, Inc. v.

Commissioner, 716 F.2d 1241, 1243-1245 (9th Cir. 1983), revg.

T.C. Memo. 1980-282.

     Petitioner has the burden of proving that the payments to

Mr. Unthank were reasonable.    See Rule 142(a).   Petitioner

contends the amounts paid to its president and CEO, Mr. Unthank,

in the years at issue constituted reasonable compensation under

section 162(a)(1).    Conversely, respondent contends Mr. Unthank’s

compensation for the years at issue was unreasonable.     The Court

of Appeals for the Ninth Circuit, to which an appeal in this case

would normally lie, has addressed the issue of burden of proof in

estate tax valuation cases in a series of three decisions.
                              - 10 -

Estate of Mitchell v. Commissioner, 250 F.3d 696 (9th Cir. 2001),

affg. in part, vacating in part and remanding 103 T.C. 520 (1994)

and T.C. Memo. 1997-461; Estate of Simplot v. Commissioner, 249

F.3d 1191 (9th Cir. 2001), revg. and remanding 112 T.C. 130

(1999); Morrissey v. Commissioner, 243 F.3d 1145 (9th Cir. 2001),

revg. and remanding Estate of Kaufman v. Commissioner, T.C. Memo.

1999-119.   In each of these cases the Commissioner determined an

estate tax deficiency based upon an increase in the fair market

value, over that claimed on the tax return, of shares in a

closely held corporation.   Estate of Mitchell v. Commissioner,

supra at 698-699; Estate of Simplot v. Commissioner, supra at

1193; Morrissey v. Commissioner, supra at 1147.   Subsequently,

the Commissioner submitted expert reports supporting his

concessions that the value of the subject stock was less than

that determined in the statutory notice.   Estate of Mitchell v.

Commissioner, supra at 702; Estate of Simplot v. Commissioner,

supra at 1193-1194; Morrissey v. Commissioner, supra at 1147.

     Confronting this scenario, the Court of Appeals in each

instance indicated that the Commissioner’s adoption of a

litigation posture deviating from the valuation stated in the

notice of deficiency resulted in a forfeiture of any presumption

of correctness and placed the burden of proof on the

Commissioner.   Estate of Mitchell v. Commissioner, supra at 702;

Estate of Simplot v. Commissioner, supra at 1193; Morrissey v.
                                  - 11 -

Commissioner, supra at 1148-1149.       Under the rule of Golsen v.

Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th

Cir. 1971), this Court will follow a Court of Appeals decision

which is squarely in point where appeal from our decision lies to

that Court of Appeals.

       The notice of deficiency issued to petitioner determined Mr.

Unthank’s reasonable compensation to be $655,000 and $660,000 for

2002 and 2003, respectively.      Respondent’s expert report and

posttrial briefs valued the reasonable compensation at $1,461,000

for 2002 and $670,100 for 2003.      Nonetheless, the record in this

case is such that our conclusion would be the same regardless of

the burden of proof.       We therefore shall base our ruling on the

preponderance of the evidence.

       The Court of Appeals uses five factors to determine the

reasonableness of compensation, with no single factor being

determinative.    Elliotts, Inc. v. Commissioner, supra at 1245.

The parties agree that we should apply the factors in Elliotts,

Inc.    The factors are:    (1) The employee’s role in the company;

(2) comparison with other companies; (3) the character and

condition of the company; (4) potential conflicts of interest;

and (5) internal consistency in compensation.       Id. at 1245-1248.

When officers who control the corporation set their own

compensation, careful scrutiny is necessary to determine whether

the alleged compensation is in fact a distribution of profits and
                                 - 12 -

a constructive dividend.   Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1156 (1980).

II.   Applying the Elliotts Factors

      We will apply each factor in turn.

      A.   Role in the Company

      This factor focuses on the employee’s importance to the

success of the business.   Pertinent considerations include the

employee’s position, hours worked, and duties performed.

Elliotts, Inc. v. Commissioner, supra at 1245.

      During the years at issue Mr. Unthank was the sole

shareholder, president, CEO, and COO of Multi-Pak.   Among the

services he performed were:   (1) Engineering services; (2)

functioning as a draftsman; (3) designing machines; (4)

negotiating contracts; (5) ordering equipment; (6) making

financial arrangements to acquire products; (7) acquiring

inventory; (8) making payments on payables; (9) functioning as a

troubleshooter in the operation of the machines and business

overall; (10) developing new accounts; (11) making policy

decisions concerning operations and customer development, and

(12) determining the product liability insurance coverage and

risk management.

      In 2002 Mr. Unthank reconfigured the new warehouse facility

to accommodate petitioner’s operations and meet FDA regulations,

drafted floor plans for the adjoining building, determined
                                  - 13 -

electrical distribution for each room, determined the compressed

air filtration system for each room, helped design the lighting

system, and designed the warehouse layout and flow pattern.

     Mr. Unthank made every important decision for petitioner’s

operations during the years at issue.      His devoting all of his

time to petitioner’s operations directly contributed to its

financial condition.   This factor weighs in petitioner’s favor.

     B.     External Comparison

     This factor compares the employee’s compensation with that

paid by similar companies for similar services.      Elliotts, Inc.

v. Commissioner, 716 F.2d at 1246; see sec. 1.162-7(b)(3), Income

Tax Regs.    Expert witness testimony is appropriate to help the

Court understand an area requiring specialized training,

knowledge, or judgment.    See Fed. R. Evid. 702; Snyder v.

Commissioner, 93 T.C. 529, 534 (1989).      Courts often use expert

witness opinions to evaluate the reasonableness of compensation.

Nonetheless, the Court is not bound by an expert’s opinion and we

may either accept or reject expert testimony in the exercise of

sound judgment.    Helvering v. Natl. 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.      Furthermore, the Court may be

selective in determining what portions of an expert’s opinion, if

any, to accept.    Parker v. Commissioner, 86 T.C. 547, 562 (1986).

Both parties introduced expert witness reports in support of
                               - 14 -

their respective positions, and these reports relate to our

analysis of comparable salaries.

          1.   Petitioner’s Expert

     Petitioner presented the expert testimony of Kevin J. Murphy

(Professor Murphy), an adviser to the Special Master of executive

compensation for the Department of the Treasury and a professor

of economics and law at the University of Southern California.

Professor Murphy, in reaching his conclusion that petitioner’s

compensation was reasonable, focused on two inquiries:   First,

whether the payments Mr. Unthank received were reasonable

relative to payments received by similarly situated executives in

similarly situated firms (competitive pay analysis); and second,

whether the payments Mr. Unthank received were commensurate with

his services rendered.

                (a)   Competitive Pay Analysis

     Professor Murphy’s competitive pay analysis reflected his

belief that the skills and abilities necessary to lead Multi-Pak

are similar to the skills and abilities necessary to lead firms

in a variety of light manufacturing, engineering, and business

service industries.   The competitive pay analysis compared Mr.

Unthank’s compensation with the average compensation received by

CEOs in the S & P SmallCap 600 (defined as small capitalization

firms excluding financial services and utilities) from 1993 to

2003.   The data is derived from S & P’s “ExecuComp” database,
                               - 15 -

which includes detailed executive compensation information

extracted from corporate proxy statements and 10-K statements for

companies in the S & P 500, S & P MidCap 400, and S & P SmallCap

600.    Professor Murphy presented a regression model which allowed

him to compare Multi-Pak with the SmallCap 600 firms on a size-

adjusted basis.    The median SmallCap 600 firms had revenues in

2003 of $510 million, which was roughly $501 million more than

Multi-Pak.    Many firms in the SmallCap 600 paid their CEOs

through salary, bonuses, and stock options or restricted stock

grants while Mr. Unthank was paid from salary and bonuses.

       For the years 2002 and 2003, after adjusting for

petitioner’s size in relation to the size of the companies in the

comparison group, Mr. Unthank’s salary and bonuses were at the

very top of the scale when compared with the salary and bonuses

received by CEOs of those companies and was in the 94th or 95th

percentile when compared with those CEOs’ total pay (including

grants to them of stock options and of restricted stock).      If no

adjustment is made for the relative size of the companies, Mr.

Unthank’s salary and bonuses were at the 95th and 97th

percentiles in relation to the salary and bonuses received by

CEOs in the comparison group in 2002 and 2003, respectively, and

were in the 67th and 68th percentiles, respectively, when

compared with those CEOs’ total pay.    Mr. Unthank’s 2002 and 2003

total compensation approximated the average total compensation
                                - 16 -

received by SmallCap 600 CEOs but significantly exceeded the

average salary and bonus received by these executives.

     Professor Murphy concluded that the payments Mr. Unthank

received in 2002 and 2003 are within a range of reasonable

compensation.   He stated that although Mr. Unthank was highly

paid, there was nothing inappropriate or unreasonable per se in

paying an executive in the 95th percentile of total compensation

on a size-adjusted basis.

                (b)    Assessment of Services Rendered

     Professor Murphy claimed that the 61-percent increase in

Multi-Pak’s revenues from 2000 to 2002 was in large part due to

Mr. Unthank and, as a result thereof, Mr. Unthank’s 75-percent

increase in compensation from 2001 to 2003 was not unreasonable.

According to Professor Murphy, the revenue increased because of

the extensive retooling/rebuilding of the packaging machine made

necessary by Nu-Skin and because of the acquisition of the second

production facility.    In his expert report, Professor Murphy

stated that it was routine to give bonuses based on cumulative

performance over the past 3 to 5 years and that Mr. Unthank

accordingly received bonuses in 2002 and 2003 when the increase

in sales and revenue was realized from the acquisition of the

building and the increase in business from Nu-Skin.

     In Professor Murphy’s opinion, even though petitioner’s

sales dropped in 2003, it is not unusual for a corporation to pay
                              - 17 -

discretionary bonuses in a period when sales are in decline if it

is determined that the decline is not the fault of the executive.

An example would be bonuses paid when, by reason of a bad

economy, sales dropped.   In addition, Professor Murphy did not

find any evidence that petitioner paid bonuses to Mr. Unthank for

the purpose of absorbing taxable profit.

          2.   Respondent’s Expert

     Respondent presented expert testimony from David Fuller (Mr.

Fuller), an expert in the area of compensation.     Mr. Fuller is

president of Valve, Inc., a financial consulting firm.     Mr.

Fuller has been a valuation consultant for financial and tax

reporting purposes for 20 years.     Mr. Fuller opined that

reasonable levels of compensation for Mr. Unthank would have been

$1,461,300 for 2002 and $670,100 for 2003.

     Mr. Fuller analyzed whether an independent investor would be

satisfied with his or her return on an investment in petitioner

after Mr. Unthank’s compensation.     Mr. Fuller conducted the

independent investor test under three distinct scenarios.

     In the first scenario Mr. Fuller used eight publicly traded

companies that he said were as similar as possible to Multi-Pak

in terms of products, dynamics, and services.     The eight publicly

traded companies were listed as follows:
                                           - 18 -

                      Total Assets      Revenue        EBITDA       Net Income      Total Equity

AEP Ind.               $469,000,000    $660,600,000   $47,900,000    ($1,800,000)   $61,600,000
BEMIS Co.             2,256,700,000   2,369,000,000   401,400,000    165,500,000    959,000,000
CCL Ind.                852,000,000   1,073,000,000   117,200,000     13,800,000    277,300,000
Chesapeake            1,352,900,000     822,200,000   112,400,000     21,900,000    476,600,000
Graphic Packaging     1,957,700,000   1,247,300,000   273,900,000    (11,200,000)   132,500,000
Pactiv Corp.          3,412,000,000   2,880,000,000   617,000,000    148,000,000    897,000,000
Sealed Air Corp.      4,260,800,000   3,204,300,000   680,000,000   (309,100,000)   813,000,000
Sonoco Products       2,436,400,000   2,701,400,000   405,300,000    135,300,000    867,400,000

       In this scenario Mr. Fuller’s objective was to establish the

reasonable amount of compensation to Mr. Unthank from the

standpoint of an independent investor who owned the company

throughout the years 2002 and 2003.                     To do this, he estimated the

appropriate rate of return by observing pretax rates of return on

equity for the publicly traded companies identified above.                                He

started with Multi-Pak’s book value of equity and multiplied that

by the pretax rates of the public companies, producing a dollar

value of return that an independent investor would require for

each year.          He then subtracted that value from Multi-Pak’s

earnings before interest or taxes.                    He opined that the difference

was the value of reasonable shareholder compensation.                               Scenario 1

resulted in estimated values of $1,462,000 and $1,030,600, for

2002 and 2003, respectively.

       In the second scenario, Mr. Fuller undertook to estimate the

amount of compensation to Mr. Unthank that would be reasonable

from the standpoint of an independent investor who purchased the

company on December 31, 2001 or 2002.                      Mr. Fuller looked at the

Pratt Stats database, a national database that publishes

information relating to business valuations, to find purchases of
                               - 19 -

companies similar to Multi-Pak.   Mr. Fuller then estimated a

reasonable rate of return by observing rates of return based on

EBITDA (earnings before interest, taxes, depreciation, and

amortization) as a percentage of the market value of invested

capital for the similar companies.      He then subtracted that rate

of return from Multi-Pak’s EBITDA rate of return on equity before

deductions for shareholder compensation and taxes.     The remaining

amount after accounting for depreciation was then estimated to be

the indicated value of reasonable shareholder compensation.       The

concluded levels for scenario 2 were $1,301,900 and $585,100 for

2002 and 2003, respectively.

     In the third scenario, as in the second, Mr. Fuller sought

to estimate the amount of compensation to Mr. Unthank that would

be reasonable from the perspective of an independent investor who

had purchased the company on December 31, 2001 or 2002.       But here

Mr. Fuller tried to estimate the appropriate rate of return

through the use of the buildup method.     The buildup method

determines a reasonable rate of return on an investment based on

the expected return on assets with similar risk exposure.       Mr.

Fuller then subtracted the rate of return, as so determined, from

Multi-Pak’s rate of return on equity before interest and taxes

and before deductions for shareholder compensation.     The

remaining amount was then estimated to be the indicated value of

reasonable shareholder compensation.     The concluded levels for
                              - 20 -

scenario 3 were $1,180,600 and $394,600 for 2002 and 2003,

respectively.

     Mr. Fuller reached an opinion as to reasonable compensation

based on each of his three scenarios and then averaged the three

conclusions, giving each equal weight, to come to his final

conclusion.   Mr. Fuller’s report concluded that as a percentage

of revenue, the 2002 compensation levels were 18.4 percent, 16.4

percent, and 14.9 percent for scenarios 1, 2, and 3,

respectively, with an arithmetic average of 16.5 percent.    The

2003 compensation levels were 10.9 percent, 6.2 percent, and 4.2

percent in scenarios 1, 2, and 3, respectively, with an

arithmetic average of 7.1 percent.

     Mr. Fuller increased his estimate of reasonable compensation

for Mr. Unthank for 2002 to include an allowance of $146,500 for

working double shifts for a quarter of the year as an engineer,

and to compensate Mr. Unthank for the retooling efforts in 2001.

Mr. Fuller reached this number using the Zweig White survey,

which Mr. Fuller testified was used to observe reported

compensation levels for principals, partners, and owners of

multidiscipline engineering firms.     According to the Zweig White

survey, the upper quartile annual compensation amount for

principals, partners, and owners of such companies in the Pacific

region was $293,000.   Mr. Fuller then divided $293,000 by 2 and

gave $146,500 to Mr. Unthank as an added amount for the extra
                                 - 21 -

work he put in for the retooling effort in 2001.      Mr. Fuller

opined that reasonable levels of compensation for Mr. Unthank

would have been $1,461,300 for 2002 and $670,100 for 2003.

According to Mr. Fuller, these amounts would properly compensate

Mr. Unthank for his efforts in the retooling process.

          3.     Conclusion

     We do not find the opinion of either party’s expert

completely convincing.    Neither expert’s comparables were similar

to petitioner.    Petitioner’s expert selected the S & P SmallCap

600 as a comparison to petitioner, while respondent’s expert

selected eight publicly traded companies that he deemed similar.

The S & P SmallCap 600 includes companies from different sectors

of the market that on average have revenues 58 times greater than

petitioner’s while the eight publicly traded companies that

respondent’s expert deemed similar had revenues on average 200

times higher than petitioner’s.      Although Mr. Fuller testified

that he adjusted his analysis to account for this size

difference, he did not explain how.       Mr. Fuller acknowledged that

there are few companies that are actually comparable to

petitioner and therefore doing an external executive compensation

comparison is difficult.      Thus, Mr. Fuller’s analysis of the

“amount as would ordinarily be paid for like services by like

enterprises under like circumstances” is not definitive.      See

sec. 1.162-7(b)(3), Income Tax Regs.
                                - 22 -

     Mr. Fuller based his conclusion on an analysis of whether an

independent investor would be satisfied with his or her return on

an investment in petitioner after Mr. Unthank’s compensation.      In

his first scenario, Mr. Fuller selected eight companies in the

packaging industry and compared each company’s CEO’s compensation

to that of Mr. Unthank.   At trial Mr. Fuller testified, however,

that it would be a “mischaracterization” to believe he picked

these eight as the companies most reasonably comparable to

petitioner.    In fact, Mr. Fuller stated that he did not select

these eight companies for purposes of determining compensation

but to determine what return on equity an independent investor

would expect from an investment in a healthy company in the

packaging industry.

     Petitioner was virtually debt free and had few liabilities

on its balance sheet.   But the average debt-equity ratio of the

eight companies that Mr. Fuller selected was 7 to 3 for both

years in question.    Equity in a firm with such debt is inherently

riskier than equity in a firm without as much debt, and thus

shareholders will demand a higher rate of return on equity in the

former firm.   “The riskier the venture the greater the rate of

return necessary to compensate for that risk.”    Finkelman v.

Commissioner, T.C. Memo. 1989-72, affd. without published opinion

937 F.2d 612 (9th Cir. 1991).    “The greater the percentage of

debt, the riskier that company will be as an investment (all
                                - 23 -

other things being equal), and the greater the rate of return

will have to be in order to attract investors.”     Celebrity

Cruises, Inc. v. Essef Corp., 478 F. Supp. 2d 440, 452 (S.D.N.Y.

2007).

      Additionally, Mr. Fuller stated that he gave Mr. Unthank an

allowance of $146,500 for working double shifts for one quarter

in 2001 as an engineer and to compensate Mr. Unthank for the

retooling efforts.   Mr. Fuller testified that the Zweig White

survey is used in his practice for reasonable compensation cases

concerning engineering firms.    We fail to see how this survey is

relevant to petitioner’s operations.     First, petitioner is not an

engineering firm.    Second, Mr. Unthank’s role in the company was

not only that of an engineer but also that of a designer and

developer who oversaw the decision to retool and managed the

retooling process while structuring the company’s contracts.

Because Mr. Fuller’s analysis was based on dissimilar companies

and because Mr. Unthank was not just an engineer on the retooling

project, we disagree with respondent’s expert testimony.

     We now turn to petitioner’s expert, Professor Murphy.      In

estimating whether Mr. Unthank’s compensation was reasonable,

Professor Murphy did not perform the analysis, required in the

applicable caselaw, of whether an independent investor would have

been satisfied by his or her return on investment.    In addition,

Professor Murphy’s only point of comparison was the S & P
                              - 24 -

SmallCap 600.   The median 2003 revenue for the S & P SmallCap 600

is $510 million, which is significantly higher than petitioner’s

revenue of $8.77 million in 2003.   Also, the S & P SmallCap 600

is not an index that focuses on companies similar in business to

petitioner.   The S & P SmallCap 600 has businesses in the energy,

health care, and technology sectors.   Although Professor Murphy’s

report, unlike Mr. Fuller’s, made adjustments in an attempt to

account for the difference between petitioner’s revenues and

those of the companies selected as comparables, Professor

Murphy’s report lacked an independent investor test and his

companies were too dissimilar to provide a comparison to

petitioner.

     In summary, we have not found the analyses performed or the

opinions expressed by either of the parties’ experts to be

persuasive or reliable.   Therefore, we find that the

comparison to the compensation paid by unrelated firms is a

neutral factor.

     C.   Character and Condition of the Company

     This factor focuses on petitioner’s size as measured by its

sales, net income, or capital value; the complexities of the

business; and general economic conditions.   See Elliotts, Inc. v.

Commissioner, 716 F.2d at 1246.

     Petitioner is prominent in the industry of packaging

vitamins, pills, and other small items in the Western United
                                - 25 -

States.   While petitioner’s revenue increased from 2001 to 2002,

they declined from 2002 to 2003.    Despite the decrease in 2003,

revenue remained almost 50 percent higher than in 2000, before

the major retooling efforts in 2001.     Equity, revenue, and gross

profit in 2002 and 2003 were petitioner’s highest.    However,

petitioner’s net income remained low even though revenues had

increased.   For the years in issue, net income after taxes was

$93,000 and negative $474,000, respectively.5

     Petitioner’s business was complex.    It involved purchasing a

new warehouse in 2001, remodeling it, adding new machines, and

hiring additional workers.   In addition, petitioner’s ability to

quickly respond to the increased production demands in 2001 of

Nu-Skin, its major customer, by increasing hours and purchasing

more warehouse space contributed significantly to its rise in

total sales in 2002 and 2003.    The acquisition of the adjoining

building in October 2001 added 35,000 square feet, more than

tripling petitioner’s plant capacity, starting in 2002 and

continuing in subsequent years.    Petitioner did this work while

assuming no debt during the years at issue, and thus the company

had very small liabilities on its balance sheet.

     Although petitioner’s net income in 2002 and 2003 was low

when compared to revenues, other factors such as equity, revenue,



     5
      Petitioner had total tax liabilities of $47,600 and $0 in
2002 and 2003, respectively.
                              - 26 -

and gross profit point towards a successful operation.    Neither

party presented direct evidence by which we can definitively

compare petitioner’s operations with those of similar businesses.

However, the evidence does suggest that petitioner was one of the

more successful companies of its kind.    Accordingly, we find that

this factor favors petitioner.

     D.   Conflict of Interest

     This factor examines whether a relationship exists between

the company and the employee which would permit the company to

disguise nondeductible corporate distributions as section

162(a)(1) compensation payments.   Close scrutiny may be used when

the paying corporation is controlled by the compensated employee,

as in the instant case.   Elliotts, Inc. v. Commissioner, supra at

1246-1247.   However, the mere fact that the individual whose

compensation is under scrutiny is the sole shareholder of the

company, even when coupled with an absence of dividend payments,

“does not necessarily lead to the conclusion that the amount of

compensation is unreasonably high”.    Id. at 1246.   There is no

question in this case that Mr. Unthank, as the sole shareholder,

president, and CEO occupied a position deserving scrutiny.

     The Court of Appeals for the Ninth Circuit has held that the

reasonableness of compensation should be evaluated from the

perspective of a hypothetical independent investor.    Under the

independent investor test, a company’s annual return on equity
                                - 27 -

usually begins with a company’s net income after taxes for that

year.    Dexsil Corp. v. Commissioner, 147 F.3d 96, 99 (2d Cir.

1998), vacating T.C. Memo. 1995-135; Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir.

2000).     If the company’s earnings on equity after payment of the

compensation at issue remain at a level that would satisfy a

hypothetical independent investor, there is a strong indication

that the employee is providing compensable services and that

profits are not being siphoned out of the company disguised as

salary.     Elliotts, Inc. v. Commissioner, supra at 1247.   The

Court of Appeals in Elliotts, Inc. calculated the return on

equity using the yearend shareholders’ equity.     Id.

        Petitioner’s accountant, Mr. Brown, calculated petitioner’s

return on equity to be 26.2 percent and 5.2 percent for 2002 and

2003, respectively.     In those computations Mr. Brown added back

interest, taxes, and depreciation into his estimation of

petitioner’s net income.     Respondent’s expert, Mr. Fuller,

calculated the return on equity to be 4.4 percent and -15.8

percent for 2002 and 2003, respectively.     Mr. Fuller did not add

back interest, taxes, and depreciation into his calculation.

        Dividing petitioner’s net profit (after payment of

compensation and a provision for income taxes) by the yearend

shareholder’s equity as reflected in its financial statements

yields return on equity of 2.9 percent and -15.8 percent in 2002
                               - 28 -

and 2003, respectively.   See John L. Ginger Masonry, Inc. v.

Commissioner, T.C. Memo. 1997-251.

     In Elliotts, Inc. v. Commissioner, supra at 1247, the Court

of Appeals found that a 20-percent average rate of return on

equity would satisfy a hypothetical independent investor.     But

the Court of Appeals also stated that there could be a situation

in which a corporation might suffer a loss or an inadequate

return on equity yet compensation paid to employees is

reasonable.   “[A] formula should reasonably compensate for the

work done, the performance achieved, the responsibility assumed,

and the experience and dedication of the employee.”    Id. at 1248.

     Petitioner became the president of Multi-Pak in 1973 when it

was near bankruptcy and has since helped to bring it financial

stability.    During the years in issue, its sales were at or near

all-time highs and it had little or no debt.   Mr. Unthank was

present during all client negotiations and managed the redesign

and expansion of the corporation to triple its original size.       He

has been the active president, CEO, and COO for all years at

issue.   Though an independent investor may prefer to see higher

rates of return, we believe an independent investor would note

that Mr. Unthank was the sole reason for this company’s

significant rise in sales in 2002 due to his agreement with Nu-

Skin and the subsequent expansion of the company.   Mr. Unthank
                               - 29 -

made every important decision for petitioner and had the most

important role in increasing its sales and limiting its debt.

     However, we agree with respondent that a negative 15.8-

percent return on equity in 2003 calls into question the level of

Mr. Unthank’s compensation for that year.     When compensation

results in a negative return on shareholder equity, we cannot

conclude, in the absence of a mitigating circumstance, that an

independent investor would be pleased.      Donald Palmer Co. v.

Commissioner, T.C. Memo. 1995-65, affd. without published opinion

84 F.3d 431 (5th Cir. 1996).

     We find this factor to favor petitioner in 2002 and

respondent in 2003.

     E.   Internal Consistency of Compensation

     Finally, evidence of an internal inconsistency in a

company’s treatment of payments to employees may indicate that

the payments go beyond reasonable compensation.      Elliotts, Inc.

v. Commissioner, 716 F.2d at 1247.      “Bonuses that have not been

awarded under a structured, formal, consistently applied program

generally are suspect * * * On the other hand, evidence of a

reasonable, longstanding, consistently applied compensation plan

is evidence that the compensation paid in the years in question

was reasonable.”   Id.   The bonus should not be decided after

perusing the year’s profits.    Nor-Cal Adjusters v. Commissioner,

503 F.2d 359, 362 (9th Cir. 1974), affg. T.C. Memo. 1971-200.
                              - 30 -

Payment of bonuses at yearend when the corporation knows its

revenue for that year may enable it to disguise dividends as

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

1315 (5th Cir. 1987), affg. T.C. Memo. 1985-267; Estate of

Wallace v. Commissioner, 95 T.C. 525, 556 (1990), affd. 965 F.2d

1038 (11th Cir. 1992).

     In Vitamin Vill., Inc. v. Commissioner, T.C. Memo. 2007-272,

this Court found that the bonuses paid were not awarded under a

structured, formal, or consistently applied program but were paid

under the taxpayer’s plan to award a bonus for present hard work

and prior years’ lack of compensation when the taxpayer became

more profitable.   Generally, incentive compensation plans are

designed to increase the compensation to employees by some

fraction of the benefit the corporation derives from the

employee’s efforts.   See Elliotts, Inc. v. Commissioner, supra at

1248 (stating that “Incentive payment plans are designed to

encourage and compensate that extra effort and dedication which

can be so valuable to a corporation.”).

     Petitioner argues that the record shows a reasonable and

relatively consistently applied compensation schedule that was

based on the employees’ monthly productivity.   After Mr. Unthank

took over in 1972, petitioner paid Mr. Unthank a monthly bonus

dependent on petitioner’s performance and profits for that month.

Mr. Unthank testified that there was no established monthly
                                - 31 -

amount but that he determined at the end of each month the amount

he and his sons received on the basis of performances.    In 2002

and 2003 Mr. Unthank paid himself a monthly bonus of $100,000 to

$250,000 in 19 of the 24 months.    In four other instances, Mr.

Unthank paid himself a bonus of $50,000 or less; and in another,

he paid himself about $375,000.    In addition, Mr. Unthank’s sons,

Alan, Darin, and Erik, each had monthly bonuses that ranged from

zero to $90,000.

     Petitioner awarded bonuses every month based on both Mr.

Unthank’s and his sons’ performances.    This Court has previously

found that a taxpayer’s payment of bonuses throughout the year

and the declaration of the amount at the end of the year does not

indicate unreasonableness.   Escrow Connection, Inc. v.

Commissioner, T.C. Memo. 1997-17.    The fact that the recipient is

a shareholder-employee does not make the plan unreasonable.

Elliotts, Inc. v. Commissioner, supra at 1248.

     Accordingly, we find that petitioner’s treatment of Mr.

Unthank’s bonuses was under a consistent business policy.

     F.   Conclusion

     Mr. Unthank, as petitioner’s sole executive officer and

president, was the driving force behind petitioner’s success.

His dedication and hard work resulted in the company’s record

sales for the years at issue.    When revenues and sales rose in

2002, almost all of the rise could be attributed to Mr. Unthank.
                               - 32 -

We believe that an independent investor would accept a 2.9-

percent return on equity for 2002 in the light of the roughly $3

million growth in sales from 2000 and the long-term potential of

the company.    We find that petitioner’s compensation paid was

reasonable for that year.

     In 2003 Multi-Pak saw a drop in sales and revenue, but

petitioner still gave Mr. Unthank more compensation than he had

received in 2002.   Even though the 2003 revenue and equity

numbers were the second highest in petitioner’s history, return

on equity in 2003 was -15.8 percent, an amount which would not be

acceptable for an independent investor.    Mr. Unthank’s total

compensation from 1999 to 2001 averaged $1,196,099.    For 2002 we

have found that an independent investor would have been willing

to accept a 2.9-percent return on equity in the light of the

impressive sales growth of the business.    Accordingly, with a

drop in sales in 2003, an independent investor would expect lower

compensation.   If Mr. Unthank’s salary is reduced to $1,284,104

in 2003, the return on equity for petitioner rises to 10 percent

in 2003.   We believe this would be sufficient given the overall

character of the company.    The Court therefore finds that

petitioner is entitled to deduct $2,020,000 and $1,284,104 in

2002 and 2003, respectively, under section 162(a)(1).
                                - 33 -

III.   Accuracy-Related Penalty for 2002 and 2003

       Respondent determined that petitioner was liable for

accuracy-related penalties under section 6662(a) for negligence

or intentional disregard of rules and regulations for tax years

2002 and 2003.    Petitioner argues that it is not liable for these

penalties because it relied reasonably on its accountant’s advice

in preparing its returns.    We have found that petitioner’s 2002

compensation to Mr. Unthank was proper.    Consequently, there is

no underpayment of tax for 2002 on which the accuracy-related

penalty under section 6662(a) may be imposed.

       As relevant herein, section 6662(a) and (b)(1) imposes a

20-percent accuracy-related penalty on the portion of an

underpayment that is due to negligence or intentional disregard

of rules or regulations.    Negligence includes a failure to

attempt reasonably to comply with the Code, whereas disregard

includes a careless, reckless, or intentional disregard.      Sec.

6662(c).

       A section 6662(a) accuracy-related penalty shall not be

imposed to the extent that the taxpayer shows that an

underpayment is due to the taxpayer’s having reasonable cause and

acting in good faith.    Sec. 6664(c); secs. 1.6662-3(a),

1.6664-4(a), Income Tax Regs.    Reasonable cause requires that the

taxpayer exercise ordinary business care and prudence as to the

disputed item.    United States v. Boyle, 469 U.S. 241 (1985).       A
                                - 34 -

good-faith reasonable reliance on the advice of an independent,

competent professional as to the tax treatment of an item may

meet this requirement.     Id. at 250; sec. 1.6664-4(b)(1), Income

Tax Regs.     Whether a taxpayer relies on professional advice and

whether such reliance is reasonable hinge on the facts and

circumstances of the case and the law that applies to those facts

and circumstances.     Sec. 1.6664-4(c)(1), Income Tax Regs.

     For a taxpayer to rely reasonably upon professional advice

to negate a section 6662(a) accuracy-related penalty, the

taxpayer must prove by a preponderance of the evidence that the

taxpayer meets each requirement of the following three-prong

test:     (1) The adviser was a competent professional who had

sufficient expertise to justify reliance; (2) the taxpayer

provided necessary and accurate information to the adviser; and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment.     Ellwest Stereo Theatres, Inc. v. Commissioner, T.C.

Memo. 1995-610; see also Rule 142(a)(2).

        The record convinces us that petitioner has met each of

these requirements for 2003.     We do not find anything in the

record that causes us to believe that Mr. Brown was not a

competent professional with sufficient expertise to justify

reliance.     Mr. Brown testified that Mr. Unthank would call him

with the bonus amounts and that Brown & Co. made a decision on

reasonableness at the end of the year.     Because petitioner
                             - 35 -

actually relied in good faith on its accountant’s advice as to

the matters at hand and the reliance was reasonable, we decline

to sustain respondent’s determination as to the accuracy-related

penalty for 2003.

     To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
