                         T.C. Memo. 1997-421



                       UNITED STATES TAX COURT



          MAX BURTON ENTERPRISES, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 26467-95.                Filed September 22, 1997.



     James A. Jensen, Charles J. Ingber, and Joel P. Leonard,

for petitioner.

     Robert S. Scarbrough, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Chief Judge:    Respondent determined a deficiency of

$214,220 in petitioner’s Federal income tax for the tax year

ended June 30, 1990.   The issue for decision is whether

deductions claimed by petitioner for salary and bonuses paid to
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its officers, who were also shareholders, exceeded reasonable

compensation.

     Unless otherwise indicated, 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.

                        FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.    At the

time the petition was filed, petitioner’s principal place of

business was in Tacoma, Washington.    During the year in issue,

petitioner produced and sold stove-top grills, stove-top burner

covers, and other kitchen accessories.

     Petitioner was incorporated in the State of Washington on

September 5, 1979, by Max Burton.   Max Burton was the father of

Linda Burton (Ms. Burton) and Alfred Burton (Mr. Burton) and the

husband of Evelyn Burton.   Ms. Burton was married to Robert

Denovan (Denovan).

     From September 13, 1979, through June 30, 1983, Max Burton

served as president and treasurer, and Mr. Burton served as vice

president and secretary, of petitioner.    From July 1, 1983,

through his death on July 3, 1997, Max Burton was president and

treasurer, Ms. Burton was vice president, and Mr. Burton was

secretary, of petitioner.   From July 7, 1987, through June 30,
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1990, Ms. Burton was president, Denovan was vice president, and

Mr. Burton was secretary and treasurer, of petitioner.

     Immediately prior to Max Burton’s death, the outstanding

shares of petitioner were owned as follows:

                 Owner                      Shares Owned

            William Mueller                       500
            Max Burton                          7,300
            Linda Burton                          500
            Alfred Burton                       1,100
            Robert Denovan                        600
              Total                            10,000

The 500 shares of stock owned by William Mueller were redeemed by

petitioner for $5,000 during the tax year ended June 30, 1990.

As of June 30, 1990, the outstanding shares of petitioner were

owned as follows:

                         Number of               Percentage of
                         Shares Held             Shares Held

Linda Burton                1,100                       44%
Alfred Burton               1,100                       44%
Evelyn Burton                 150                        6%
Robert Denovan                150                        6%

     In November 1985, Max Burton was diagnosed with cancer.         He

underwent chemotherapy and surgery.          During his illness,

petitioner’s business, as described by Ms. Burton, “pretty much

ran itself.”    Attempts to sell the business had been

unsuccessful, and Max Burton was anxious to have the business

continue.    Max Burton spoke to Ms. Burton, Mr. Burton, and

Denovan about continuing the business.          Ms. Burton was initially
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reluctant but agreed only when Max Burton consented to her ideas

about increasing the level and scope of business activity.

     In June 1986, Max Burton and Ms. Burton went to Korea, where

the burner covers that were sold by petitioner were manufactured.

They observed a cooking concept known as “bulgogi”, in which meat

was cooked on a metal plate placed over hot charcoal.    As of

January 1, 1987, Ms. Burton took over the affairs of petitioner.

By 1987, petitioner, primarily through the efforts of Ms. Burton,

had adapted the bulgogi cooking concept to American stove

burners.    The “Burton Stove Top Grill” was first sold in the U.S.

market in 1987.

     Ms. Burton attended community college for 2 years after high

school.    After taking over petitioner’s business, she attended

continuing education classes in finance for small businesses,

computers, advertising, letter writing, brochure writing, and

employee relations.    Between 1976 and 1978, she worked with her

father as he started the burner cover business, but she was not

paid for that work.    After completing her 2 years of college, she

worked for Alaska Airlines for a year.    She then worked for the

Port of Seattle Police Department for 5 years, but she left there

in 1982 when she married Denovan, who was a sergeant with the

Port of Seattle Police Department.

     In 1982, Ms. Burton was employed in petitioner’s business.

At that time, Ms. Burton made initial sales calls, developed
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sales promotional material, and developed an in-house system of

tracking customers to increase sales.    Because of declining

business and differences with her father about business

decisions, Ms. Burton left petitioner in 1985 and began to work

for Continental Airlines.

     Ms. Burton worked at Continental Airlines until 1987 and

remained as an employee on inactive status until 1990.    While at

Continental Airlines, she was a customer service agent for about

6 months and then was promoted to a supervisory position.    She

very much enjoyed that job and particularly the valuable travel

benefits available by reason of that employment.

     After the death of Max Burton, no employee of petitioner had

executive responsibilities other than Ms. Burton, Mr. Burton, and

Denovan.   Ms. Burton was responsible for the general management

of petitioner.   She directly supervised the other two officers,

established company goals and philosophies, and directed

manufacturing quality control.    She was responsible for seeking

overseas manufacturers, and she personally negotiated

manufacturing and shipping agreements with them.    Many of the

contracts that were negotiated by Ms. Burton were with Korean

companies.   She traveled to foreign countries, including Korea,

Taiwan, and China, in order to seek overseas manufacturers and to

negotiate manufacturing and shipping agreements.
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     Ms. Burton established and was personally involved in the

operation of petitioner’s public relations division, creating

various advertising and sales-related literature and other

promotional materials.   She designed the packaging material for

petitioner’s products and promoted petitioner to various national

and regional newspapers.   As petitioner’s spokespersons and

goodwill ambassadors, Ms. Burton and Denovan planned and

personally participated in national trade shows to promote

petitioner’s products since 1987.

     Ms. Burton implemented a strategic change in petitioner’s

marketing focus.   Prior to her becoming president, petitioner had

sold its goods primarily to small giftware shops.   She eliminated

petitioner’s catalog/retail sales and concentrated on selling

petitioner’s products on a wholesale basis.   To implement the

change in marketing focus away from the small giftware shops to

the large national department stores, new sales representatives

were required.

     Denovan replaced petitioner’s existing force of giftware

sales representatives with houseware sales representatives.

Denovan assembled a nationwide team of sales representatives,

managed through a network of sales organizations.   Ms. Burton and

Denovan negotiated commission agreements with petitioner’s sales

representatives and agreed to pay the sales representatives a

commission of up to 15 percent.   As a result of its change in
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marketing strategy, petitioner secured national department stores

including J.C. Penney’s, Bloomingdale’s, the Bon Marche, Dayton

Hudson, Marshal Field’s, and Dillards as new customers for

petitioner’s products.

     When Ms. Burton became president of petitioner, petitioner

had a $60,000 line of credit with the Bank of Puget Sound.      When

the Bank of Puget Sound refused to increase petitioner’s line of

credit, Ms. Burton approached other banks.    SeaFirst Bank agreed

to provide petitioner with a $100,000 line of credit.    From 1988

through 1990, Ms. Burton and Mr. Burton worked closely with

Robert Drugge, a vice president of SeaFirst Bank, to increase

petitioner’s line of credit to finance petitioner’s expansion.

SeaFirst Bank began providing letters of credit that were used by

petitioner and issued to manufacturers of petitioner’s products.

On or about June 1, 1990, SeaFirst Bank increased petitioner’s

line of credit to $2,700,000.    During the relevant periods,

Ms. Burton, Mr. Burton, and Denovan signed personal guaranties to

guaranty the repayment of lines of credit extended by the Bank of

Puget Sound and SeaFirst Bank.

     Mr. Burton, as secretary and treasurer of petitioner, was

responsible for all accounting functions of petitioner, prepared

financial plans and budgets, prepared loan applications, and was

in charge of relations with SeaFirst Bank.    Mr. Burton studied

accounting and computer operations at a community college.
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Beginning in 1982, Mr. Burton designed, installed, and maintained

the computer system of petitioner.       Part of that system included

a program that tracked customer responses to advertisements and a

program used for the company’s accounting.      At all relevant

times, Mr. Burton also worked for a company known as Fiserv,

installing computer systems for banks.

     As vice president of petitioner, Denovan developed and

executed sales and marketing strategies and was responsible for

organizing and managing petitioner’s national sales

representatives.    He was responsible for hiring employees and was

in charge of the shipping of petitioner’s products from suppliers

to vendors.   During the calendar year 1990, petitioner employed a

total of 30 employees.    At all relevant times, Denovan was

employed full time by the Port of Seattle Police Department,

where he was responsible for training and scheduling special

teams of police.

     Petitioner had gross receipts and retained earnings for its

tax years as follows:

                         1987       1988          1989         1990

Gross receipts        $990,388   $975,254      $1,222,973   $4,675,219
Retained earnings      215,154    231,401         241,839      341,239

     On June 29, 1990, bonus checks were issued by petitioner.

Bonuses were paid to Ms. Burton, Mr. Burton, and Denovan in the

amounts of $700,000, $200,000, and $100,000, respectively.

Twenty percent of these amounts was withheld and paid to the
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Internal Revenue Service as Federal income tax.               The proceeds of

the bonus checks were immediately returned to petitioner in

exchange for promissory notes dated June 29, 1990.                The bonuses

that were paid to petitioner’s employees during the calendar year

1990, other than amounts paid to its officers, were each less

than $1,000.

     The total compensation (salary and bonus) deducted by

petitioner for its tax years was as follows:

          1984      1985         1986     1987     1988        1989       1990

Linda
Burton    $22,078     0      $   600    $11,000   $24,000    $59,225    $751,750

Alfred
Burton     7,957    $2,625   4,800        8,950    7,000       7,100     217,750

Robert
Denovan     0         0          0         0         800       3,500     110,750


Petitioner had a group medical and life insurance plan for all of

its employees, including its officers.            The officers decided to

take their compensation in the form of salary and bonuses and not

to adopt a pension or other retirement plan.                Petitioner did not

pay dividends.

     Respondent determined that the amount of compensation that

was paid to the above individuals was unreasonable.                   The salaries

that were claimed were allowed as reasonable compensation, but

bonuses were reduced as follows:

     Ms. Burton’s salary                          $ 51,750
     Bonus allowed                                 258,880
     Total allowed                                $310,630
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     Mr. Burton’s salary                    $ 17,750
     Bonus allowed                            88,890
     Total allowed                          $106,640

     Denovan’s salary                       $ 10,750
     Bonus allowed                            56,630
     Total allowed                          $ 67,380

                               OPINION

     Section 162(a)(1) allows as a deduction “a reasonable

allowance for salaries or other compensation for personal

services actually rendered”.   Section 1.162-9, Income Tax Regs.,

provides that bonuses paid to employees are deductible “when such

payments are made in good faith and as additional compensation

for the services actually rendered by the employees, provided

that such payments, when added to the stipulated salaries, do not

exceed a reasonable compensation for the services rendered.”

     Whether an expense that is claimed pursuant to section

162(a)(1) is reasonable compensation for services rendered is a

question of fact that must be decided on the basis of the

particular facts and circumstances.      Paula Constr. Co. v.

Commissioner, 58 T.C. 1055, 1058-1059 (1972), affd. without

published opinion 474 F.2d 1345 (5th Cir. 1973).       The burden is

on petitioner to show that it is entitled to a compensation

deduction larger than that allowed by respondent.       Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1324 (5th Cir.

1987), affg. T.C. Memo. 1985-267.
                               - 11 -


     Under certain circumstances, prior services may be

compensated in a later year.   Lucas v. Ox Fibre Brush Co., 281

U.S. 115 (1930); American Foundry v. Commissioner, 59 T.C. 231,

239 (1972), affd. in part and revd. in part 536 F.2d 289 (9th

Cir. 1976).   However, in such instances, the taxpayer must

establish that there was not sufficient compensation in the prior

periods and that, in fact, the current year’s compensation was to

compensate for that underpayment.   Estate of Wallace v.

Commissioner, 95 T.C. 525, 553-554 (1990), affd. on another

ground 965 F.2d 1038 (11th Cir. 1992).

     The cases contain a lengthy list of factors that are

relevant in the determination of reasonableness, including:   The

employee’s qualifications; the nature, extent, and scope of the

employee’s work; the size and complexities of the business; a

comparison of salaries paid with gross income and net income; the

prevailing general economic conditions; a comparison of salaries

with distributions to stockholders; the prevailing rates of

compensation for comparable positions in comparable concerns; the

salary policy of the taxpayer as to all employees; and the amount

of compensation paid to the particular employee in previous

years.   Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115

(6th Cir. 1949), affg. a Memorandum Opinion of this Court; see

also Commercial Iron Works v. Commissioner, 166 F.2d 221, 224

(5th Cir. 1948).   In Elliotts, Inc. v. Commissioner, 716 F.2d
                              - 12 -


1241, 1245-1247 (9th Cir. 1983), revg. and remanding T.C. Memo.

1980-282, the Court of Appeals for the Ninth Circuit divided the

factors into five broad categories, to wit, the employee’s role

in the company; comparison of the employee’s salaries with those

paid by similar companies for similar services; the character and

condition of the company, including the complexities of the

business and general economic conditions; factors indicating a

conflict of interest, such as the employee’s shareholder status;

and internal consistency in a company’s treatment of payments to

employees.   No single factor is determinative.    Pacific Grains,

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

T.C. Memo. 1967-7; Home Interiors & Gifts, Inc. v. Commissioner,

73 T.C. 1142, 1156 (1980).   When the case involves a closely held

corporation with the controlling shareholders setting their own

level of compensation as employees, the reasonableness of the

compensation is subject to close scrutiny.   Owensby & Kritikos,

Inc. v. Commissioner, supra; Elliotts, Inc. v. Commissioner,

supra at 1246.

     Respondent relies on Maggio Bros. Co. v. Commissioner, 6

T.C. 999, 1006 (1946), and contends that the bonuses in question

were not paid during petitioner’s 1990 tax year.    Respondent

argues that the payments by checks dated June 29, 1990, and

immediate loans back to petitioner “lacked economic substance and

were entered into solely for tax-avoidance purposes.”    Respondent
                                - 13 -


acknowledges that, because this argument was not set forth in the

statutory notice, respondent bears the burden of proof on this

issue.   We are not persuaded that the evidence in the record

supports the conclusion that bonuses were not actually paid

during the tax year in issue.    Respondent has not proven that

this case is comparable to Maggio Bros. Co. v. Commissioner,

supra at 1006, where “the stockholders had no intention of

receiving the proceeds of the bonus checks as salary payments in

the respective taxable years”.    Id.    We do, however, consider the

facts concerning those transactions as part of our analysis of

whether the compensation deducted by petitioner was reasonable.

     A second area of dispute between the parties is whether the

bonuses that were paid for the fiscal year ended in 1990 were

intended to compensate the recipients of those bonuses for

undercompensation in earlier years.      Ms. Burton, Mr. Burton, and

Denovan each testified credibly that they accepted minimal

compensation in the early developmental years in anticipation

that their efforts would be rewarded in later years.     We are

persuaded that the bonuses that were paid in June 1990 were

intended in part to compensate for undercompensation in earlier

years.

     Petitioner must also prove that its executive employees were

in fact undercompensated in earlier years.     Respondent argues

that the executives were not undercompensated in earlier years
                                - 14 -


based on limited sales and low or negative return on equity in

the earlier years.   Each party presented expert testimony in

support of its positions on appropriate compensation levels.     We

are not bound by the opinion of any expert when the opinion is

contrary to our own judgment.     Bausch & Lomb, Inc. v.

Commissioner, 92 T.C. 525, 597 (1989), affd. 933 F.2d 1084 (2d

Cir. 1991).    We may embrace or reject expert testimony, whichever

in our judgment is most appropriate.     Helvering v. National

Grocery Co., 304 U.S. 282, 295 (1938).    Thus, we are not

restricted to choosing the opinion of one expert over another but

may extract relevant findings from each in drawing on our own

conclusions.    Estate of Hall v. Commissioner, 92 T.C. 312, 338

(1989).   Here, the experts’ usefulness is primarily in the data

that they collected and analyzed rather than in their ultimately

subjective evaluations of petitioner’s officers.

     Respondent’s expert, E. James Brennan III (Brennan),

determined “maximum” and “highest average” annual total

compensation levels for each position.    He acknowledged that, in

comparison to other officers in similar businesses, petitioner’s

officers were undercompensated.    He concluded that Ms. Burton was

entitled to a high level of compensation and that during fiscal

years 1988 and 1989 Ms. Burton was paid approximately $67,000

below the average total compensation amounts paid to chief

executive officers of bonus-paying companies of similar size.
                              - 15 -


Brennan then attempted to justify the undercompensation by

referring to Ms. Burton’s limited relevant experience and lack of

formal credentials.   He opined:

     If Petitioner’s top financial and sales executives (who
     worked only part-time * * *) were similarly credited
     with half the highest average rates for experienced
     full-time executives in same-size enterprises, that
     would create approximately $45K in undercompensation in
     FY88, and approximately $40K in FY89. Such amounts are
     more than made up by granting them the highest averages
     in FY90, when they were still part-time executives with
     minimal objective credentials.

     We agree that the executives’ limited experience and lack of

formal credentials could be factors to be taken into account.

There is, however, no evidence in the record of the experience or

credentials of those persons earning the salaries that the

experts used for comparison, and petitioner’s business is not of

the character requiring formal education.   Thus perceived

deficiencies in formal training of the employees should not be

used as a direct offset from compensation determined by the use

of comparables.

     Petitioner’s expert, Tracy A. Bean (Bean) of Arthur Andersen

LLP, did not address the limited experience and credentials of

the executives.   Nor did she consider the lack of complexity of

the business operations of petitioner.   She added $257,665 for

long-term incentives and $16,623 for retirement benefits to the

cash compensation averages of the comparable companies.   We

believe that these additions are unwarranted without proof that
                               - 16 -


petitioner’s employees could command such incentives in a

business controlled by outside investors.    See Elliotts, Inc. v.

Commissioner, 716 F.2d at 1245.

     Bean did not determine reasonable salaries for each of the

executives separately.    Using comparisons at the 75th percentile,

she concluded that petitioner “could have paid compensation to

its executive team for 1987 to 1990 in the amount of $1,411,700.”

We are not persuaded that the amounts should be aggregated in

this manner.   Rather, compensation to each officer should be

separately evaluated.    Bean’s “team” approach inappropriately

treats all three executives as performing above average services.

     Upon consideration of all of the data in the experts’

reports, the stipulated facts, and the testimony of petitioner’s

officers concerning the roles that they performed in petitioner’s

business, we conclude that Ms. Burton’s contributions were

extraordinary but that those of Mr. Burton and Denovan were not.

Thus Ms. Burton’s compensation should take into account Brennan’s

“highest maximum” ($378,260) and Bean’s 90th percentile

($312,905) compensation to chief executive officers and add

undercompensation acknowledged by Brennan for 2 years.    In

addition to her role as chief executive officer, Ms. Burton

shared with Denovan many duties of a sales executive and is

entitled to a supplement for that role.    See Elliotts, Inc. v.

Commissioner, supra at 1245.
                                - 17 -


     Mr. Burton’s compensation should take into account Brennan’s

“highest average” ($73,540) and Bean’s median ($68,741) for chief

financial officers as well as the undercompensation acknowledged

by Brennan for 2 years.   Denovan’s compensation should take into

account Brennan’s “highest average” ($89,430) and Bean’s median

($81,937) for top sales executives and undercompensation

acknowledged by Brennan for 2 years.     Petitioner has not

persuaded us that the undercompensation levels exceeded those

acknowledged by Brennan and thus has failed to meet its burden of

proving greater entitlements.

     Using our best judgment on the entire record, we conclude

that, for the fiscal year ended June 30, 1990, reasonable

compensation, including compensation for earlier years, is

$525,000 for Ms. Burton and $160,000 for Mr. Burton.     The amount

determined in the same manner for Denovan would exceed the amount

paid to him during that year, and petitioner’s deduction is

limited to the amount actually paid.     To take account of these

conclusions,

                                           Decision will be entered

                                     under Rule 155.
