                          T.C. Memo. 2002-109



                      UNITED STATES TAX COURT



              INTERNATIONAL CAPITAL HOLDING CORP.
                AND SUBSIDIARIES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 6512-00.               Filed May 1, 2002.



     David D. Aughtry and Charles E. Hodges II, for petitioners.

     Donald W. Williamson, Jr., Carolyn L. Rountree, and Gary F.

Walker, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Petitioners sought redetermination of

deficiencies in Federal income taxes and accuracy-related

penalties determined by respondent as follows:
                                - 2 -

                                 Accuracy-related
                                      Penalty
     Year        Deficiency          Sec. 6662
     1995        $244,906            $48,981
     1996         333,094             66,619


After concessions by the parties, we must decide whether amounts

paid by petitioners to a related corporation are deductible as

compensation under section 162(a)(1).1   We hold they are.

                          FINDINGS OF FACT

     Many facts were stipulated, and we incorporate by this

reference the parties’ stipulation of facts and the accompanying

exhibits.    When the petition was filed, petitioners’ principal

places of business were in Georgia.

     1.     Petitioners

     Petitioners are an affiliated group of corporations, which

filed consolidated Federal income tax returns for 1995 and 1996

using an accrual method of accounting.    The group’s parent

corporation is International Capital Holding Corporation (ICHC),

a holding company.

     From September 1987 through 1996, the affiliated group

included ICHC and subsidiaries NC Acquisition Corporation (NCAC);

Resort Designs, Inc. (RDI); and Norcom, Inc.    ICHC has owned a

controlling interest in NCAC from the time of NCAC’s formation on



     1
        Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the subject years. Rule
references are to the Tax Court Rules of Practice and Procedure.
                                   - 3 -

August 1987.     In September 1987, NCAC purchased 100 percent of

the common stock of Norcom in a leveraged buyout.     Norcom is the

only operating company in petitioners’ affiliated group.      It

manufactures and wholesales school supplies, such as notebooks,

filler paper, and binders.     From the time of its acquisition by

NCAC through the end of 1996, Norcom has been a thinly

capitalized and highly leveraged company.

     2.      Petitioners’ Owners

     During all time periods relevant to this case, petitioners

were controlled by H. Ross Arnold (Mr. Arnold).     From September

1987 through January 1991, Mr. Arnold owned 82.33 percent of

ICHC.     From January 1991 through 1996, ICHC was 100-percent owned

by Mr. Arnold.2

     Mr. Arnold is a nonpracticing attorney who previously worked

in investment banking.     Mr. Arnold is in the business of

purchasing small and medium-sized closely held companies through

leveraged buyouts.     Generally, Mr. Arnold does not involve

himself in his individual capacity in the day-to-day operations

of the companies he owns.     Instead, Mr. Arnold uses another

company he owns, Quest Capital Corp. (Quest), to provide




     2
        The only other ownership interests in petitioners were
held by Paul F. Lombardi (Mr. Lombardi) and Mr. Arnold’s wife.
Mr. Lombardi owned approximately 1 percent of the common stock of
NCAC from April 1990 through April 1994. From April 1994 through
the end of 1996, Mr. Arnold’s wife owned 1 percent of NCAC.
                                 - 4 -

financial, investment, and strategic management services to his

portfolio of companies.3

3.   Quest

     Quest is a private investment management company.     Since its

incorporation, Mr. Arnold has been Quest’s sole shareholder and

president.    Mr. Arnold has been a member of Quest’s board of

directors since October 1990, and its sole member since December

1993.    Quest is not a member of petitioners’ affiliated group.

     Quest employs people who are specially trained in

accounting, finance, management, or law.     From 1987 through 1996,

Quest employed at least two attorneys, numerous C.P.A.s, and many

individuals with MBA degrees.    Quest’s primary purpose is to

provide financial and investment advice to Mr. Arnold and his

portfolio of companies, including Norcom.     For example, Quest was

actively involved in the equity and debt financing of the

portfolio companies and annually reviewed 30 to 40 potential

acquisitions for Mr. Arnold or one of his controlled companies,

including Norcom.

4.   The Acquisition of Norcom

     When NCAC acquired Norcom in 1987, Norcom had incurred

numerous years of operating losses.      The leveraged acquisition of

Norcom was accomplished largely through an $18 million line of



     3
        Prior to June 1989, Quest operated as a sole
proprietorship owned by Mr. Arnold.
                               - 5 -

credit from Bank South, which provided funds to acquire Norcom

and a line of credit for working capital.   Mr. Arnold personally

guaranteed the Bank South loan.   Additionally, Messrs. Arnold and

Lombardi each lent small amounts of cash to ICHC to help NCAC

acquire Norcom.

     The loan agreement with Bank South included numerous

restrictions on Norcom’s activities, two of which are relevant to

this case.   First, the loan agreement prohibited Norcom from

declaring distributions without the bank’s approval.   Second, the

aggregate amount of compensation Norcom could pay to its officers

and directors was restricted to 110 percent of the prior year’s

total.   In early 1990, Norcom requested and was granted a waiver

of these restrictions for Norcom’s fiscal year that ended on

January 31, 1990.   Norcom requested a waiver of the restriction

on distributions because it had declared a $1.6 million dividend

in August 1989.   At least a portion of the dividend was requested

by Bank South so that another member of the affiliated group,

RDI, could pay off a loan from Bank South, which RDI did not have

the ability to pay.   This was the only dividend Norcom declared

from 1987 through the end of 1996.

     In February 1991, LaSalle National Bank replaced Bank South

as Norcom’s primary lender.   LaSalle provided Norcom with an

extension of credit in the amount of $23.5 million.    Mr. Arnold

personally guaranteed at least $2 million of this debt.   Like the
                                 - 6 -

agreement with Bank South, the agreement with LaSalle prohibited

Norcom from declaring distributions.     Although the LaSalle

agreement did not expressly limit the amount of compensation

Norcom could pay to its officers, directors, or outside

consultants, a net worth requirement in the agreement prevented

Norcom from paying major fees without consulting LaSalle.       From

May 1991 through December 1996, the LaSalle line of credit was

amended 11 times.

5.   Services Which Quest Provided to Norcom

     At the heart of the factual dispute in this case is the

extent to which Quest provided consulting services to Norcom.

Petitioners claim that at least since the early 1990s Norcom’s

management team lacked anyone who carried out the duties of a

chief financial officer (CFO).    According to petitioners, Quest

served as the CFO, without being fully compensated.     Respondent

claims that Norcom had a full management team and that Quest was

fully compensated for any services it provided.

     a.   September 1987 to April 1992

     From shortly after its acquisition in 1987 through April

1992, Norcom had an essentially complete management team for a

company of its size.   In relevant part, Norcom’s management team
                               - 7 -

consisted of Mr. Arnold, Mr. Lombardi, Joseph Zelazny, and Vince

Ciccarello.4

     Mr. Arnold was the chairman and a member of the board of

directors of Norcom since its acquisition.5   He also served as

Norcom’s secretary from September 1988 to June 1992.    Mr. Arnold

did not keep an office at Norcom’s facilities and was not

actively involved in Norcom’s day-to-day management.    Norcom did

not compensate Mr. Arnold for his work until he began receiving a

salary in 1991.

     Norcom’s day-to-day management was largely handled by Mr.

Lombardi, a CPA who possessed significant management experience.

He served as CEO, treasurer, and assistant secretary of Norcom

from the time it was acquired in 1987, and in September 1988 also

became president of Norcom.   Mr. Lombardi was responsible for all

aspects of Norcom’s operations, including strategic planning,

budgeting, negotiating with lenders, manufacturing, sales and

marketing, acquiring equipment, and hiring personnel.   Mr.

Lombardi was compensated each year of his employment at Norcom

until he resigned in April 1992.




     4
        Mr. Ciccarello was the vice president of sales and
marketing. In August 1993, he was replaced by Ted Crews III.
The sales and marketing responsibilities are not material to this
case and are not discussed further.
     5
        Mr. Arnold was the sole member of Norcom’s board of
directors at the times Norcom made the two disallowed payments.
                              - 8 -

     Mr. Zelazny has been Norcom’s controller since 1987.    His

responsibilities included, among other things, oversight of

Norcom’s day-to-day cash management, preparation of monthly and

annual financial statements, and dealings with Norcom’s

accountants.   Although Mr. Zelazny was involved in dealings with

Norcom’s lenders, for the most part he was not responsible for

finding potential lenders, negotiating agreements with the

lenders, finding additional sources of equity financing, or

fulfilling other functions typically assigned to a CFO.

     Quest’s involvement with Norcom before Mr. Lombardi’s

resignation in April 1992 was limited.   Quest employees were

involved in acquiring Norcom; seeking additional equity

financing; obtaining debt financing; renegotiating loan

agreements, including both the Bank South and LaSalle lines of

credit; and overseeing Norcom’s operations, including its real

estate and long-term growth plan.   These Quest services were

largely provided by Mr. Arnold, Robert Wright, John McColl, and

their support staffs.

     When these services were provided by Quest, there was no

written agreement requiring Norcom to compensate Quest.    While

only Mr. Arnold testified as to the existence of an oral

agreement between Quest and Norcom, numerous Quest employees

testified that Norcom was not paying Quest because at that time

payments were not permitted by Norcom’s lenders.   In fact, no
                               - 9 -

compensation was paid by Norcom to Quest before April 1992.

However, minimal expenses Quest incurred in 1991 were reimbursed

by Norcom.

     b.   April 1992 Through 1996

     The relationship between Quest and Norcom changed

significantly in April 1992 when Mr. Lombardi resigned from

Norcom.   Immediately after Mr. Lombardi’s resignation, Mr. McColl

assumed oversight of the day-to-day operations of Norcom,

especially with respect to oversight of Norcom’s finances.6    Mr.

McColl moved his office to Norcom and worked at Norcom on a full-

time basis.   In addition to oversight of Norcom’s operations, Mr.

McColl became a Norcom officer.7    From June 1992 until December

1993, he served as Norcom’s secretary and treasurer.     From August

1992 until December 1993, he also served as the executive vice

president of Norcom.   The record does not indicate that Mr.

McColl was ever compensated by Norcom.



     6
        Mr. Arnold at least nominally assumed some of Mr.
Lombardi’s responsibilities by temporarily taking the positions
of president and CEO of Norcom. Despite holding these offices,
the evidence does not indicate that Mr. Arnold was actively
involved in the management of Norcom.
     7
        Petitioner claimed that Mr. McColl was not an employee of
Norcom. Because respondent has not disputed this claim, we have
accepted it as a stipulated fact. Accordingly, we have not
considered whether Mr. McColl was an employee of Norcom for
Federal tax purposes and that any work he performed for Norcom
was under such employment and not on behalf of Quest. Sec.
3121(d)(1) (defining an employee of a corporation to include its
officers).
                               - 10 -

     In addition to his oversight of Norcom’s operations, Mr.

McColl made two important hiring decisions at Norcom.    First, in

August 1992 he hired Richard Cross III to be Norcom’s interim,

part-time president.    Thereafter, Messrs. McColl and Cross worked

together as coleaders of Norcom.    Mr. Cross worked 2.5 days per

week, while Mr. McColl worked full time at Norcom.

Responsibility for operational, sales, and marketing issues fell

primarily on Mr. Cross, while Mr. McColl focused on the financial

management of Norcom.    Mr. Cross continued to be Norcom’s

president until April 1993.    At that time, Mr. Cross assumed the

title of CEO, which he held until December of 1993.    Norcom paid

$459,340 for 17 months of work by Mr. Cross.

     In April 1993, Mr. McColl hired Hal Rahn to replace Mr.

Cross as Norcom’s president.    Mr. Rahn continued to serve in that

capacity through 1996.   Like Mr. Cross, Mr. Rahn focused on

operational, sales, and marketing issues at Norcom.    High-level

financial and investment issues continued to be handled by Mr.

McColl and others at Quest.    Norcom compensated Mr. Rahn for his

services.

     In 1993 Mr. McColl also elevated Mr. Zelazny to vice

president of finance.    Although Mr. Zelazny was given an

additional title in 1993, his duties continued to be primarily

that of a controller.    Norcom has not employed any senior level

officers with significant financial expertise or experience after
                              - 11 -

Mr. Lombardi resigned in 1992.   Instead, Norcom looked to Quest

to carry out the duties of a CFO.

     Since acquiring Norcom in 1987, Mr. Arnold has assigned a

high-ranking Quest employee with expertise in financial and

investment issues to oversee the financial management of Norcom.

Initially, Robert Wright provided such oversight.   On or about

the time of Mr. Lombardi’s resignation in 1992, Mr. McColl served

this role, and Quest substantially increased the services it

provided to Norcom.   In 1994, Robert Espy became the Quest

officer responsible for management of Norcom’s finances.    During

1995 and 1996, Mr. Espy and his staff were actively involved in

Norcom’s financial management.

     The services Quest provided to Norcom from 1987 through 1996

were mostly financial and investment advice.   These included

consulting on Norcom’s bank loans, financing of equipment,

leases, acquisition and sale of real property, and development of

business plans.   Quest played a critical role in negotiating

Norcom’s consolidation of its operations from four facilities

down to a single, larger plant, which was accompanied with a

sale/leaseback of the new plant.    Quest personnel also reviewed

Norcom’s monthly and annual financial statements, as would a CFO.

Quest hired at least two high ranking Norcom officers: Mr. Cross

as president in 1992 and Mr. Rahn as president in 1993.    Quest

personnel typically were not involved in the day-to-day
                              - 12 -

operations of Norcom, with the exception of Mr. McColl’s work in

1992-93.

6.   Payments From Norcom to Quest

     Norcom did not make any payments to Quest before 1991 for

management services.   In October 1991, Norcom paid Quest $1,716

to reimburse Quest for expenses incurred by Mr. McColl in a

meeting he conducted with LaSalle regarding Norcom’s loan.     This

appears to be the only pre-1992 payment from Norcom to Quest that

relates to consulting services provided by Quest.    From July

through December 1993, Quest issued monthly invoices to Norcom

for $3,146 for a “consulting fee.”     From July 1993 through the

end of 1996, Quest regularly issued invoices to Norcom for

reimbursement of expenses.   Also, in July 1993, Norcom paid to

Quest $76,000 for “management services” Quest provided to Norcom.

     On January 1, 1994, Norcom and Quest entered into a formal

consulting agreement (the 1994 consulting agreement).     The 1994

consulting agreement provided that Quest would provide to Norcom

advice on financial, strategic planning, and operational issues.

In turn, Norcom was required to pay Quest an annual consulting

fee of $62,500, payable in monthly installments of $5,208.33.

From the beginning of 1994 through the end of 1996, Norcom paid

Quest the monthly consulting fees.     Respondent did not challenge

the deductibility of these compensation payments.
                               - 13 -

     The 1994 consulting agreement had the following integration

clause:

     Entire Agreement, Amendments and Modification. This
     Agreement supersedes in the entirety any and all prior
     agreements or arrangements between the parties with respect
     to the subject matter hereof, and this Agreement may not be
     amended or modified in any respect other than by a writing
     that references this Agreement, is signed by the party
     against whom the amendment or modification is sought to be
     enforced.

     The 1994 agreement was later revised to include the

following clause:

     (b) Other Fees. From time to time, additional
     compensation will be paid to * * * [Quest] based upon
     the extent of involvement in and services provided to
     NORCOM at the discretion of the Board of Directors.

     In September 1995, Mr. Espy proposed to Mr. Rahn that Norcom

make a payment to Quest that would be in addition to the monthly

consulting fee of $5,208.33.   Messrs. Espy and Rahn agreed that

Norcom would pay Quest $1 million for services Quest had

previously provided to Norcom.   Later, Messrs. Rahn and Espy

approached Mr. Arnold to obtain his approval of the payment,

which he granted.   Before the payment could be made, Norcom and

Quest had to ensure that any payment to Quest would not violate

any terms of its loan agreement with LaSalle.   In the fall of

1995, Messrs. Arnold and Espy sought LaSalle’s consent to the

proposed payment.   LaSalle granted its consent for Norcom to make

the payments to Quest as compensation for services provided by

Quest.
                              - 14 -

     After securing LaSalle's consent to the $1 million payment,

Messrs. Espy and Rahn collaborated in the preparation of the

following resolution for Norcom’s Board of Directors:

               WHEREAS, certain employees of Quest Capital
          Corp. have conducted meetings with and given
          consultations to * * * [Norcom's] management,
          provided advisory services in marketing, strategic
          planning, systems, and technical operations,
          advised the Corporation's employees and negotiated
          on behalf of * * * [Norcom] in connection with
          numerous bank transactions, reviewed and analyzed
          monthly financial statements and the annual
          operating budget for 1996, and acted as general
          consultant to * * * [Norcom] as to its
          productivity and profitability; and

               WHEREAS, the president has proposed to the
          board that * * * [Norcom] pay a management fee to
          Quest Capital Corp. in the amount of $1,000,000.00
          in consideration for the aforementioned services;

               THEREFORE IT IS RESOLVED, that the president
          is authorized and directed by the board of
          directors to pay the amount of $1,000,000.00 to
          Quest Capital Corp. for the consulting services
          described herein.

On December 14, 1995, Mr. Arnold, Norcom's sole director at the

time, executed the resolution.   On December 29, 1995, Norcom paid

$1 million to Quest as a management fee.

     As part of its audit of Norcom’s 1995 books, Norcom’s

outside accountants advised petitioners that they should treat a

portion of the payment as a dividend to obtain the benefits of

certain tax credits.   In response to this suggestion, Norcom and

Quest reiterated their intention that the entire payment was

compensation for services rendered and should be treated as such.
                             - 15 -

     Effective August 1, 1996, Mr. Rahn, as Norcom's president,

and Mr. Espy, as Quest's Chief Operating Officer, executed a

second consulting agreement (the 1996 consulting agreement).   In

the 1996 consulting agreement, Norcom stated that it desired

Quest to provide "management, banking, and marketing services in

connection with the operation of * * * [Norcom's] business, bank

relationship, vendor relationships and customer relationships".

      The 1996 agreement provided that, for 5 years, Quest would

provide the following services to Norcom:

          a) Reporting and Financial Planning Services -
          Assistance and review of all reports required
          pursuant to loan agreements and other financing
          arrangements to which * * * [Norcom] is a party;
          review, renegotiate and extend the lines of credit
          made abailable [sic] by its lending institution;
          review of financial statements, annual budgets,
          projections, insurance reports, and other
          financial reports necessary for the operation of *
          * * [Norcom's] business.

          b) Consulting Services - Consulting and advisory
          services in regard to international marketing,
          strategic planning, systems, technical operations
          and such other matters as * * * [Norcom] deems
          reasonably necessary for the conduct of its
          business.

          c) Equipment - Assistance in determining lease
          versus buy decisions on new equipment; negotiate
          bank financing on new equipment purchases and
          provide overall consultation as to the
          cost/benefit relationship of acquiring said
          equipment.
                               - 16 -

     Under the 1996 agreement, Quest was to be compensated as

follows:

           a) During the term of this Agreement, a yearly fee
           will be paid equal to approximately 10% of the
           gross profit of * * * [Norcom] based on internally
           prepared financial statements. Pursuant to the
           terms and conditions of * * * [Norcom's] loan
           agreement with LaSalle National Bank, payments
           approximating 25% of the total fee will be made on
           October 10th of each year with the remaining 75%
           of the estimated fee paid during the last week of
           the fiscal year of * * * [Norcom]. No payment
           will be made under this agreement if it were to
           cause an event of default under any covenant in
           the LaSalle National Bank Loan Agreement. In
           addition, management of * * * [Norcom] and the
           Board of Directors will decide each year what
           additional fees, if any, will be payable to Quest
           based on the services rendered and the amount of
           time involved by Quest personnel.

     For the months of September through December 1996, Quest

also issued invoices at the monthly rate of $10,000.    Norcom

promptly paid the amounts invoiced.     Respondent did not challenge

the deductibility of these payments.

     During the fall of 1996, Messrs. Rahn and Espy commenced

discussions concerning the amount of compensation to be paid to

Quest during 1996.   They relied on the same considerations

underlying the 1995 payment.   Mr. Espy, with input from Messrs.

Arnold and Rahn, then drafted the following resolution for

Norcom’s board of directors:

                WHEREAS, certain employees of Quest Capital
           Corp. have conducted meetings with and given
           consultations to * * * [Norcom's] management,
           provided advisory services in marketing, strategic
           planning, systems, and technical operations,
                              - 17 -

           advised the Corporation's employees and negotiated
           on behalf of * * * [Norcom] in connection with
           numerous bank transactions, renegotiated and
           extended the existing bank line with LaSalle
           National Bank, reviewed and analyzed monthly
           financial statements and the annual operating
           budget for 1997, and acted as general consultant
           to * * * [Norcom] as to its productivity and
           profitability; and

                WHEREAS, the president has proposed to the
           board that * * * [Norcom] pay a management fee to
           Quest Capital Corp. in the amount of $700,000.00
           in consideration for the aforementioned services,
           this amount being consistent with the Services
           Agreement and the amounts paid in 1994 and 1995
           which are hereby ratified as to amount and prior
           year's consistent practice and methodology;

                THEREFORE IT IS RESOLVED, that the president
           is authorized and directed by the board of
           directors to pay the amount of $700,000.00 to
           Quest Capital Corp. for the consulting services
           described herein.

In December 1996 Norcom's board of directors executed the

resolution, and $700,000 was paid to Quest as a management fee.



                              OPINION



     We must decide whether the payments from Norcom to Quest are

deductible under section 162(a)(1).8    Section 162(a)(1) allows a


     8
         That section provides:

          SEC. 162(a).   In General.–-There shall be allowed
     as a deduction all the ordinary and necessary expenses
     paid or incurred during the taxable year in carrying on
     any trade or business, including–-

                                                     (continued...)
                               - 18 -

business to deduct “a reasonable allowance for salaries and other

compensation for personal services actually rendered” as an

ordinary and necessary business expense.    In this case,

deductibility requires that the payment be (1) purely for

services rendered and (2) reasonable in amount. Trinity Quarries,

Inc. v. United States, 679 F.2d 205 (11th Cir. 1982); Estate of

Wallace v. Commissioner, 95 T.C. 525, 553-554 (1990), affd. 965

F.2d 1038 (11th Cir. 1992); Paula Constr. Co. v. Commissioner, 58

T.C. 1055 (1972), affd. without published opinion 474 F.2d 1345

(5th Cir. 1973); Law Offices–-Richard Ashare, P.C. v.

Commissioner, T.C. Memo. 1999-282; sec. 1.162-7(a); Eyefull, Inc.

v. Commissioner, T.C. Memo 1996-238; Pulsar Components Intl.,

Inc. v. Commissioner, T.C. Memo. 1996-129, Income Tax Regs.

     It is well established that a payment is deductible as

compensation only to the extent that it was actually intended as

such.    Elec. & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1340

(1971), affd. without published opinion 496 F.2d 876 (5th Cir.

1974); Eyefull, Inc. v. Commissioner, supra.    Whether such intent

existed is a factual question to be decided on the basis of the

facts and circumstances of the case.    Paula Constr. Co. v.

Commissioner, supra at 1059.    The burden of proof rests upon



     8
        (...continued)
                 (1) a reasonable allowance for salaries
            or other compensation for personal services
            actually rendered;
                               - 19 -

petitioners to prove that they are entitled to deduct an amount

greater than that determined by respondent.9     Rule 142(a); Paula

Constr. Co. v. Commissioner, supra at 1058; Elec. & Neon, Inc. v.

Commissioner, supra at 1340.

     While compensation for personal services is a deductible

expense, distributions of corporate earnings and profits

constitute dividends and are not deductible.     Therefore, a

corporation has an incentive to characterize as compensation

payments which are actually distributions of profits.     Sec.

1.162-7(b)(1), Income Tax Regs.   Thus, the Court must closely

scrutinize the alleged compensation paid to determine if it is a

disguised distribution of profits.      Pulsar Components Intl, Inc.

v. Commissioner, supra; Mad Auto Wrecking, Inc. v. Commissioner,

T.C. Memo. 1995-153.

     The provision of services by one company to another company

does not alone establish the existence of a business relationship

consistent with the payment of compensation.      Eyefull, Inc. v.

Commissioner, supra (citing Paula Constr. Co. v. Commissioner,

supra at 1058).   “There must also be evidence that at the time



     9
        Pursuant to sec. 7491, the burden of proof can be shifted
to respondent if certain conditions are met, including that the
examination was commenced before July 22, 1998. Internal Revenue
Restructuring & Reform Act of 1998, Pub. L. 105-206, sec.
3001(c), 112 Stat. 727; Higbee v. Commissioner, 116 T.C. 438
(2001). The examination in this case commenced before the
effective date. Accordingly, sec. 7491 is not applicable to this
case.
                               - 20 -

the services were rendered the parties understood them to be part

of a business transaction conducted for profit.”    Id.

     Petitioners allege that Quest provided valuable investment,

financial, and management consulting services to Norcom over an

extended period of time.    Petitioners further allege that in 1995

and 1996 they paid reasonable compensation to Quest for these

services.   Respondent takes the position that (1) Norcom lacked

the requisite compensatory intent; and (2) the payments do not

constitute reasonable compensation because petitioners failed to

establish the extent of the services rendered.   We disagree with

respondent.

     Intent To Compensate

     The evidence strongly supports petitioners’ contention that

they intended to compensate Quest for services rendered when they

made the $1 million payment in 1995 and the $700,000 payment in

1996.   The Court finds it especially significant that both

payments were initially negotiated by officers of Norcom and

Quest who did not hold any ownership interest in either company.

Specifically, Mr. Espy, chief operating officer of Quest,

approached Mr. Rahn, president of Norcom, with the suggestion

that Norcom compensate Quest for services rendered, whereupon

Messrs. Espy and Rahn negotiated the amount of the payments.    The

Court sees no reason to second-guess payments that were

negotiated by two disinterested members of the management teams
                                - 21 -

at Quest and Norcom.   Law Offices–-Richard Ashare, P.C. v.

Commissioner, supra (declining to second-guess the wisdom of the

board of directors as to the amount of compensation paid to a

principal of the taxpayer).

     There was also uncontroverted testimony by disinterested

parties that immediately before and after the 1995 payment was

made, Norcom intended it to be compensation for services

rendered.   Specifically, prior to making the 1995 payment,

Messrs. Arnold and Espy approached LaSalle to obtain the bank’s

approval.   Loan officers at LaSalle testified that they were

informed that the payment was compensation for services

previously rendered by Quest.    Notably, LaSalle did not question

whether Quest had provided services to Norcom or the amount of

the payment.   Shortly after the 1995 payment was made to Quest,

petitioners’ tax adviser learned of the payment and was told by

petitioners that the entire payment was compensation for services

rendered.

     Additionally, the payments to Quest were contemplated by the

revised 1994 consulting agreement.10     That agreement provides


     10
        Petitioners alleged that the 1994 consulting agreement
was revised, but they were unable to locate a final signed
version of the allegedly revised agreement. Petitioners did
produce a draft of the revised agreement. On brief, respondent
urged the Court to find that the 1994 agreement included the
additional clause that petitioner claimed was part of the revised
agreement. We interpret the parties’ proposed findings of fact
                                                   (continued...)
                              - 22 -

that Norcom could make such compensation payments to Quest based

upon the extent of the services provided by Quest.11   Notably,

respondent has accepted the deductibility of other payments made

under the 1994 consulting agreement.12

     It is also clear that for both the 1995 and 1996 payments,

Norcom followed its normal procedure for determining officer

compensation.   Specifically, Norcom’s president, Mr. Rahn, made a

recommendation to Norcom’s board of directors of the amount the

salary and bonuses to be paid to Norcom’s officers.    For both the

1995 and 1996 payments, Mr. Rahn was involved in determining the

amount of compensation to be paid and in making a recommendation

to Norcom’s board of directors about such compensation.

     Petitioners’ claim that Norcom’s payment of compensation to

Quest was deferred until 1995 because its financial condition and

financing arrangements precluded such payments is strongly

supported by the evidence.   Prior to the change in ownership in


     10
      (...continued)
as a stipulation that the agreement was revised as alleged by the
petitioners. Although we are not bound by the parties’
stipulated facts, the record is absent of facts indicating that
the stipulation is clearly erroneous. Rule 91(a); Jasionowski v.
Commissioner, 66 T.C. 312, 318 (1976)
     11
        Similarly, the 1996 consulting agreement provides for
the application of a formula to determine the amount of
additional compensation payments Norcom would make to Quest.
     12
        Respondent has not alleged that these payments were
contingent payments that are deductible only if they satisfy the
test provided in sec. 1.162-7(b)(2), Income Tax Regs.
                               - 23 -

1987, Norcom had sustained years of operating losses.    Although

Norcom was restored to profitability after the acquisition,

Norcom’s ability to compensate Quest was limited.    At all times

it continued to be highly leveraged with millions of dollars of

debt.   The lender, Bank South, viewed Norcom as financially

unstable and required Mr. Arnold to personally guarantee Norcom’s

loan.   Although Norcom was profitable in the years after the

ownership change, its financial condition was depleted in 1989 by

the payment of a $1.6 million dividend, which was requested by

Bank South.    Norcom’s poor financial condition is further

evidenced by the fact it did not begin to compensate all of its

officers until 1991.

     The Bank South loan agreement expressly restricted the

amount of compensation Norcom could pay to its officers and

directors.    Moreover, both the Bank South loan and the LaSalle

loan limited Norcom’s ability to make payments to related

parties.   As petitioners have alleged, Norcom’s financial

condition and its financing arrangements severely limited its

ability to compensate Quest until Norcom’s financial condition

improved dramatically in 1995.

     It is also clear that Norcom’s management team lacked high-

level financial planning expertise, at least after Mr. Lombardi

resigned in early 1992.    Instead of replacing Mr. Lombardi with

an officer with a finance background, Norcom looked to Quest for
                              - 24 -

advice and counsel on financial and investment issues.     Numerous

persons at Quest possessed relevant experience and training not

found at Norcom.

     Finally, with respect to both payments, Norcom’s board of

directors executed resolutions detailing that the payments were

being made to Quest for valuable services Quest had previously

provided to Norcom.   Both resolutions are consistent with the

parties’ conclusion that the 1994 agreement envisioned that

Norcom’s board could exercise its discretion and make additional

compensation payments to Quest.

     We find unpersuasive respondent’s arguments that petitioners

lacked the requisite compensatory intent.13   Respondent initially

drew the Court’s attention to the fact that only Mr. Arnold

testified as to knowledge of a pre-1993 oral agreement between

Norcom and Quest.   Respondent correctly notes that Mr. Lombardi,

Norcom’s CEO and president from 1987 through April 1992,

testified that he had no knowledge of any oral agreement.    The

Court chooses not to rely upon his testimony.   We find that Mr.

Lombardi’s testimony was biased because Mr. Lombardi had a


     13
        We note that respondent’s briefs were not in accordance
with Rule 151(e)(3), which governs proposed findings of fact, and
could have been rejected. Respondent’s proposed findings of fact
were rarely concise statements of fact and often were not based
upon evidence. Proposed findings of fact should not be based
upon statements made in a request for admission (unless the
subject matter of the request has been admitted or deemed
admitted).
                             - 25 -

dispute with Mr. Arnold over their respective ownership interests

in Norcom, as a result of which Mr. Lombardi resigned from Norcom

and later sued Mr. Arnold.

     Moreover, the lack of additional testimony regarding a pre-

1993 agreement is neither surprising nor necessarily

inconsistent with Norcom’s having the requisite compensatory

intent at the time the payments were made in 1995 and 1996.

Closely held corporations often act informally, with decisions

not being documented in writing.     Levenson & Kline, Inc. v.

Commissioner, 67 T.C. 694, 714 (1977); Eyefull, Inc. v.

Commissioner, T.C. Memo. 1996-238.    Additionally, in determining

whether Norcom possessed the requisite intent, the relevant time

is when the purported compensation payment was made.     Tool

Producers, Inc. v. Commissioner, T.C. Memo. 1995-407.14    The

Court finds it notable that numerous witnesses testified that

before 1993 Quest was not paid by Norcom because Norcom’s

financial condition precluded it from compensating Quest.       In any

event, the substantial written documentation between the parties

and the parties’ actions demonstrate that Norcom possessed the

requisite intent when it made the payments.




     14
        Unlike in Eyefull, Inc. v. Commissioner, T.C. Memo.
1996-238, respondent has not alleged that Norcom and Quest lacked
the necessary business relationship, such that Quest did not
provide services with a view toward being compensated.
                              - 26 -

     Respondent also alleges that numerous contracts limited

Norcom’s ability to compensate third parties, including Quest.

Specifically, respondent calls the Court’s attention to Norcom’s

Bank South loan agreement, which prohibited commissions, finder’s

fees, and investment banking fees, as well as Norcom’s real

estate contracts that prohibited payments of real estate broker

commissions.   These contracts do not suggest Norcom did not

intend to compensate Quest.   The services Quest provided to

Norcom were similar to that of a chief financial officer, and we

do not believe that compensation for such services was prohibited

by these agreements.

     Additionally, respondent claims that Norcom’s intent to

compensate Quest for services rendered before 1994 is capped at

the $62,500 annual fee provided for in the 1994 consulting

agreement, plus the amounts invoiced by Quest before the 1994

consulting agreement became effective.   We do not find that

Norcom intended to limit the compensation of Quest to these

amounts.   The 1994 consulting agreement expressly provides that

Norcom will consider making compensation payments to Quest that

are in addition to the required payment of $62,500.   The

agreement provides that such additional compensation is to be

reflective of Quest’s “involvement in and services provided to

NORCOM.”   Moreover, there is nothing in the agreement that would
                             - 27 -

not permit Norcom to compensate Quest for services provided to

Norcom before 1994.

     We find that the circumstances underlying Norcom’s payments

to Quest in 1995 and 1996 confirm that the payments were made to

compensate Quest for services rendered.

     Reasonableness of the Compensation

     The second element of the compensation test is whether the

payments are reasonable in amount.    Trinity Quarries, Inc. v.

United States, 679 F.2d at 210; Estate of Wallace v.

Commissioner, 95 T.C. at 553; Haffner’s Serv. Stations, Inc. v.

Commissioner, T.C. Memo. 2002-38.    Respondent has conceded that

the payments were reasonable if petitioners substantiate that the

services were provided as claimed.

     To determine whether petitioners satisfied this condition,

we must initially determine the extent of the services

petitioners claimed to have received from Quest.   In the

petition, petitioners made the following claims regarding the

services provided by Quest to Norcom: (1) Norcom hired Quest in

the early 1990s, (2) Quest employed at least four senior level

management advisers who worked with Norcom, and (3) Quest

provided along with other services, the following:   (i) analyzing

Norcom’s financing needs; (ii) hiring senior and key executives

at Norcom; (iii) managing Norcom’s facilities; (iv) negotiating
                               - 28 -

sales and leases on Norcom’s behalf; and (v) developing Norcom’s

business plans.15

     Petitioners established that Quest began to provide services

at least as early as 1991, when Norcom began to reimburse Quest’s

expenses.   Moreover, Quest’s services to Norcom increased

substantially in early 1992 after Mr. Lombardi resigned.

     The evidence established that numerous senior-level Quest

employees or consultants worked on Norcom matters, including

Messrs. McColl, Espy, Arnold, Wright, and Cross (prior to his

employment at Norcom).   Additionally, numerous other Quest

employees provided valuable services to Norcom in support of

these individuals.

     The evidence also establishes that Quest provided all of the

services identified in the petition, plus many others.    We find

that petitioners have established that services were provided as

claimed in the petition.    Throughout the 1990s Quest worked on

Norcom’s financing needs.    This includes attempts to find new


     15
        Petitioners made essentially the same claims in a
position paper provided to respondent during the audit.
Conversely, respondent argues that petitioner must establish that

     Norcom was the largest client of Quest and its
     predecessor and that the personnel of Quest and its
     predecessor spent the majority of their time in
     performing services for Norcom.

The Court finds no indication in the record that petitioners made
any such claims to this Court at the time that respondent made
his concession. No such claims were made in the petition.
                              - 29 -

sources of equity financing and repeated work on Norcom’s debt

financing.   Quest personnel were also very active in Norcom’s

equipment financing.

     Quest also played a critical role in hiring the last two

Norcom presidents.   Mr. McColl hired both Mr. Cross and Mr. Rahn.

Additionally, Mr. McColl himself assumed numerous offices at

Norcom, without being paid by Norcom.

     Quest played a very important role in negotiating Norcom’s

consolidation of its operations from four facilities down to a

single, larger facility.   Quest assisted in negotiating the

purchase, sale, and leaseback of Norcom’s plant.   Quest personnel

played similarly important roles in equipment acquisitions.

Quest participated in the development of Norcom’s business plans,

particularly with respect to financing and investment issues.

Quest reviewed numerous potential acquisitions for Norcom, which

would have allowed Norcom to expand and diversify its business.

Additionally, Quest hired Mr. Cross to provide a review of

Norcom’s operations after Mr. Lombardi resigned.   We find that

petitioners have established that services were provided as

claimed in the petition and that respondent has conceded that the

compensation was reasonable in amount.   Accordingly, petitioners’

payments of $1 million in 1995 and $700,000 in 1996 are

deductible under section 162(a)(1) as ordinary and necessary

expenses.
                             - 30 -

     We have considered all arguments made by respondent, and to

the extent not discussed above, we find them to be without merit.

To reflect the foregoing,

                                  Decision will be entered for

                             petitioners.
