                        T.C. Memo. 1996-316



                      UNITED STATES TAX COURT



        LEONARD PIPELINE CONTRACTORS, LTD., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 28985-91.               Filed July 15, 1996.



     Marc L. Spitzer and James P. Powers, for petitioner.

     Susan E. Seabrook, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS, Judge:   Leonard Pipeline Contractors, Ltd. petitioned

the Court to redetermine respondent’s determination of an $807,983

deficiency in its income tax for its taxable year ended September

30, 1987, and additions to tax pursuant to section 6653(a)(1)(A) in

the amount of $40,399 and section 6653(a)(1)(B) in the amount of 50
                                      -2-

percent of the interest on $807,983.           The deficiency is based on

respondent's     determination   that       $1,642,593   of   the   $1,777,800

petitioner deducted as compensation paid to its president, Richard

L. Leonard, was unreasonable.

     Following respondent’s concession of the additions to tax, the

sole issue for decision is the amount of compensation paid by

petitioner that is reasonable and thus deductible as a section 162

business expense.

     All section references are to the Internal Revenue Code in

effect for the year in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.          Except where indicated

by the notation Can$ (standing for Canadian), all dollars are U.S.

dollars.

                           FINDINGS OF FACT

     Some   of   the   facts   have    been    stipulated     and   are   found

accordingly.     The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

     At the time petitioner Leonard Pipeline Contractors, Ltd.

filed its petition herein, its principal place of business was in

Scottsdale, Arizona.     Petitioner filed its 1987 Federal income tax

return based on a fiscal year ending September 30, 1987.

Petitioner's History

     Petitioner was incorporated in Canada on September 28, 1977.

From its incorporation through the year in issue, petitioner

engaged in pipeline construction and related activities, either
                                          -3-

directly or through joint ventures in the United States, Canada,

Saudi     Arabia,   and    Mexico.      Mr.    Leonard       has    been   petitioner’s

president since its inception.

      Leonard       Baun    Holdings,         Ltd.     (LBH),       another       Canadian

corporation, originally owned 51 percent of petitioner’s common

stock and 50 percent of its preferred stock. The remaining 49

percent     of   petitioner’s      voting       stock    and       50   percent    of   its

preferred stock were owned by an unrelated publicly held company.

        At the time petitioner was organized, Mr. Leonard owned 75

percent of the LBH stock and R.W. Baun owned 25 percent.1                                In

October 1977, LBH sold to petitioner all of its assets (except for

its   participation        right   in   three        major   pipeline      construction

contracts) for Can$6 million and its goodwill for Can$700,000.

      In 1978, two additional Canadian corporations were organized,

R.L. Leonard Holdings, Ltd. (RLLH) and R.L. Leonard Consultants

(RLLC). Mr. Leonard owned all the stock in these corporations.

        In 1979, LBH was renamed Leonard Pipeline Holdings, Ltd.

(LPH).     In 1983, a new Canadian corporation was formed, Leonard

Pipeline Construction, Ltd. (LPC).               This corporation was owned by

LPH, which was owned by RLLH.

        In 1984, LPH, RLLH, and RLLC consolidated. RLLH was the

surviving corporation, with Mr. Leonard its sole shareholder. RLLH

owned 100 percent of both LPC and petitioner.

      1
          Mr. Baun's stock in Leonard Baun Holdings, Ltd. was
redeemed in 1979.
                                       -4-

     Petitioner became a U.S. corporation on April 18, 1985,2 by

filing an application for certificate of registration and articles

of continuance under Wyoming law.             These documents list Casper,

Wyoming, as petitioner's corporate address.            After the application

and certificate of registration were filed, all of petitioner's

U.S. tax returns state a Scottsdale, Arizona, mailing address.

     On January 5, 1987, Mr. Leonard incorporated Leonard Pipeline

Construction   Co.    (LPCC),     an    S    corporation,     with   petitioner

consenting to the use of its corporate name.                 In December 1987,

petitioner merged into the S corporation.

     Accordingly, during the year in issue, petitioner’s sole

shareholder was RLLH, whose sole shareholder was Mr. Leonard.

Petitioner’s Financial Statements

     Petitioner’s     financial    statements        for    fiscal   years   1978

through 1987   were    prepared    using      the   percentage-of-completion

method of accounting for long-term construction contracts. Its

income tax returns, however, were prepared on the completed-

contract   method.    Consequently,         the   amounts   reflected   on   its

financial statements vary from those reflected on its income tax

returns.

     Petitioner reported the following amounts on its financial

statements:



     2
          Prior to becoming a U.S. corporation, petitioner filed
Forms 1120F, U.S. Income Tax Return of a Foreign Corporation.
                                          -5-
Fiscal                                                     After-tax      Dividends
Year          Assets      Gross Revenue    Gross Profit    Net Income       Paid

1978        $13,797,060   $13,261,695     $1,581,772          $476,805      ---

1979        10,651,010    21,321,960       2,770,522       1,099,341      $255,063

1980         7,367,576       705,640      (1,048,785)         298,798       ---

1981        13,225,920    40,852,715       4,550,930       1,455,211        ---

1982         7,015,414    10,244,505        (102,826)         (489,941)     ---

1983         5,931,770     1,213,983        (232,193)         (135,116)    631,785

1984-
 1986        3,424,358     8,945,181            960,902       (859,615)   1,082,164
                          26,019,914

1987         2,946,961       559,312            114,798       (139,525)      ---
                                                          1
Total          N/A        123,124,905             N/A      1,705,958      1,969,012
        1
              The full amount of the 1987 compensation paid to Mr. Leonard,
        as well as the amount of the distribution of a 1985 in-kind dividend
        that had been treated as a loss for financial accounting purposes,
        have been taken into account in calculating petitioner's aggregate
        after-tax net income.     The aggregate before-tax net income was
        slightly over $6 million.

        Petitioner reported the following amounts on its Forms 1120F,

U.S. Income Tax Return of a Foreign Corporation, for fiscal years

1979-84, and Forms 1120, U.S. Corporation Income Tax Return, for

1985-87:
                                         -6-

                                                    Taxable Income
                                                  (after compensation
                                                  deduction but before
Fiscal    Total         Gross         Gross            NOL and                Dividends
Year      Assets        Sales         Profit      special deductions)           Paid

1979     $10,736,361   $7,293,533    $51,170        ($2,219,417)                N/A

1981     13,509,999    6,728,333    (773,038)        (3,555,130)                N/A

1982      7,314,042    43,924,265   7,425,068        5,370,502                  N/A

1983      5,988,429    1,629,951     631,942           224,775                  N/A

1984      4,881,551       85,160    (261,106)          517,618                  N/A

1985      1,944,932       N/A         N/A             (177,704)                 N/A

1986      3,424,362       N/A         N/A             (141,442)                 N/A

1987      2,964,861    5,740,283    1,592,523        3,119,831                  N/A


Petitioner's 1987 taxable income before the compensation deduction

was $4,922,631.

Dividends

       Petitioner paid RLLH a Can$743,828 dividend in 1983, and a

Can$878,787 dividend in January 1985 out of petitioner's capital

account.     Under Canadian tax law at the time, when a dividend was

paid out of a capital account, the distribution was not taxable

because it represented the nontaxable portion of capital gain.

Shareholder's Equity

       Petitioner      reported     shareholder's     equity       on   its    audited

financial statements as follows:

         Fiscal Year                            Shareholder's Equity

            1986                                       $969,242

            1987                                      1,786,314
                               -7-

We ignore earlier years due to the conversion of a portion of

shareholder's equity into long-term liabilities.

Richard L. Leonard

     At all relevant times, Mr. Leonard was petitioner’s president,

chief operating officer, and chief financial officer.    Mr. Leonard

has extensive experience in the pipeline industry.      He began his

career as a laborer at a Kansas City pipeline firm.    After serving

as an aviator in World War II, Mr. Leonard returned to transmission

pipeline work for Midwestern Constructors in Tulsa, Oklahoma,

working on major postwar projects.     He held various positions for

pipeline contractors in the 1950's, serving as chief inspector for

Truckline Gas Co. Mr. Leonard was later appointed a superintendent

by Anderson Brothers Pipeline Contractors, where he was responsible

for finding and bidding on construction jobs and handling public

relations work.

     In 1955, Mr. Leonard moved to Canada to assume the position of

general superintendent for Majestic Contractors, where he conducted

all of the contract bidding and estimates.    During this time, Mr.

Leonard was involved in the TransCanada Pipeline, the first large

diameter gas pipeline across Canada.

     In 1964, Mr. Leonard became a shareholder and chief operating

officer of Canadian Parkhill, Ltd. (Parkhill).     During his tenure

with Parkhill, the company constructed over 700 miles of pipeline

across the United States and Canada.
                                     -8-

     In 1970, Mr. Leonard co-founded Joyce/Leonard Canada, Ltd.

(Joyce/Leonard).    He   successfully      negotiated    a    joint   venture

contract for the company to perform 600 miles of double jointing3

on the Trans-Alaska pipeline project.           Following this project,

Joyce/Leonard was awarded contracts for pipeline construction in

Australia   and   Indonesia.   Mr.    Leonard   became       sole   owner   of

Joyce/Leonard in 1976 and renamed the company Leonard Pipeline

Contractors, Ltd., the predecessor to petitioner.

     In October 1977, Mr. Leonard secured for petitioner a joint

venture contract for 750 miles of double jointing and yard coating

of pipe in Saudi Arabia.    In addition, Mr. Leonard facilitated the

fulfillment of petitioner’s contracts for the construction or

reconditioning of over 600 miles of pipeline in the United States,

Canada, and Mexico.

     Between 1982-84, petitioner's pipeline work was slow.                  In

early 1985, Mr. Leonard secured the All American Pipeline project

for petitioner4 wherein petitioner contracted to coat, insulate,

and wrap 325 miles of pipeline in Texas, Arizona, and California.


     3
          Mr. Leonard developed the “double-jointing" process.
This process consists of cleaning and joining together two
lengths of pipe using semi-automatic welding. It is done in a
covered facility under controlled conditions with the joined
pipes then transported to the field.
     4
          Mr. Leonard ultimately pleaded guilty to a criminal
information filed against him in the Southern District of Texas
for obtaining the All American Pipeline contract through fraud.
He was sentenced to 3 years of unsupervised probation and fined
$1,000.
                                      -9-

In February of that year, petitioner formed a joint venture with

Anchor Wate Co. to perform this contract.             Mr. Leonard personally

guaranteed a $1.5 million debt by petitioner to the Royal Bank of

Canada in connection with this project.5

     Mr. Leonard was directly responsible for petitioner’s growth

and success.   Over the years, despite his criminal conviction, see

infra note 4, Mr. Leonard had a favorable reputation in the

pipeline construction industry.           Petitioner relied entirely upon

Mr. Leonard (and on his personal guaranty) to obtain the necessary

financial backing to participate in large pipeline construction

projects.

Compensation Paid to Mr. Leonard

     Petitioner       contracted    for   Mr.     Leonard’s   management   and

consulting   services     through    RLLC   for    calendar   years   1978-82.

Pursuant to a contract between RLLC and petitioner, RLLC paid Mr.

Leonard for the services that he provided to petitioner for these

years.   Despite this financial arrangement, Mr. Leonard considered

petitioner to be his employer.

     Mr.    Leonard    received     the   following    amounts   through   the

corporate entities and joint ventures with which he was involved:




     5
          Petitioner was not permitted to pay compensation to Mr.
Leonard in 1985 and 1986 due to restrictions imposed by the Royal
Bank of Canada in connection with the line of credit extended to
petitioner.
                                          -10-
Year       Payor                                  Amount

1979       Not specified                          $695,176     Can

1980       RLLC                                     18,195     Can
           LPH                                     150,000     Can

1981       RLLC                                     18,109     Can
           LPH                                      50,000     Can
           personal use of corporate car             2,640     Can

1982       RLLC                                     43,228     Can

1983       RLLC                                    155,175     Can
           Petitioner                              364,185     Can

1984       Petitioner                                7,500     Can

1985       Petitioner/Anchor Wate joint venture    110,000
           Petitioner/Texas Coating Supply          52,252
                 joint venture

1986       Petitioner/Anchor Wate joint venture    120,000
           Petitioner/Texas Coating Supply          22,748

1987       Petitioner (bonus)                     1,680,000
                      (wages)                        97,700
           Environmental Builders, Inc.              21,000

1988       LPCC                                   1,176,684


The reasonableness of the $1,777,700 ($1,680,000 bonus plus $97,700

wages) payment to Mr. Leonard from petitioner in 1987 is at issue

herein.6

       We note that Mr. Leonard also received dividends from RLLH in

1983       and    1984   in   the   respective   amounts      of   Can$500,000   and

Can$200,000.


       6
          Petitioner issued a check to Mr. Leonard on Sept. 28,
1987, and Mr. Leonard deposited it in his personal bank account.
Simultaneously, Mr. Leonard transferred $289,703 of the bonus
back to petitioner. While the record is unclear as to why Mr.
Leonard remitted the $289,703 to petitioner, it appears he
believed that he owed petitioner this amount.
                                  -11-

Other Circumstances

       Mr. Leonard had open-heart surgery in 1977 and 1980.         Around

1983, he considered himself substantially retired.           In 1986, Mr.

Leonard’s doctor recommended that he limit his work to 6-8 hours a

day.   In 1987, at 67 years of age, Mr. Leonard limited his work to

7-8 hours a day, 6 days a week.

       In 1985, Mr. Leonard underwent a divorce.           Pursuant to a

February 27, 1986, temporary support order of the Superior Court of

Arizona, Mr. Leonard was required to cause one of his corporations

to pay his estranged wife a salary; accordingly, petitioner paid

Mrs. Leonard $3,000 a month (even though she did not work for

petitioner).    In April 1987, the Maricopa County Superior Court

entered a decree of dissolution of marriage with regard to the

Leonards.    Mr. Leonard and his estranged wife agreed to a property

settlement divorce and separation agreement.            Pursuant to this

agreement,   Mrs.   Leonard   received    from   Mr.   Leonard   money   and

property valued at $1,680,000.           She also received a 1985 380

Mercedes Benz automobile (which had previously been owned by

petitioner), as well as 1,165,000 class A shares of RLLH stock.

       Following his divorce, Mr. Leonard decided to restructure his

companies in light of his imminent retirement. Mr. Leonard retired

in mid-1988.
                                         -12-

William T. Perks

       William T. Perks is a Canadian chartered accountant and

attorney who served as Mr. Leonard's tax and legal adviser.                      Mr.

Perks advised Mr. Leonard on the formation and reorganization of

his pipeline industry entities and on subsequent transactions. Mr.

Perks also worked for petitioner.

       In February 1987, Mr. Leonard approached Mr. Perks about the

prospect of petitioner's paying Mr. Leonard a bonus.                    Mr. Leonard

believed that he was entitled to a bonus because: (1) The All

American    Pipeline   project       was    completed     and     petitioner     had

unencumbered     financial       resources      to   compensate     him    and   (2)

petitioner’s activities were going to cease shortly.                    Mr. Leonard

also believed he should receive from petitioner an amount equal to

the value of the money and property ($1,680,000) awarded to his

former wife in their divorce proceedings.

       In connection with Mr. Leonard’s request, Mr. Perks consulted

with   Arthur    Andersen    &     Co.   (Arthur     Andersen)     in    Milwaukee,

Wisconsin,      in   May     and     September       1987.      Arthur    Andersen

representatives prepared a written analysis, “R.L. Leonard-Analysis

of Reasonable Compensation-LPC Ltd.’s Y/E 9/30/87.”                 This analysis

discussed    nine    factors      relevant      to   whether    compensation      is

reasonable and provided Arthur Andersen’s opinion with respect to
                                     -13-

the application of those factors to the proposed bonus.              Arthur

Andersen concluded that five factors supported the reasonableness

of   the   proposed   bonus,   one     was   undeterminable,   and   three

contradicted the reasonableness of the proposed bonus.               Arthur

Andersen recommended that petitioner document (1) that part of the

bonus was payment for past services rendered to petitioner, and (2)

the reasons why prior years’ compensation levels were inadequate.

Board Approval of the Bonus

     Petitioner's board of directors consisted of Mr. Leonard and

his son.    On September 28, 1987, petitioner’s board of directors

held a special meeting to discuss the Arthur Andersen analysis and

to determine the appropriate bonus to be paid to Mr. Leonard.           The

board understood that petitioner could deduct the bonus as an

expense under U.S. tax law. The board considered Mr. Leonard’s

service to petitioner and his prior compensation to determine the

amount of the bonus.   The minutes of the board meeting (prepared by

Mr. Perks) state, in pertinent part, as follows:


     1.   The President, through his efforts as early as 1984
     and resultant personal and business contacts acquired
     from those efforts, was able to have the corporation
     placed on the bidding list for All American Pipeline
     Company.

     2.   The President[,] having acquired expertise in the
     coating and insulation of pipe in Saudi Arabia during
     1978 through to 1980[,] was able to develop a new
                               -14-

     insulation process starting in 1984, which process was
     ultimately successful in securing the All American
     contract (the “contract”).

     3.   The corporation, notwithstanding the successful
     insulating process, would have been unable to complete
     the contract without the financial backing of a public
     corporation or a joint venture partner with financial
     backing. The President, through his thirty years
     association with the President of the Permanent Concrete
     Ltd., was able to secure a financially strong joint
     venture partner for the corporation, which partner
     secured for the joint venture Five Million Dollars
     ($5,000,000) of financing and obtained approximately
     Twenty-Three Million Dollars ($23,000,000) of bonding.
     This was accomplished without giving up more than fifty
     percent of the participation which would have otherwise
     been the case.

     4.   The    President    personally     guaranteed    the
     corporation’s share of the bank financing and indemnified
     the joint venture partner, Anchor Wate, a subsidiary of
     Permanent Concrete Ltd., in respect of the bonding and
     further pledged his assets in support of the guarantee.

     5.   The President has received no compensation from the
     corporation for 1985 and 1986. In addition, the
     corporation was unable to pay compensation to its
     President in those years due to Royal Bank of Canada
     credit line restrictions, which credit line was also
     personally guaranteed by him. Not until now, with the
     contract completed and the benefits from subsequent
     grading and fencing contracts awarded being realized, is
     the corporation in a position to adequately compensate
     its President for his unique and extremely profitable
     contribution to the corporation.

Accordingly, the board unanimously agreed to pay Mr. Leonard a

$1,680,000 bonus.
                                     -15-

Notice of Deficiency

        Respondent determined in the notice of deficiency that only

$135,207 of the $1,777,800 compensation (bonus and wages) that

petitioner paid Mr. Leonard in 1987 was reasonable.       Accordingly,

the notice of deficiency disallows the remainder of petitioner's

claimed deduction for Mr. Leonard's compensation.

                                 OPINION

     Section 162(a)(1) permits a corporation to deduct “a reasonable

allowance for salaries or other compensation for personal services

actually rendered” as an ordinary and necessary business expense.

Compensation payments are deductible under section 162(a)(1) if they

are reasonable, and paid “purely for services” rendered to the

business.      Sec. 1.162-7(a), Income Tax Regs. More specifically,

bonuses paid to employees are deductible only when made in good

faith and as additional compensation for services actually rendered

by the employees, provided that when added to the salaries, they do

not exceed reasonable compensation for the services rendered.

Rapco, Inc. v. Commissioner, T.C. Memo. 1995-128, affd. 85 F.3d 950

(2d Cir. 1996); sec. 1.162-9, Income Tax Regs.        Courts generally

focus    on   the   reasonableness   requirement.   Elliotts,   Inc.   v.

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

remanding T.C. Memo. 1980-282.
                                      -16-

       Whether an expenditure that is claimed as a section 162(a)(1)

deduction is reasonable is a factual question that must be decided

considering all the facts and circumstances.           Pacific Grains, Inc.

v. Commissioner, 399 F.2d 603, 605 (9th Cir. 1968), affg. T.C. Memo.

1967-7; Estate of Wallace v. Commissioner, 95 T.C. 525, 553 (1990),

affd. 965 F.2d 1038 (11th Cir. 1992).          Petitioner bears the burden

to show that it is entitled to a compensation deduction larger than

that allowed by respondent.          Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933); Nor-Cal Adjusters v. Commissioner, 503 F.2d

359,   361   (9th   Cir.    1974),   affg.   T.C.   Memo.   1971-200.    Should

petitioner prove respondent’s determination incorrect, then we must

decide the proper amount of reasonable compensation based upon the

entire record.      Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C.

564, 568 (1974), affd. 528 F.2d 176 (10th Cir. 1975).

       Courts   consider     numerous    factors     when   determining    the

reasonableness of compensation.          The U.S. Court of Appeals for the

Ninth Circuit, to which an appeal in this case would lie, uses the

five-factor test enumerated in Elliotts, Inc. v. Commissioner, supra

at 1245-1248: (1) The employee’s role in the company; (2) a

comparison of the compensation paid to the employee with the

compensation    paid   to    similarly    situated   employees   in     similar

companies; (3) the character and condition of the company; (4)
                                   -17-

whether a conflict of interest exists that might permit the company

to disguise dividend payments as deductible compensation; and (5)

whether the compensation was paid pursuant to a structured, formal,

and consistently applied program.       No single factor is dispositive.

Pacific Grains, Inc. v. Commissioner, supra at 606.

      Respondent essentially posits that Mr. Leonard was regularly

and fully compensated through petitioner's affiliated entities for

the services he performed.        Mr. Leonard controlled his means of

compensation, using whatever method was most tax advantageous.             In

fact, respondent argues, Mr. Leonard treated the various companies

as his personal pocketbook. Further, petitioner declared dividends

over the years, which also benefited Mr. Leonard. Respondent argues

that the 1987 payment to Mr. Leonard was not intended to compensate

him for personal services, but rather to remove capital from

petitioner because of Mr. Leonard's imminent retirement.

      Respondent thus argues that the $1,777,800 petitioner deducted

as compensation for its fiscal year 1987 is not reasonable and that

Mr. Leonard was not undercompensated in prior years.             Respondent

contends (at trial and on brief) that petitioner is not entitled to

deduct more than $160,710 as total compensation for 1987.          However,

respondent alternatively argues that should the Court determine that

Mr.   Leonard   was   also   entitled   to   a   retirement   benefit,   then
                                       -18-

petitioner would be entitled to deduct up to $328,160 as total

reasonable compensation.

       Petitioner    argues   that     it     paid      Mr.    Leonard     inadequate

compensation for its first 9 years of existence.                   After consulting

with   qualified     tax   advisers,    it       decided      to   pay   Mr.   Leonard

$1,777,800 in salary and bonus in 1987 as compensation for the

significant services he had provided over the years. Petitioner

contends that Mr. Leonard’s exceptional service to petitioner

justifies the amount paid.

       Bearing in mind the parties’ arguments, we shall analyze and

apply the factors enunciated by the U.S. Court of Appeals for the

Ninth Circuit in order to determine reasonable compensation for Mr.

Leonard.

(1) Role in Company

       The   first   factor   focuses       on    the    compensated       employee's

importance to the success of the business. Pertinent considerations

include the employee's position, hours worked, duties performed, and

the general importance of the employee to the company. 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).                      Where a large

salary increase is at issue (such as here), it is useful to compare
                                -19-

past and present duties and salary payments.       Elliotts, Inc. v.

Commissioner, supra at 1245.

     Whether an employee has personally guaranteed his employer’s

debt is also a factor to be examined in this context.        In some

instances, an employee’s personal guaranty of his employer’s debt

may entitle the employer to compensate the employee with additional

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

1325 n.33 (5th Cir. 1987), affg. T.C. Memo. 1985-267; Acme Constr.

Co. v. Commissioner, T.C. Memo. 1995-6; BOCA Constr. Inc. v.

Commissioner, T.C. Memo. 1995-5.

     The history of Mr. Leonard's contributions to petitioner must

be considered, rather than just his contributions during the year

in issue, because the compensation petitioner paid to Mr. Leonard

during the year in issue represents, in part, an attempt to rectify

prior undercompensation. Respondent readily admits that Mr. Leonard

was petitioner's key employee and the main reason for its success.

As president, he was the driving force behind the business from its

inception, and his personal services were almost single-handedly

responsible for its success.   Mr. Leonard   developed cost-effective

methods of double jointing and coating that gave petitioner a

competitive advantage in the pipeline construction industry. His

contacts and experience contributed to petitioner's business by his
                                  -20-

ability to obtain contracts from all over the world.           Mr. Leonard

was dedicated to his work and essential to petitioner's business.

     While Mr. Leonard was the driving force behind petitioner, he

was in the process of retiring during the year in issue and reduced

his workload to 7-8 hours a day, 6 days a week.        While these hours

are less than he worked in previous years, Mr. Leonard's reduced

workload must be balanced against his 40 years of knowledge and

experience in the industry.

     We are mindful that petitioner's sole activity during the year

in issue was to report income, which had previously been earned, on

a contract-completed basis.   However, because part of the bonus was

attributable to Mr. Leonard's past services, we consider this fact

unimportant.

     Finally, Mr. Leonard personally guaranteed petitioner’s $1.5

million debt to the Royal Bank of Canada.             While Mr. Leonard

testified   that   guaranteeing   debts   was   his   normal   method   of

conducting business, we believe that the personal guaranty further

illustrates Mr. Leonard's importance to petitioner. See Owensby &

Kritikos, Inc. v. Commissioner, supra.

     This factor favors petitioner.

(2) External Comparison

     This factor compares the employee’s compensation with that paid

by similar companies in similar industries for similar services.
                                  -21-

Elliotts, Inc. v. Commissioner, 716 F.2d at 1246; see sec. 1.162-

7(b)(3), Income Tax Regs.

     Both   parties   rely   on   expert    opinions   for   purposes   of

determining external comparison.         As the trier of fact, we must

weigh the evidence presented by the experts in light of their

demonstrated qualifications in addition to all other credible

evidence.   Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th

Cir. 1973), affg. 54 T.C. 493 (1970); IT&S of Iowa, Inc. v.

Commissioner, 97 T.C. 496, 508 (1991).        However, we are not bound

by any expert opinion that is contrary to our judgment.         Estate of

Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg. T.C.

Memo. 1954-139; Estate of Hall v. Commissioner, 92 T.C. 312, 338

(1989); Chiu v. Commissioner, 84 T.C. 722, 734 (1985).         We may be

selective in deciding to accept or reject expert opinion in its

entirety, or accept selective portions of it. Helvering v. National

Grocery Co., 304 U.S. 282, 294-295 (1938); Orth v. Commissioner, 813

F.2d 837, 842 (7th Cir. 1987), affg. Lio v. Commissioner, 85 T.C.

56 (1985); Seagate Tech., Inc. v. Commissioner, 102 T.C. 149, 186

(1994). We may reach a decision based on our own analysis of all the

evidence in the record.      Silverman v. Commissioner, 538 F.2d 927,

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

     Respondent’s expert, Emmett James Brennan III, prepared a

report and testified as to compensation in corporate pay practices.

Mr. Brennan is president of a compensation consulting firm who has
                                     -22-

testified before this Court on numerous occasions. See, e.g.,               PMT,

Inc. v. Commissioner, T.C. Memo. 1996-303; Lumber City Corp. v.

Commissioner, T.C. Memo. 1996-171; Pulsar Components Intl., Inc. v.

Commissioner,    T.C.   Memo.   1996-129;     Alondra    Indus.,     Ltd.    v.

Commissioner,    T.C.   Memo.   1996-32;     Guy   Schoenecker,      Inc.    v.

Commissioner, T.C. Memo. 1995-539; Mad Auto Wrecking, Inc. v.

Commissioner,    T.C.   Memo.    1995-153;     Boca     Constr.,     Inc.    v.

Commissioner, T.C. Memo. 1995-5; L & B Pipe & Supply, Inc. v.

Commissioner, T.C. Memo. 1994-187; Mortex Manufacturing Co. v.

Commissioner, T.C. Memo. 1994-110; Thomas A. Curtis, M.D., Inc. v.

Commissioner, T.C. Memo. 1994-15; Automotive Inv. Dev., Inc. v.

Commissioner,    T.C.   Memo.   1993-298;     Diverse    Indus.,     Inc.    v.

Commissioner, T.C. Memo. 1986-84; Owensby & Kritikos, Inc. v.

Commissioner, T.C. Memo. 1985-267.

     Mr. Brennan determined that $328,160 was the “highest maximum

amount of total compensation for the highest-paid position that

could be attributed to” Mr. Leonard for tax year ending September

30, 1987.   He further concluded that the “highest average amount of

total compensation for the highest-paid position that could be

attributable to” Mr. Leonard was $160,710.         Mr. Brennan based these

conclusions     on   surveys    of    the   amounts     fabricated     metals

manufacturing companies and general construction companies (with

revenues equal to petitioner’s) would pay a chief executive officer.

None of these industries was specifically involved in the pipeline
                                 -23-

construction industry.      Mr. Brennan computed his compensation

figures based solely upon gross sales revenues.7 His report neither

included an amount representing retirement benefits for Mr. Leonard8

nor analyzed amounts paid to Mr. Leonard in prior years.

     At trial, Mr. Brennan testified that petitioner substantially

underpaid Mr. Leonard prior to 1987. Mr. Brennan also admitted that

providing   a   financial   guaranty    would   justify   Mr.   Leonard's

"eligibility for those highest average and highest maximum numbers"

that he determined.

     Petitioner relied on two pipeline industry experts, Michael

Wagner and Michael Kesner. Both testified as to the unique features

of the pipeline construction industry and its relatively small size.

     Mr. Wagner has been employed as a senior executive officer in

major Canadian pipeline construction companies and at the time of

trial was an industry consultant.       His testimony regarding large

bonus payments was based solely upon his personal receipt of a

$1,300,000 bonus from his employer, O.J. Pipelines, in 1983,9 and

was not tied to any specific formula.      In Mr. Wagner's opinion, a


     7
          The gross sales revenue figure Mr. Brennan used for
petitioner was incomplete; it did not include any part of either
the net income or the gross revenue from the All American
contract.
     8
          In the event we determine (which we do) that Mr.
Leonard is entitled to a retirement benefit, Mr. Brennan would
allocate $167,450 for such benefit.
     9
            O.J. Pipelines' 1983 gross revenues exceeded $100
million.
                               -24-

reasonable range for Mr. Leonard's 1987 base salary was $180,000-

$200,000; a reasonable range for his 1987 bonus was $1,200,000-

$2,000,000.

     Mr. Kesner is an expert specializing in compensation matters

for Arthur Andersen in Chicago.10   He concluded that Mr. Leonard’s

1987 compensation was reasonable for three alternative reasons: (1)

Mr. Leonard was undercompensated by $2,005,000-$2,700,000 in prior

years; (2) the compensation was a deal bonus for locating and

delivering profitable business opportunities; and (3) part of the

bonus was a lump-sum payment in lieu of a formal retirement plan.

Mr. Kesner used survey data, and assumed revenues of $40 million for

each of the years.

     We are unpersuaded by the analyses performed or opinions

expressed by either respondent’s or petitioner’s experts.     As in

previous cases, we do not accept Mr. Brennan's conclusions because

they are not based on data from businesses that are sufficiently

similar to petitioner’s or that have the significant characteristics

of a specialized industry.    Messrs. Wagner and Kesner were also

unconvincing because they were not objective and simply promoted

petitioner’s position.   See Laureys v. Commissioner, 92 T.C. 101,

129 (1989).   We do not accept their conclusions.




     10
          Mr. Kesner was not involved in Arthur Andersen's 1987
advice to Mr. Perks and petitioner.
                                           -25-

(3)   Character and Condition of Company

      The    next       factor    considers       the   company's    character       and

condition.       Relevant    considerations         are   the    company’s    size    as

measured     by     its    sales,    net    income,       or    capital   value;     the

complexities of the business; and general economic conditions.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1246; see E. Wagner &

Son, Inc. v. Commissioner, 93 F.2d 816, 819 (9th Cir. 1937).

      Petitioner, a relatively large company, was engaged in the

highly specialized pipeline construction business. The pipeline

construction industry is noted for periods of growth and subsequent

decline.     Mr. Leonard's double-jointing process, which was a unique

method      at    the     time,   helped     promote      petitioner's       business.

Petitioner's income stream was dependent upon Mr. Leonard's ability

to successfully bid and perform lucrative contracts.

      The ratio of Mr. Leonard's 1987 bonus to gross sales for that

year is 29 percent ($1,680,000 divided by $5,740,283).                       The ratio

of Mr. Leonard's 1987 bonus to petitioner's taxable income before

the compensation deduction is 34 percent ($1,680,000 divided by

$4,922,631). These percentages are reasonable in light of Mr.

Leonard's work for petitioner over the years as well as the prior

years' undercompensation.

      This factor favors petitioner.
                                 -26-

(4)   Conflict of Interest




      The next factor considers potential conflicts of interest.

This factor examines whether a relationship exists between the

company and employee that might permit the company to disguise

nondeductible     corporate   distributions   as   section   162(a)(1)

deductible compensation. We must closely scrutinize cases where the

paying corporation is controlled by the compensated          employee.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1324;

Elliotts, Inc. v. Commissioner, supra at 1246-1247.     However, “the

mere existence of such a relationship * * * 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.     We adopt the perspective of an independent investor

to determine whether the investor would be satisfied with the

company’s return on equity after the compensation at issue was paid.

Id. at 1247.     Return on equity is calculated by dividing taxable

income before net operating losses by the shareholder’s equity. Id.

at 1245, 1247.

      Mr. Leonard was not a direct shareholder of petitioner; rather,

he indirectly owned all of petitioner's stock by virtue of his

ownership of RLLH.    Thus, this is a scenario that we must closely

scrutinize for the effects of a conflict of interest.
                                     -27-

     While petitioner declared dividends to RLLH in 1983 and 1985,

petitioner neither directly paid dividends to Mr. Leonard nor paid

dividends during the year in issue.                Petitioner's compensation

scheme was bonus-heavy and salary-light, which may suggest masked

dividends.     See Rapco, Inc. v. Commissioner, 85 F.3d at                .

     However, in evaluating the compensation payment from the

perspective of a hypothetical investor, we divide taxable income

before net operating losses by the shareholder's equity for each

fiscal year:

                       Taxable Income        Shareholder's         Return on
Fiscal Year            Before NOL's             Equity             Investment

   1986                 ($141,442)                 $969,242             -15%

   1987                 3,119,831              1,786,314                175%

Petitioner's    rate   of   return   for    1987    would     surely   satisfy   a

hypothetical investor.       See Elliotts, Inc. v. Commissioner, supra

at 1247 (an average return on equity of 20 percent would satisfy an

independent investor).

     The evidence bearing on this factor weighs in both directions.

Petitioner did not declare dividends in 1987, and Mr. Leonard's

compensation was bonus-heavy and salary-light.              On the other hand,

a hypothetical investor would be satisfied with the annual 1987

return.   We thus consider this factor neutral.

(5) Internal Consistency

     The final factor focuses on whether the compensation was paid

pursuant to a structured, formal, and consistently applied program.

Bonuses not paid pursuant to such plans are suspect. Id.
                                 -28-

     The record does not indicate that petitioner determined Mr.

Leonard’s bonus based on any consistently applied formula or plan.

Neither is there information in the record regarding petitioner's

other employees.

     It is, however, permissible to pay and deduct compensation for

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

281 U.S. 115, 119-120 (1930); American Foundry v. Commissioner, 59

T.C. at 239.   Petitioner did not compensate Mr. Leonard during 1985

and 1986 for two reasons. First, the pipeline construction industry

is volatile, and petitioner's earning history reflects the classic

cycle of boom and bust.    Petitioner was unable to pay Mr. Leonard

a bonus prior to 1987 because of economic instability.     Secondly,

petitioner’s board of directors determined that the restrictions

placed by the Royal Bank of Canada prohibited petitioner from

compensating Mr. Leonard during these years. In 1987, the board

concluded that petitioner benefited from Mr. Leonard’s securing the

right to bid on and participate in large pipeline construction

projects, as well as his expertise and reputation in the coating and

insulation of pipe.    While we are mindful that petitioner's board

consisted only of Mr. Leonard and his son, we nonetheless believe

(and thus hold) that petitioner's 1987 compensation to Mr. Leonard

represented, in part, an attempt to rectify his 1985 and 1986

undercompensation,11   see Lucas v. Ox Fibre Brush Co., supra, and in


     11
          The fact that Mr. Leonard was compensated by the
petitioner-Anchor Wate joint venture in 1985 and 1986 does not
                                                   (continued...)
                                       -29-

part, an attempt to recoup from petitioner part of the payments Mr.

Leonard had made pursuant to his divorce settlement.

     We are also mindful that high compensation is more reasonable

when there is a corresponding lack of fringe benefits such as

pension plans or stock options which might normally be expected.

Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988), affg.

T.C. Memo. 1986-407.      In these situations, an employer may pay more

compensation than it would have paid had it offered a pension or

profit    sharing    plan.      Petitioner     did   not   have   any   type   of

retirement plan.

     Here,    on    the   one   hand   there   was    no   formal,   consistent

compensation program, and the 1987 bonus was partially an attempt

to recoup from petitioner part of the payments Mr. Leonard had made

pursuant    to   his   divorce    settlement;    on    the   other   hand,     the

compensation was paid, in part, to correct prior undercompensation

and to rectify the absence of a pension plan.                Accordingly, this

factor is neutral.

Amount of Reasonable Compensation

     Having thoroughly considered the evidence, and in light of the

factors enunciated by the U.S. Court of Appeals for the Ninth

Circuit, we conclude that petitioner paid excessive compensation to

Mr. Leonard in fiscal year 1987.         However, in light of the value of




     11
      (...continued)
change this conclusion.
                                  -30-

Mr. Leonard’s services, we are persuaded that petitioner is entitled

to a greater compensation deduction than that allowed by respondent.

     Any   attempt    to   determine     reasonable   compensation   with

mathematical precision is impossible. See, e.g., Jones Bros. Bakery

v. United States, 188 Ct. Cl. 226, 245, 411 F.2d 1282, 1294 (1969).

Using our best judgment, we conclude that $700,000 would represent

a reasonable amount of compensation to Mr. Leonard for 1987.          The

$700,000 amount represents $300,000 as a lump-sum retirement payment

and $400,000 for salary and bonus.       See Pepsi-Cola Bottling Co. of

Salina, Inc. v. Commissioner, 61 T.C. 564, 568 (1974), affd. 528

F.2d 176 (10th Cir. 1975); see also Cohan v. Commissioner, 39 F.2d

540 (2d Cir. 1930).

     To reflect concessions and the foregoing,


                                             Decision will be entered

                                         under Rule 155.
