                          T.C. Memo. 1997-338



                      UNITED STATES TAX COURT



    SUNBELT CLOTHING COMPANY, INC., f.k.a. UNPRINTED T-SHIRT
WAREHOUSE, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE,
                           Respondent



     Docket No. 704-95.                         Filed July 28, 1997.



     Stanley L. Blend and Elizabeth A. Dawson, for petitioner.

     Melanie R. Urban, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:   Respondent determined deficiencies in

petitioner's Federal income taxes and an addition to tax as

follows:
                                 - 2 -


                                         Accuracy-related Penalty
           FYE        Deficiency               Sec. 6662(a)1

         7/29/90      $677,203                  $135,441
         7/28/91       650,359                   130,072
         8/02/92       499,789                    99,958
     1
      Respondent has conceded the accuracy-related penalty under
sec. 6662(a) for the years in issue.


     After concessions, the sole issue for decision is whether

the amount of compensation paid by petitioner to its officers,

Daniel Bennett and Burton Sokol, was reasonable and thus

deductible as a business expense under section 162(a).1


                         FINDINGS OF FACT


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

The stipulation of facts and second stipulation of facts are

incorporated herein by this reference.

     Petitioner is a catalog wholesaler of fashionable women's

sportswear.   Its principal place of business was in San Antonio,

Texas, at the time the petition was filed in this case.

Petitioner was incorporated on June 12, 1978, under the name

Unprinted T-Shirt Warehouse, Inc.    Its name was changed to

Sunbelt Clothing Co. on January 25, 1991.



     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                   - 3 -


     Petitioner's original shareholders and their respective

shareholdings were:


                Shareholder                Shareholdings

              Daniel A. Bennett             45   shares
              William P. Wylie              15   shares
              John T. Wylie                 15   shares
              William W. Robbins            10   shares
              James B. Morris               15   shares


     Petitioner's original plan to issue 10 shares of stock to

William W. Robbins and 15 shares of stock to James B. Morris was

canceled due to their desire to cease active participation in

petitioner.    During petitioner's first year of operations, Mr.

Bennett hired Mr. Sokol as an employee to help him with the

business.   On June 29, 1979, Mr. Sokol became a shareholder in

petitioner by purchasing 15 shares of stock from Mr. Bennett and

obtaining 15 treasury shares from petitioner.             As a result of

these transactions, Mr. Sokol and Mr. Bennett each became a one-

third shareholder of petitioner.      The final one-third was held by

John T. Wylie and his son, William.         With the exception of Mr.

Wylie and his son, none of petitioner's shareholders were related

to one another through blood or marriage.          On December 31, 1982,

the stock of William P. Wylie and John T. Wylie was redeemed by

petitioner.    After that redemption, Messrs. Bennett and Sokol

became equal shareholders in petitioner.
                               - 4 -


     Prior to petitioner's incorporation, Mr. Bennett owned a

printed T-shirt business, which he started in 1973 or 1974.    Mr.

Bennett chose to distinguish petitioner from other industry

participants by creating "Sunbelt"-branded product lines and

distributing them through a company-designed catalog that was

mailed directly to existing and potential customers.   The catalog

was an efficient and economical way for petitioner to offer its

clothing lines to a large number of customers without incurring

the expenses associated with direct salespeople.   Petitioner's

initial catalog consisted of only two pages and was sent to

customers found through trade journal advertisements or in the

yellow pages.   Petitioner's catalog expanded from 20 pages in

1982 to approximately 100 pages by 1989.   During fiscal years

ending July 29, 1990, July 28, 1991, and August 2, 1992,

petitioner produced eight catalogs per year, which included four

full-scale seasonal catalogs and at least four sale and special

mailing catalogs.   Petitioner mailed over 250,000 copies of each

catalog to various wholesalers and retail customers.   From these

mailings, petitioner generated over 100,000 customers.

Petitioner's customers have traditionally been small retail

clothing and general merchandise stores.   Orders for merchandise

were processed using inhouse trained telephone personnel

operating through phone banks at petitioner's offices.
                                 - 5 -


     Petitioner worked with a large number of outside contractors

to provide all its products.   For any given garment, petitioner

would typically work closely with other companies to design the

garment and with manufacturers to develop and approve product

samples, coordinate raw materials production, and insure that

quality products were delivered on a timely basis.   Bid proposals

and product samples were solicited from several manufacturers,

and petitioner would contract for specific production amounts

with one or more manufacturers.    During each of the fiscal years

1990 through 1992, petitioner purchased clothing products from 25

to 50 different manufacturers.

     Prior to petitioner's 1992 fiscal year, completed products

were delivered to petitioner at one of six warehouses in San

Antonio, Texas.   Sometime in fiscal year 1991, Mr. Bennett hired

the architects and the builder and found the land to build a new

150,000-square foot distribution center to improve petitioner's

inventory management and customer service capabilities.   Mr.

Bennett also contracted for a computerized state-of-the-art

inventory tracking system to provide for more efficient order

picking, packing, and billing operations.   Mr. Bennett also

implemented additional technological advancements, such as wire-

guided forklifts for the new distribution center.

     As petitioner's president, Mr. Bennett was in charge of day-

to-day operations.   During petitioner's formative years, Mr.
                                - 6 -


Bennett took primary responsibility for originating the concepts

for products; choosing the colors for T-shirts and clothing to be

manufactured and marketed; determining the forecast of customer

orders based on previous years' sales activity; determining the

quantity, sizes, and colors to order for the upcoming seasons of

each product; hiring and training personnel; developing a

marketing plan; developing petitioner's customer base;

advertising and promotion; and developing a plan to fill customer

orders.

     Mr. Bennett was a hands-on manager, involved in every aspect

of petitioner's operations.   He was responsible for the

development of petitioner's catalog, which included the hiring of

the photographers and models that were used to produce the

catalogs.   He also approved the clothing, sketches, and colors

for the photography sessions.   In addition, Mr. Bennett attended

and directed the sessions, which required traveling to the

various locations.   Mr. Bennett also worked with the catalog

design personnel to review the approximately 7,200 slides taken

for each catalog in order to decide on the layout of the catalog.

Furthermore, Mr. Bennett determined how much space in a catalog

to allocate to each product, the layout of pictures in the

catalog, and which product photographs to pair with others.

During the years at issue, sketches for photograph sessions were

always approved by Mr. Bennett before the session took place.     He
                                 - 7 -


also selected and approved each and every product to be included

in the catalog.   Mr. Bennett was also constantly researching

products and fashion forecasts for national and international

markets.   He also personally designed many of petitioner's

products over the years.   Mr. Bennett typically worked 60 or more

hours per week, 7 days a week.

     Mr. Bennett hired Mr. Sokol as an employee because of Mr.

Sokol's qualifications in the textile industry.    Mr. Sokol held a

bachelor of science degree in textile engineering.   Prior to

coming to work for petitioner, Mr. Sokol worked in Mexico for 25

to 30 years, first as the general manager of a knitting firm and

then as owner of a textile machinery sales firm.   Mr. Sokol's

duties during petitioner's formative years were to locate

manufacturers to make the products according to Mr. Bennett's

specifications, visit and inspect the factories to ensure they

had adequate machinery and personnel to fill the volume of orders

that petitioner would be demanding, and assure that the products

of the manufacturers met petitioner's quality control

specifications.   In addition, Mr. Sokol oversaw the operations at

petitioner's warehouse and maintained its facilities.

     During the years in issue, Mr. Sokol was dealing with 50 or

more manufacturers.   Mr. Sokol visited the manufacturing

facilities throughout the United States and abroad, so that

quality control and on-time supply could be assured.    In
                                - 8 -


addition, Mr. Sokol oversaw petitioner's inventory operations at

six separate warehouse locations.   Mr. Sokol worked full time for

petitioner, as well as many weekends and late nights.

     On August 9, 1991, petitioner redeemed all of Mr. Sokol's

stock, leaving Mr. Bennett as the sole shareholder.    There was no

connection between the redemption of Mr. Sokol's stock and the

compensation previously paid to Mr. Bennett and Mr. Sokol during

the years in issue.    The purpose of the redemption was to allow

Mr. Sokol to retire.   Nevertheless, after the redemption, he

remained as a part-time employee of petitioner working

significantly reduced hours, taking more vacations, and receiving

less pay, all at his own initiative.    Mr. Sokol worked for

petitioner until his death on November 26, 1993.

     In 1988, petitioner entered into a continuing guaranty with

Texas Commerce Bank-San Antonio for $3 million.    Mr. Bennett

personally guaranteed petitioner's obligation.    In 1989, Mr.

Sokol agreed to guarantee personally petitioner's line-of-credit.

In 1990, petitioner's credit line was amended and increased to

$6.5 million.   In 1991, the line-of-credit was increased again to

$11.5 million, and Mr. Sokol was removed as a guarantor.

     Petitioner prospered under the leadership of Messrs. Bennett

and Sokol.   The following chart reflects the yearly increases in
                                          - 9 -


petitioner's gross sales, net income, shareholder equity, and

return on equity based on beginning of year equity:2

                        Gross            Net        Shareholder     Return on Equity
       FYE              Sales          Income         Equity      (Based on beg. year)

    5/31/1980          $547,842        $33,513         $39,940            N/A
    5/31/1981         1,156,145         59,700         108,128       149.37 percent
    5/31/1982         1,586,016         63,438         174,566        58.67 percent
    5/31/1983         2,504,203         50,533         225,099        28.95 percent
    5/31/1984         3,622,449         76,662         294,761        34.06 percent
    5/31/1985         6,175,083         91,764         385,783        31.13 percent
    5/31/1986         7,833,297        124,685         510,468        32.32 percent
    7/31/19861        1,473,885         48,749         559,217          9.55 percent
    7/31/1987        10,538,339        401,344         960,561        71.77 percent
    7/31/1988        20,030,341      1,511,694       2,452,255       157.38 percent
    7/30/19892       39,802,165      3,273,771       5,702,026       133.50 percent
    7/29/1990        54,455,167      4,662,632      10,316,658        81.77 percent
    7/28/1991        69,748,749      6,754,903      17,023,561        65.48 percent
                                                                      3
    8/02/1992        70,059,961      5,550,348      13,949,909          65.95 percent

       1
         In fiscal year 1986, petitioner changed its fiscal year end to July 31, which
resulted in a short fiscal year from June 1, 1986, to July 31, 1986.
       2
         In fiscal year 1989, petitioner's taxable year was changed to a 52/53 week
fiscal year ending on the closest Sunday to July 31.
      3
          Adjusted for the buyout of Mr. Sokol's stock, which occurred on Aug. 9, 1991.




      On August 31, 1986, petitioner's board of directors (Mr.

Bennett and Mr. Sokol) met to summarize and consolidate, into one

writing, the formal and informal meetings of the board of

directors concerning the dividend policy of petitioner.

Petitioner's board of directors resolved that, prior to payment

of substantial dividends, the following would need to be

accomplished:         (1) The compensation due key personnel of

petitioner would need to be paid; (2) adequate reserves to fund



      2
          The parties have stipulated the accuracy of these figures.
                              - 10 -


existing operations would need to be maintained; (3) adequate

reserves to accommodate planned sales expansion and product-line

expansion (forecasted to be substantial for the 5 years following

the August 31, 1986, meeting) would need to be maintained; (4)

reserves to facilitate the anticipated construction of a major

warehouse facility would need to be set aside; and (5) adequate

reserves to facilitate expansion of petitioner's operations

overseas would need to be established.

     The dividends paid by petitioner during the fiscal years at

issue were:


                 Shares          Dividends       Dividends
    FYE        Outstanding         Paid          Per Share

   7/29/90         60             $48,000          $800
   7/28/91         60              48,000           800
   8/02/92         30              24,000           800


     Mr. Bennett, petitioner's president, and Mr. Sokol,

petitioner's treasurer (and later vice president), were

authorized to receive salaries for their day-to-day work as

petitioner's employees.   Nevertheless, in order to maintain

adequate cash flow at the beginning of petitioner's operations,

Mr. Bennett waived any salary payments through January 1, 1980.

As reflected in the minutes of petitioner's annual meeting of

directors on June 29, 1979, Mr. Bennett further agreed to accept

only $1,000 as monthly compensation after January 1, 1980, in

return for a resolution on behalf of petitioner to "more
                               - 11 -


adequately compensate Mr. Bennett and to reimburse Mr. Bennett by

adequately improving his salary at such future date as the

corporation is in a position to do so."   Mr. Sokol also agreed to

work for an amount less than his normal wage rate in return for

petitioner's promise to provide additional future compensation at

such time as petitioner's cash flow permitted.

     From incorporation through fiscal year 1989, petitioner paid

Messrs. Bennett and Sokol the following salaries:


             FYE            Mr. Bennett          Mr. Sokol

        6/1/78-5/31/79          -0-                 N/A
        6/1/79-5/31/80          -0-               $17,000
        6/1/80-5/31/81        $20,000              35,000
        6/1/81-5/31/82         29,000              31,000
        6/1/82-5/31/83         30,000              36,000
        6/1/83-5/31/84         43,500              49,500
        6/1/84-5/31/85         76,000              76,000
        6/1/85-5/31/86         94,000              94,000
        6/1/86-7/31/86         15,000              15,000
        8/1/86-7/31/87        106,000             106,000
        8/1/87-7/31/88        157,855             128,047
        8/1/88-7/30/89      1,552,783             305,668


     During the years in issue, compensation for Messrs. Bennett

and Sokol was determined on an annual basis by mutual agreement.

Even though Messrs. Bennett and Sokol were equal shareholders

during fiscal years 1990 and 1991, their compensation was unequal

because their contributions and responsibilities were not the

same.    In fiscal year 1992, Mr. Sokol's compensation was reduced

significantly reflecting the reduction in his responsibilities

and time commitment.
                             - 12 -


     During fiscal years 1990 through 1992, Messrs. Bennett and

Sokol were paid the following salaries:


           FYE           Mr. Bennett          Mr. Sokol

         7/29/90          $2,030,000          $670,000
         7/28/91           2,030,000           670,000
         8/02/92           2,050,192           173,077


Petitioner deducted these amounts.

     In the notice of deficiency, respondent disallowed

petitioner's deductions for salaries paid to Messrs. Bennett and

Sokol that were in excess of the following amounts:


           FYE           Mr. Bennett         Mr. Sokol

         7/29/90          $485,027           $230,202
         7/28/91           541,273            252,634
                                               1
         8/02/92           585,391               N/A

     1
      Compensation paid to Mr. Sokol for the 1992 fiscal year is
not in dispute.


                             OPINION


     The sole issue for decision is whether the amounts

petitioner paid to Messrs. Bennett and Sokol from fiscal years

1989 through 1992 constituted reasonable compensation for

services rendered within the meaning of section 162(a)(1).3

     3
      Sec. 162(a)(1) allows as a deduction a reasonable allowance
for compensation for personal services actually rendered.
Respondent concedes that the amount of any compensation found to
                                                   (continued...)
                              - 13 -


Whether the compensation is reasonable is a question to be

resolved on the basis of an examination of all the facts and

circumstances of the case.   Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1155 (1980).   Respondent's

determination is presumed correct, and petitioner bears the

burden of proving the reasonableness of the compensation.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

     In addressing the reasonableness of compensation, courts

have considered a number of factors including:   (1) The

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

the employee's work; (3) the size and complexities of the

employer's business; (4) a comparison of salaries paid with the

employer's gross and net income; (5) the prevailing general

economic conditions; (6) a comparison of salaries paid with

distributions and retained earnings; (7) the prevailing rates of

compensation for comparable positions in comparable concerns;

(8) the amount of compensation paid to the particular employee in

previous years; and (9) the salary policy of the employer as to

all employees.   Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th

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

v. Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987), affg. T.C.

Memo. 1985-267; Home Interiors & Gifts, Inc. v. Commissioner,


     3
      (...continued)
be reasonable was paid for services rendered.
                                 - 14 -


supra at 1155-1156.    No single factor is determinative; rather,

we must consider and weigh the totality of facts and

circumstances in arriving at our decision.      Rutter v.

Commissioner, supra at 1271; Owensby & Kritikos, Inc. v.

Commissioner, supra at 1323.


1.   Employee's Qualifications


      An employee's superior qualifications for his or her

position with the business may justify high compensation.      See,

e.g., Home Interiors & Gifts, Inc. v. Commissioner, supra at

1158; Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C.

338, 352-353 (1972).

      By virtue of their training, experience, creativity, and

dedication, both Messrs. Bennett and Sokol were exceptionally

qualified for petitioner's business.      Together, they understood

and controlled every aspect of petitioner's operations.      Mr.

Bennett was the creative force behind petitioner's catalog, its

sole marketing tool.    Complementing Mr. Bennett's creativity was

the experience of Mr. Sokol, a textile engineer who had worked in

the textile industry for over 30 years.

      Petitioner's profitability rested upon its sales.     The

primary reasons for petitioner's sales, growth, and success were

Messrs. Bennett's and Sokol's ambition, creativity, vision, and
                               - 15 -


energy.   See Home Interiors & Gifts, Inc. v. Commissioner, supra

at 1158; Dave Fischbein Manufacturing Co. v. Commissioner, supra.



2.   Nature, Extent, and Scope of the Employee's Work


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

general importance to the success of a business may justify high

compensation.    Home Interiors & Gifts, Inc. v. Commissioner,

supra at 1158.   In this case, the history of Messrs. Bennett's

and Sokol's contributions to petitioner must be considered,

rather than just their contributions during the years in issue,

because the compensation petitioner paid to them during the years

in issue represents, in part, an attempt to rectify prior

undercompensation.

      Mr. Bennett was petitioner's key employee and the main

reason for its success.   As president, he was the driving force

behind petitioner's business from its inception.   Mr. Bennett was

responsible for the designing and selection of the clothes

petitioner sold.   He was also responsible for the design and

creation of petitioner's catalog--its sole method of advertising.

Mr. Bennett ensured that the catalog was photographed, assembled,

printed, and mailed to his specifications.   He also oversaw in-

house store order operations, forecasting demand, developing a

customer base, overseeing facilities construction, and working

with banks to ensure financial stability for petitioner.
                              - 16 -


     Mr. Sokol's responsibilities were more limited than Mr.

Bennett's, but his compensation was also considerably less.      Mr.

Sokol, nevertheless, performed a wide variety of activities which

contributed to the success of a very successful company.    As

petitioner's vice president and treasurer, Mr. Sokol was

responsible for petitioner's bank relations, purchasing,

inventory, as well as sourcing the products (i.e., finding and

hiring the manufacturers, then verifying the quality).   As part

of his sourcing responsibilities, Mr. Sokol inspected the

operations of 25 to 50 different manufacturers in order to

determine their manufacturing capabilities.

     Messrs. Bennett and Sokol worked long hours for petitioner.

Both worked weekends and week nights in addition to the 40-hour

workweek.   They often worked together afterhours at Mr. Sokol's

home.   They performed all petitioner's executive and managerial

functions and performed or oversaw virtually all its day-to-day

activities.   Petitioner's growth and prosperity were due directly

to their skills, dedication, and creativity.

     Courts have also considered whether an employee personally

guaranteed his or her employer's debt in determining whether the

employee's compensation is reasonable.    In certain situations, an

employee's personal guaranty of his or her employer's debt may

entitle the employer to pay a greater salary to the employee than

the employer would otherwise have paid.   See Owensby & Kritikos,
                              - 17 -


Inc. v. Commissioner, 819 F.2d at 1325 n.33; R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 51 (1972); see also Acme Constr. Co. v.

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

Commissioner, T.C. Memo. 1995-5.     Here, both Messrs. Bennett and

Sokol personally guaranteed the repayment of petitioner's multi-

million dollar revolving line-of-credit.


3.   Size and Complexities of the Employer's Business


      Courts have considered the size and complexity of a

taxpayer’s business in deciding whether compensation is

reasonable.   Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d

176, 179 (10th Cir. 1975), affg. 61 T.C. 564 (1974).

      Petitioner's gross sales--an indicator of its size--were

$54,455,167, $69,748,749, and $70,059,961, respectively, for

fiscal years 1990, 1991, and 1992.     By 1990, petitioner's

operations involved rental space in six separate warehouses and

eventually required the construction of a 150,000-square foot

distributing center with a computerized inventory tracking system

to handle the sales volume.   In addition, petitioner employed

approximately 200 people during the years in issue.


4.   Comparison of Salaries Paid to Net and Gross Income


      Courts have compared sales, net income, and capital value to

amounts of compensation in deciding whether compensation is
                                 - 18 -


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

1325-1326; Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C.

at 1155-1156.

     During the fiscal years 1980 through 1988, petitioner paid

Messrs. Bennett and Sokol less compensation than they were

entitled to.    Petitioner increased its yearly gross sales from

$547,842 in fiscal year 1980 to $39,802,165 by fiscal year 1989.

For the years in issue, Messrs. Bennett's and Sokol's salaries as

a percentage of gross sales, gross profit, net income (before

deducting their compensation and after paying taxes), and taxable

net income (before deducting their compensation) were:


                Gross          Gross           Net          Taxable
   FYE          Sales          Profit         Income        Income

 7/29/90    4.96 percent   16.00 percent   36.67 percent   26.78 percent
 7/28/91    3.87 percent   13.83 percent   28.56 percent   20.78 percent
 8/02/92    2.93 percent   10.79 percent   26.97 percent   18.35 percent

 Averages   3.92 percent   13.54 percent   30.73 percent       21.97
percent


     We find that these percentages are reasonable in light of

the qualifications of Messrs. Bennett and Sokol, the nature,

extent, and scope of their work, and the years of prior

undercompensation.      See, e.g., Pulsar Components Intnl., Inc. v.

Commissioner, T.C. Memo. 1996-129; Acme Constr. Co. v.

Commissioner, supra; BOCA Constr., Inc. v. Commissioner, supra;

Universal Manufacturing Co. v. Commissioner, T.C. Memo. 1994-367;
                              - 19 -


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

Automotive Inv. Dev., Inc. v. Commissioner, T.C. Memo. 1993-298;

Paramount Clothing Co. v. Commissioner, T.C. Memo. 1979-64.


5.   General Economic Conditions


      This factor helps to determine whether the success of a

business is attributable to general economic conditions, as

opposed to the efforts and business acumen of the employees.

General economic conditions may affect a business' performance

and indicate the extent, if any, of the employees' effect on the

company.   Adverse economic conditions, for example, tend to show

that an employee's skill was important to a company that grew

during hard times.

      Respondent contends that the dramatic increase in gross

sales was not caused solely by the efforts of Messrs. Bennett and

Sokol, but rather, that the general economic conditions of the

times had a great impact on petitioner's business just prior to

and during the years in issue.     Respondent argues that the

increase in sales was, for the most part, a fortuitous

circumstance.

      Petitioner's gross sales rose from $54,455,167 in fiscal

year 1990 to $69,748,749 in fiscal year 1991 to $70,059,961 in

fiscal year 1992, an overall increase of 29 percent.     If the

economic conditions were indeed favorable during this period, we
                                - 20 -


would expect to see a corresponding increase in sales for the

industry in general.    However, the evidence shows that the

industry remained relatively stagnant over this period.

Respondent's own expert lists the sales figures of 11 companies

in the clothing industry during 1990, 1991, and 1992.4    The

combined sales for these companies dropped from $1,059,214,617 in

1990 to $997,443,690 in 1991 and rebounded to $1,078,385,309 in

1992.     This translates to an overall increase of only 2 percent

during this period.    Consequently, we find that the increase in

petitioner's sales, while partly due to fortuitous market

circumstances, was due primarily to the insight and hard work of

Messrs. Bennett and Sokol.


6.   Comparison of Salaries Paid With Distributions to Messrs.
     Bennett and Sokol and Retained Earnings


      The failure to pay more than minimal dividends may suggest

that reported compensation actually is (in whole or in part) a

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

1323-1324; Charles Schneider & Co. v. Commissioner, 500 F.2d 148,

151-152 (8th Cir. 1974), affg. T.C. Memo. 1973-130.

Corporations, however, are not required to pay dividends.

Indeed, shareholders may be equally content with the appreciation


      4
      Respondent's expert, Francis X. Burns of the IPC Group,
LLC, prepared a report on the compensation of Messrs. Bennett and
Sokol. This report is discussed infra.
                              - 21 -


of their stock caused, for example, by the retention of earnings.

Owensby & Kritikos, Inc. v. Commissioner, supra; Home Interiors &

Gifts, Inc. v. Commissioner, 73 T.C. at 1162.

     Petitioner paid $48,000 in dividends in fiscal years 1990

and 1991 and $24,000 in dividends in fiscal year 1992.    Whether

to pay a dividend, and the amount thereof, were business

decisions made by petitioner's board of directors.    As explained

in the August 31, 1986, minutes of petitioner's board of

directors meeting, the decision whether to pay dividends was

based on petitioner's need to:   (1) Make up past

undercompensation of its officers, (2) assure current growth, (3)

assure future growth, (4) allow for expansion into a new 150,000-

square foot distribution center, and (5) prepare for anticipated

overseas expansion.   We decline to second-guess the board of

director's business judgment under the facts of this case; we

view its decisions concerning the payment of dividends and the

amounts thereof as reasonable business decisions.

     In reviewing the reasonableness of an employee's

compensation, courts often look at whether a hypothetical

shareholder would have received a fair return on his investment

after the payment of the compensation in question.    Owensby &

Kritikos, Inc. v. Commissioner, supra at 1326-1327.

     A hypothetical investor in petitioner would have realized

the following returns on equity for the years in issue:    81.77
                              - 22 -


percent for 1990; 65.48 percent for 1991; and 65.95 percent for

1992.

      In addition to the fact that the increase in petitioner's

retained earnings most likely increased the value of its stock,

we believe that a hypothetical investor would have considered

petitioner's performance for this period impressive.5




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


      Both petitioner and respondent rely on expert testimony with

respect to this factor.   We weigh an expert's testimony in light

of his or her qualifications and considering all credible

evidence in the record.   Depending on what we believe is

appropriate under the facts and circumstances of the case, we may

either reject or accept an expert's opinion in its entirety, or

accept selective portions of it.   Helvering v. National Grocery

Co., 304 U.S. 282, 294-295 (1938); Seagate Technology, Inc. v.

      5
      These return-on-equity (ROE) figures are calculated by
dividing net income by the shareholder equity at the beginning of
the year. Respondent argues that the petitioner's ROE should be
calculated using the average of the beginning and ending
shareholder equity, rather than beginning equity as petitioner
suggests. Respondent contends that under the average equity
method, petitioner's ROE during the years in issue was actually:
58.21 percent for 1990, 49.41 percent for 1991, and 34.80 percent
for 1992. While respondent's ROE is lower, we still find the
figures impressive. Thus, even if we were to adopt the average
equity method in calculating petitioner's ROE, the results
obtained would not change our conclusion.
                              - 23 -


Commissioner, 102 T.C. 149, 186 (1994); Parker v. Commissioner,

86 T.C. 547, 562 (1986).

     Respondent presented the reports and testimony of Francis X.

Burns of the IPC Group, LLC. (IPC).    Mr. Burns and IPC specialize

in valuing intellectual property and intangible assets and in

transfer pricing issues.

     Mr. Burns chose 11 "peer group" companies and then compared

the net sales, average gross margin, and number of employees of

those 11 "peer group" companies to petitioner.   After determining

that Mr. Bennett's position most resembled a chief executive

officer (CEO) and that Mr. Sokol's position most resembled a

chief operating officer (COO), Mr. Burns then compared the CEO's

and COO's of his "peer group" to Messrs. Bennett and Sokol.    The

criteria Mr. Burns used to compare Messrs. Bennett and Sokol to

his "peer group" were limited, however, to age, number of years

of industry experience, and various positions held by the

executives.   At trial, Mr. Burns testified that he did not

specifically consider whether Messrs. Bennett or Sokol had duties

more expansive than the traditional CEO and COO, nor did he

consider the relative values of each executive to petitioner.

Mr. Burns concluded that a reasonable compensation for Mr.

Bennett would be the average of the interquartile range6 of the


     6
      The interquartile range is the range of values encompassing
the middle 50 percent of a sample group.
                                - 24 -


"peer group" CEO's, or $482,807, $532,621, and $622,714 for

fiscal years 1990, 1991, and 1992, respectively.     Using similar

techniques, Mr. Burns provided estimates of Mr. Sokol's

reasonable compensation for fiscal years 1990 and 1991 of

$354,163 and $382,330, respectively.

     Relying on Mr. Burns' report, respondent essentially argues

that Messrs. Bennett and Sokol are entitled to no more than the

industry average.    We do not find this argument persuasive.    The

regulations promulgated under section 162(a)(1) direct a

comparison of salaries paid by similar businesses to similar

employees under similar circumstances.     Sec. 1.162-7(b)(3),

Income Tax Regs.    However, section 162 is "not designed to

regulate businesses by denying them a deduction for the payment

of compensation in excess of the norm" in cases where other

factors call for higher compensation.     Home Interiors & Gifts,

Inc. v. Commissioner, 73 T.C. at 1162.

     Respondent also introduced the report and testimony of

Sigmund Wesolowski.     Mr. Wesolowski was the former president of

Pandora, Inc. (Pandora), a manufacturer, seller, and distributor

of sportswear.     Respondent argues that Pandora and petitioner

were similar companies and that Mr. Wesolowski and Mr. Bennett
                                - 25 -


held similar positions.   Respondent contends that Mr. Wesolowski

and Mr. Bennett should therefore receive similar compensation.7

     We do not agree, however, that either the companies or the

positions were that similar.    Pandora did 65 percent of its own

manufacturing, while petitioner contracted with outside

manufacturers to provide all its products.   In addition, Mr.

Bennett performed many of the duties and was responsible for many

of the tasks that Mr. Wesolowski shared with or delegated to

other employees and managers.    Finally, we cannot ignore the fact

that Pandora went out of business in 1990, shortly after Mr.

Wesolowski left the company.    Consequently, we do not find the

comparisons of petitioner and Mr. Bennett to Pandora and Mr.

Wesolowski compelling.

     Petitioner's expert, Joseph P. Gallagher of the Hay Group,

an international management consulting firm, valued Messrs.

Bennett's and Sokol's services under the "Hay Guide Chart-Profile

Method of Job Evaluation".   This methodology requires assigning

points to each executive for know-how, problem solving, and

accountability associated with the job requirements and talents

of that executive and then comparing those points to a data base


     7
      In his expert report, Mr. Wesolowski states that his base
salary was $150,000 and that he also received yearend contractual
incentives based on the performance of the company in addition to
stock options (which he did not exercise). Although he provides
a hypothetical salary based on this plan, Mr. Wesolowski does not
state the exact compensation he received in any year.
                                - 26 -


consisting of several hundred annually surveyed companies in

order to assign a base compensation value for each officer.

     Mr. Gallagher also considered the performance of petitioner

by examining its financial data.    From this data, Mr. Gallagher

concluded that petitioner has attained an exceptional level of

accomplishment which strongly suggests that the key executives,

Messrs. Bennett and Sokol, should be richly rewarded for their

financial stewardship.   Consequently, Mr. Gallagher concluded

that pay levels for Messrs. Bennett and Sokol should be "well in

excess of the market median".

     After calculating an appropriate amount of direct

compensation, Mr. Gallagher determined that a reasonable

compensation package for Messrs. Bennett and Sokol would also

include an amount necessary to fund a pension plan to provide a

competitive retirement income, as well as profit sharing to

recognize petitioner's exceptional performance.   Mr. Gallagher's

conclusions are expressed as follows:
                                       - 27 -


                   Appropriate Compensation for Mr. Bennett

             Direct        Pension    Profit      Total       Actually
 FYE      Compensation      Plan     Sharing   Compensation     Paid      Difference

7/29/90   $1,146,800      $126,100    $899,900   $2,172,800   $2,030,000 $(142,800)
7/28/91      810,000       132,400   1,292,800    2,235,200    2,030,000 (205,200)
8/02/92    1,140,300       139,000     729,700    2,009,000    2,050,200    41,200


 Total    $3,097,100      $397,500 $2,922,400    $6,417,000   $6,110,200 $(306,800)


                         Appropriate Compensation for Mr. Sokol

             Direct        Pension    Profit      Total       Actually
 FYE      Compensation      Plan     Sharing   Compensation     Paid      Difference

7/29/90     $513,400      $327,000   $300,000    $1,140,400    $670,000    $(470,400)
7/28/91      511,400       343,300    430,900     1,285,600     670,000     (615,600)

 Total    $1,024,800      $670,300   $730,900    $2,426,000   $1,340,000 ($1,086,000)


       Although we do not rely solely on Mr. Gallagher's conclusions

in this regard, we do find his qualifications in the area of

executive compensation superior to those of Mr. Burns.                    In

addition, Mr. Gallagher contemplated many of the same factors

considered by this and other courts in developing his compensation

plan for Messrs. Bennett and Sokol.              Therefore, we find his

conclusions regarding the reasonable compensation of Messrs.

Bennett and Sokol persuasive.


8.   Compensation Paid in Prior Years


       An employer may deduct compensation paid to an employee in a

year although the employee performed the services in a prior year.

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

R.J. Nicoll Co. v. Commissioner, 59 T.C. at 50, and the cases cited
                              - 28 -


therein.   We find that Messrs. Bennett and Sokol were

undercompensated in the years prior to those in issue.

     Mr. Burns, respondent's expert, concluded that both Messrs.

Bennett and Sokol were undercompensated during the early years of

petitioner.   Mr. Burns estimated that Mr. Bennett was

undercompensated a total of $479,912 for the years 1983 to 1988.

However, Mr. Burns concluded that Mr. Bennett's salary increase in

1989 more than recovered this prior undercompensation.     In

addition, Mr. Burns estimated that Mr. Sokol was undercompensated a

total of $233,322 during the same period.     In Mr. Sokol's case,

however, Mr. Burns calculated that the prior undercompensation was

not recovered until sometime in 1990.

     The record reveals that both Messrs. Bennett and Sokol were

undercompensated as far back as 1980; however, Mr. Burns'

calculations for undercompensation only go back to 1983.

Additionally, Mr. Burns calculated the amount of undercompensation

using the same method he used to figure the reasonable compensation

for Messrs. Bennett and Sokol in the years in issue.     We have

already explained why we have declined to apply Mr. Burns'

calculation to the years in issue.     We likewise find his

determination of underpayment in the prior years to be low.     We

find that the compensation paid to Messrs. Bennett and Sokol during

the years in issue was, in part, reimbursement of compensation

earned in prior years.
                               - 29 -



9.   Employer's Salary Policy As to All Employees


      Courts have considered salaries paid to other employees of a

business in deciding whether compensation is reasonable.

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1159.      We

look to this factor to determine whether Messrs. Bennett and Sokol

were compensated differently than petitioner's other employees

solely because of their status as shareholders.

      Petitioner deducted total salaries of $4,498,328, $5,203,045,

and $5,197,408 in fiscal years 1990, 1991, and 1992, respectively.

As a percentage of total salaries paid, Messrs. Bennett and Sokol

received 60.02 percent in 1990, 51.89 percent in 1991, and 39.45

percent in 1992, even though they constituted less than 1 percent

of petitioner's employees.    Respondent contends that these figures

constituted a significant proportion of petitioner's total salary

costs.

      These percentages do not necessarily indicate that the level

of compensation paid to Messrs. Bennett and Sokol was a function of

ownership rather than management responsibility.    A reasonable,

longstanding, and consistently applied compensation plan,

negotiated at arm's length, for example, is evidence that

compensation is reasonable.    Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d at 1327.
                                - 30 -


     In determining whether an arm's-length negotiation occurred

between petitioner and Messrs. Bennett and Sokol, we find the

comparison between Messrs. Bennett's and Sokol's shareholding

percentages and their respective compensations most persuasive.

Messrs. Bennett and Sokol, although equal shareholders, received

the following percentages of total officer salary:


         FYE          Mr. Bennett             Mr. Sokol

       7/30/89       83.55   percent       16.45 percent
       7/29/90       75.19   percent       24.81 percent
       7/28/91       75.19   percent       24.81 percent
       8/02/92      100.00   percent            N/A


     Messrs. Bennett and Sokol each owned 50 percent of petitioner.

Each was a board member with equal control.     Messrs. Bennett and

Sokol were not in any way related to one another and had no

incentive or outside pressures to pay the other any amount other

than that which was fair and reasonable to petitioner.

Nevertheless, the amount of compensation paid to Messrs. Bennett

and Sokol was not in proportion to their shareholdings.     Respondent

has stipulated that petitioner's redemption of Mr. Sokol's shares

was not tied to his compensation.      Based on all the facts, it is

reasonable to conclude that Messrs. Bennett's and Sokol's

compensation was bargained for at arm's length and was not a

disguised dividend.   See Owensby & Kritikos, Inc. v. Commissioner,

supra at 1326.   Indeed, Mr. Sokol sought the advice of his personal

certified public accountant, Mr. Gene Barber, regarding the issue
                              - 31 -


of reasonable compensation prior to Mr. Sokol's negotiations with

Mr. Bennett on this issue.   Mr. Barber testified that he met with

Mr. Bennett on behalf of Mr. Sokol to discuss the relative values

of Messrs. Bennett and Sokol to petitioner.   Following this

meeting, it was Mr. Barber's opinion that the services rendered by

Mr. Bennett were more valuable to petitioner than the services

rendered by Mr. Sokol.8   Based on his research, Mr. Barber

recommended several different compensation plans to Mr. Sokol

regarding various methods to allocate compensation between Mr.

Sokol and Mr. Bennett.


Conclusion


     Based upon all the facts and circumstances of this case, we

hold that the amounts that petitioner deducted in fiscal years

1989, 1990, and 1991 as compensation to Messrs. Bennett and Sokol

are reasonable.   Therefore, petitioner is entitled to deductions

for officer compensation in the amounts claimed.



                                    Decision will be entered

                               for petitioner.




     8
      We place no reliance on Mr. Barber's opinion other than to
show that Mr. Sokol sought his advice in what appears to be an
arm's-length negotiation over the amount of Mr. Bennett's
compensation.
