                         T.C. Memo. 1996-171



                       UNITED STATES TAX COURT



           LUMBER CITY CORPORATION, f.k.a. NEIMAN-REED
         LUMBER AND SUPPLY COMPANY, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16056-93.                      Filed April 10, 1996.



     Michael T. Anderson, Robert M. Jason, Kevin O'Hara, and
Thomas A. Greco, for petitioner.

     Donna F. Herbert and Mark A. Weiner, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHIECHI, Judge:    Respondent determined the following

deficiencies in, additions to, and accuracy-related penalties on

petitioner's Federal income tax:
                                            - 2 -

                                                  Additions to Tax
                            Section         Section       Section   Section Section
 Year Ended   Deficiency 6653(a)(1)(A)1     6653(a)(1)(B) 6653(a)(1) 6653(a)(2) 6661(a)
Feb. 29, 1988 $352,217      $17,611            *         $ --         --     $88,054
Feb. 28, 1989   398,225       --               --         19,911      *       99,556

                                 Section
 Year Ended      Deficiency      6662(a)
Feb. 28, 1990     $863,235       $172,647
Feb. 28, 1991      366,344         73,269

* 50 percent of the interest due on the portion of the underpayment attributable to
negligence.

          The only issue remaining is to determine the amount of the

   deduction for petitioner's taxable year ended February 28, 1990,

   to which petitioner is entitled under section 162(a)(1) for

   reasonable compensation paid to Jesse Ruf, its sole shareholder

   and chief executive officer (CEO).               We hold that the amount of

   the deduction to which petitioner is entitled is $1 million.

                                   FINDINGS OF FACT2

          Petitioner, Lumber City Corp. (Lumber City), is a California

   corporation whose principal place of business was in Van Nuys,

   California, at the time the petition was filed.

          Petitioner was formed in 1948 by Robert Neiman (Mr. Neiman)

   and Robert Reed (Mr. Reed) as Neiman-Reed Lumber and Supply Co.,

   Inc.    Petitioner began operations as a wholesale lumber operation

   and expanded to include a chain of retail home and garden im-



   1
      All section references are to the Internal Revenue Code in
   effect for the years at issue. All Rule references are to the
   Tax Court Rules of Practice and Procedure.
   2
      Except as noted, the record is unclear as to the timing of
   certain events. However, the inadequacy of the record in that
   respect does not affect our resolution of the issue presented.
                               - 3 -


provement stores.   (We shall refer to retail home and garden

improvement stores of the type operated by petitioner as home

centers.)   As of July 1981, Mr. Neiman, Mr. Reed, and Snider

Lumber Products Co. (Snider Lumber) were equal stockholders of

petitioner.

     During July 1981, UBM Group PLC (UBM), a British company,

purchased a 51-percent majority stock interest in petitioner and

an option to purchase the remaining 49 percent of its stock that

was owned one-third each by Mr. Neiman, Mr. Reed, and Snider

Lumber.   After UBM acquired 51 percent of petitioner's stock, Mr.

Neiman was hired to serve as petitioner's chairman and CEO and

Mr. Reed was hired to serve as petitioner's president and chief

operating officer (COO).

     Approximately four-and-a-half months after UBM acquired its

majority stock interest in petitioner, Mr. Reed died after a

massive heart attack and UBM's top management was forced out by

its board of directors and replaced with a new management team.

From that time until approximately April 1985, petitioner em-

ployed a number of different presidents hired by UBM and ex-

perienced many financial problems.     During April 1985, UBM

decided to sell its 51-percent stock interest in petitioner and

not to exercise its option to purchase the remaining 49 percent

of its stock.

     During April 1985, pursuant to the terms of a redemption
                               - 4 -


agreement, petitioner redeemed UBM's 51-percent stock interest

for a purchase price of $6,250,050, issued a note to UBM's parent

corporation for that amount (UBM note), and retired the redeemed

shares.   As a result of that redemption, Mr. Neiman, Mr. Reed's

estate and/or its beneficiaries,3 and Snider Lumber (referred to

collectively as the shareholders) each owned one-third of peti-

tioner, and they were personally liable on the UBM note.

     As of February 28, 1986, petitioner's liabilities exceeded

it assets and its net worth was negative $1,514,000.   According

to its audited financial statement for its fiscal year ended

February 28, 1986, that was prepared by Touche Ross & Co.,

petitioner's net income after taxes (but before utilization of

net operating loss carryforwards/carrybacks) for that year was

negative $3,599,000.   During that fiscal year, petitioner's

working capital decreased by $3,426,000 from $7,008,000 to

$3,582,000 and its cash balance decreased by $1,410,000 from

$2,815,000 to $1,405,000.   Petitioner's long-term debt increased

from $8,723,000 as of the end of its fiscal year ended February

28, 1984, to $13,092,000 as of the end of its fiscal year ended

February 28, 1986.   As of February 28, 1986, employee morale was


3
   It is unclear from the record whether Mr. Reed's estate and/or
its beneficiaries owned Mr. Reed's stock from the period beginn-
ing with Mr. Reed's death in 1981 until that stock was purchased
(as discussed below) by Stanislaus Funding Corp. in December
1986. For convenience, we shall refer hereinafter to the owner
of Mr. Reed's stock during that period as Mr. Reed's estate.
                                - 5 -


low as evidenced by the high rates of workmen's compensation

claims and inventory shrinkage that most likely resulted from

employee theft.   Petitioner was also experiencing increased

competition around that time from the entry of large discount

home centers into its market.

     After petitioner redeemed UBM's shares during April 1985,

petitioner's shareholders were interested in finding someone to

manage petitioner's business and return it to profitability so

that they could sell it.   Someone suggested to Mr. Neiman that he

contact Jesse Ruf (Mr. Ruf), who had many years of experience in

managing home centers.

     During 1970, the president of W.E. Cooper Lumber Co. (Cooper

Lumber) recruited Mr. Ruf to become its general merchandise

manager.   At that time, Cooper Lumber, which owned two stores in

Los Angeles, California, and was building a third, was in the

process of shifting from a lumberyard to a home center business.

Prior to Mr. Ruf's joining Cooper Lumber, its majority owner and

leader, Bill Cooper, died, and that company was experiencing

financial difficulties.    Upon joining Cooper Lumber, Mr. Ruf was

responsible for marketing, merchandising, advertising, day-to-day

operations, human resources, and finances.   He helped Cooper

Lumber change its product mix by downplaying its lumberyard and

increasing the variety of items it sold from 18,000 to 34,000.

While he was employed by Cooper Lumber, sales increased from
                               - 6 -


$200,000 per month to approximately $500,000 per month.

     During 1973, Lone Star Industries (Lone Star), which was

then the largest producer of cement in the Western Hemisphere and

which was looking to diversify itself, acquired Cooper Lumber and

retained Mr. Ruf to manage that business.   Upon joining Lone

Star, Mr. Ruf held the title "sales manager" and eventually

became president of its home center operations.   After acquiring

Cooper Lumber, Lone Star purchased a number of distressed com-

panies in the lumberyard and home center businesses that achieved

economic success under its management.   Generally, the companies

that Lone Star purchased were similarly situated to Cooper

Lumber; that is to say, they were companies that were having

difficulty changing from boom-market lumberyards to retail home

centers.   During 1979, Lone Star decided to sell its home center

business to four different companies.

     Instead of working for one of the companies that purchased

Lone Star's home center business, during 1979, Mr. Ruf decided to

acquire another distressed home center company, Sunset Builders

Supply (Sunset).   At that time, Sunset was operating three

stores, one of which was located in Los Angeles and the other two

of which were located in San Diego, California, and in Arizona.

When Mr. Ruf became the owner of Sunset, he sold the two stores

not located in Los Angeles and took over all responsibilities for

the remaining store, including merchandising, day-to-day opera-

tions, and finances.
                                - 7 -


     During March 1985, Mr. Neiman contacted Mr. Ruf.    For

approximately one year thereafter, they discussed on several

occasions the possibility of Mr. Ruf's becoming responsible for

the management of petitioner.   Both Mr. Neiman and Mr. Ruf

understood that Mr. Ruf would be interested in assuming that

responsibility only if Mr. Ruf were given the option to purchase

100 percent of petitioner.   Acquiring such an option was Mr.

Ruf's most important consideration in determining whether to

agree to assume responsibility for the management of petitioner.

     On April 1, 1986, petitioner entered into a management

agreement (management agreement) with Mulholland Funding Corp.

(MFC), which was owned by Mr. Ruf and his wife.    Pursuant to the

management agreement, MFC agreed to provide petitioner with the

management services of Mr. Ruf for the period that began on April

1, 1986, and terminated on March 31, 1989.4    In return, petition-

er agreed to pay MFC fixed compensation of $8,000 per month plus

additional compensation in the nature of an "operations bonus" to

be determined at the end of each fiscal year for which the

management agreement was in effect.     The operations bonus was to

be calculated at the end of each fiscal year based on the follow-

ing formula:   10 percent of the first $500,000 of petitioner's

4
   The parties stipulated that Mr. Ruf became employed by peti-
tioner beginning in March 1986; however, the management agreement
provided that neither MFC nor Mr. Ruf was to be considered an
employee of petitioner. We interpret the parties' stipulation to
mean that, pursuant to the management agreement, Mr. Ruf became
petitioner's CEO in March 1986.
                                - 8 -


net profit, 15 percent of the next $500,000 of its net profit, 20

percent of the next $1 million of its net profit, and 25 percent

of its net profit in excess of $2 million.

        Simultaneously with the execution of the management agree-

ment, petitioner's shareholders and Mr. Ruf agreed that if Mr.

Ruf were to achieve certain objectives with respect to petition-

er, they would sell 100 percent of petitioner's stock to him.      On

December 29, 1986, petitioner's shareholders and Mr. Ruf entered

into a stock option agreement that is embodied in a document

entitled "First Restatement of Stock Option Agreement" (stock

option agreement) and that provided that Mr. Ruf or his assignee

was entitled to purchase all of petitioner's stock.     On the same

date, Mr. Ruf exercised that option through his wholly owned

corporation, Stanislaus Funding Corp. (Stanislaus).     Stanislaus

purchased 100 percent of petitioner's outstanding stock at that

time.

     The stock option agreement provided that the final purchase

price for petitioner's stock was to be the sum of (1) 4.5 times

petitioner's after-tax earnings for its fiscal year ended

February 28, 1989, and (2) its book value (with certain adjust-

ments) determined as of that date.      During November 1988, peti-

tioner's former shareholders5 and Mr. Ruf decided not to follow

5
   For periods after petitioner's shareholders (viz., Mr. Neiman,
Mr. Reed's estate, and Snider Lumber) sold their stock to
Stanislaus in December 1986, we shall refer to them collectively
                                                   (continued...)
                               - 9 -


the formula prescribed in the stock option agreement for deter-

mining the final purchase price for petitioner and instead agreed

on a final purchase price for petitioner of $2,045,520.   After

November 1988, the Ruf family trust owned 100 percent of peti-

tioner's outstanding stock.6

      At the time that the stock option agreement was exercised,

Stanislaus issued petitioner's former shareholders notes in the

total principal amount of $5,150,000 (original notes).7   The

original notes provided, inter alia, that Stanislaus was not to

allow petitioner to:

     pay total compensation (including bonuses) or fees or
     make loan repayments or other distributions to Jesse
     Ruf or any affiliate thereof * * * that in the aggre-
     gate exceed $125,000 ("Base Amount") plus 10% of the
     first Five Hundred Thousand Dollars ($500,000) of net
     profits of Neiman-Reed * * *, 15% of the next Five
     Hundred Thousand Dollars ($500,000) of such net prof-
     its, 20% of the next One Million Dollars ($1,000,000)
     of such net profits, and 25% of the excess over Two
     Million Dollars ($2,000,000) of such net profits, but


5
 (...continued)
as petitioner's former shareholders.
6
   Although the parties stipulated that the Ruf family trust
owned 100 percent of petitioner's stock after November 1988, it
is unclear when the Ruf family trust acquired that stock. Both
parties refer to Mr. Ruf as the sole shareholder of petitioner
throughout the years at issue. We presume that this is because
he was in control of petitioner indirectly through the Ruf family
trust. Since the parties refer to Mr. Ruf as petitioner's sole
shareholder, we shall also refer to him herein as its sole
shareholder.
7
   In addition, Stanislaus entered into a stock pledge agreement
and an indemnity agreement, petitioner and MFC entered into a
security agreement, and Mr. Ruf and his wife entered into a
guaranty agreement.
                               - 10 -


     in no event shall distributions of such compensation,
     fees, repayments or distributions exceed $500,000 in
     the aggregate per fiscal year of Neiman-Reed; with any
     excess in earnings thereof accruing. * * *

At the time that Stanislaus purchased petitioner in December

1986, petitioner acquired MFC, and the management agreement

between petitioner and MFC was terminated.

     In November 1988, after Mr. Ruf and petitioner's former

shareholders agreed on a final purchase price for petitioner's

stock, replacement notes (replacement notes) that called for

monthly principal payments of $200,000 and no interest payments

were issued to those former shareholders in lieu of the original

notes.8    During August 1988, the restrictions contained in the

original notes on the amount of cash (whether as compensation or

otherwise) that Mr. Ruf could withdraw from petitioner were

terminated by agreement of petitioner's former shareholders.

     Effective February 29, 1988, MFC and Stanislaus merged into

petitioner, with petitioner as the surviving corporation of those

mergers.    Mr. Ruf was the sole shareholder of Stanislaus prior to

its merger into petitioner, and, according to the merger agree-

ment between Stanislaus and petitioner, he was to be the sole

shareholder of petitioner subsequent to that merger.




8
   The details of those replacement notes are not clear from the
record.
                              - 11 -


Mr. Ruf's Performance of Services for Petitioner9

     When Mr. Ruf became responsible for petitioner's management

in March 1986, he became petitioner's CEO and president.   As

such, he was responsible for all duties and functions relating to

petitioner's management and operations, including day-to-day

operations, marketing, human resources, merchandising, adver-

tising, check writing, accounts receivables, relations with

suppliers and noteholders, and real estate negotiations.   For at

least the first two or three years after he became petitioner's

CEO, Mr. Ruf worked 12 to 15 hours a day, six to seven days a

week.   With the exception of one employee who was made an officer

for the sole purpose of acting on petitioner's behalf in small

claims court and Mr. Lyons who became petitioner's chief finan-

cial officer (CFO) in either March 1989 or March 1990,10 Mr. Ruf

was petitioner's only officer.   Beginning at least as early as

March 1987 and continuing throughout the years at issue, Mr. Ruf

was the sole member of petitioner's board of directors.


9
   The record is unclear as to when certain services were per-
formed by Mr. Ruf for petitioner. However, the record indicates
that many of the results of Mr. Ruf's services first appeared
during petitioner's fiscal year ended Feb. 28, 1987, and that Mr.
Ruf continued to provide extensive services to petitioner
throughout the years at issue. Unless otherwise indicated, our
discussion herein relating to Mr. Ruf's performance of services
for petitioner relates to the period that started in March 1986
when Mr. Ruf became petitioner's CEO and ended on Feb. 28, 1991.
10
   The record is unclear as to the year in which Mr. Lyons
became CFO.
                                - 12 -


       After becoming petitioner's CEO in March 1986, Mr. Ruf

improved petitioner's relationship with its suppliers.     At the

time Mr. Ruf became petitioner's CEO, petitioner was not paying

its suppliers and other creditors because it did not have enough

cash, and its creditors were discussing the possibility of form-

ing a creditors' committee to force petitioner into bankruptcy.

Shortly after becoming petitioner's CEO in March 1986, Mr. Ruf

negotiated with petitioner's suppliers to extend its credit for

an additional 30 days even though petitioner had not paid them

for previously shipped items.    Those suppliers agreed to extend

petitioner's credit at least in part due to Mr. Ruf's reputation

in the industry for turning around troubled home centers.       In

addition, Mr. Ruf increased the communication between petitioner

and its suppliers.

       In an attempt to improve employee morale, Mr. Ruf started a

policy of having 7 a.m. meetings with petitioner's store employ-

ees.    The meetings were known as "donuts with Jess".   In addi-

tion, during petitioner's fiscal year ended February 29, 1988,

Mr. Ruf authorized on behalf of petitioner an $800,000 contribu-

tion to petitioner's employee profit-sharing plan.    Mr. Ruf also

changed petitioner's hiring policies and started to require

preemployment physicals and drug tests.    As employee morale im-

proved, petitioner suffered fewer workmen's compensation claims

and less inventory shrinkage.
                               - 13 -


     Shortly after becoming petitioner's CEO, Mr. Ruf undertook a

study of petitioner's inventory.    In connection with that study,

he temporarily stopped all buying for petitioner's stores and

systematically determined what items of inventory it would dis-

continue selling.   He decided to eliminate pet food, televisions,

video-cassette recorders, and automotive parts.    In order to

obtain cash for petitioner, he started conducting sidewalk sales

to sell its unwanted inventory.    Within approximately 90 days

after Mr. Ruf became petitioner's CEO, its inventory was reduced

by approximately $2 million.

     Shortly after becoming petitioner's CEO in March 1986, Mr.

Ruf made a number of changes in the management and administrative

structure of petitioner.   Mr. Neiman was named chairman of its

board of directors and relieved of responsibility as its CEO.

Mr. Ruf also terminated petitioner's president, CFO, director of

merchandise, director of personnel, and director of operations.

In addition to terminating petitioner's top management, Mr. Ruf

also discharged, inter alia, its director of real estate, direc-

tor of finance/controller, field merchandising manager, director

of advertising, and director of security.    He also reduced the

number of buyers for petitioner from seven to four.    As a result

of Mr. Ruf's efforts, in approximately three to six months after

Mr. Ruf became petitioner's CEO, petitioner's office staff was

cut in half from approximately 120 employees to approximately 60

employees.
                               - 14 -


       Within one year of becoming petitioner's CEO, Mr. Ruf nego-

tiated releases from the leases for three of petitioner's stores

that were adversely affecting its profits and closed those

stores.    Mr. Ruf also renegotiated the leases for petitioner's

remaining stores, most of which were with the former sharehold-

ers.    Those leases were changed from percentage leases, where the

amount of the rent increased as the sales volume increased, to

fixed-rent leases.    Mr. Ruf purchased an interest in at least one

of the stores leased by petitioner.

       In addition to renegotiating petitioner's leases, within two

years after becoming petitioner's CEO, Mr. Ruf also negotiated a

$250,000 reduction in the amount owed by petitioner under the UBM

note.    The UBM note was subsequently purchased by the former

shareholders and Mr. Ruf.11

       As petitioner's CEO, Mr. Ruf changed petitioner's retail

marketing strategy.    In order to compete with the large discount

home centers that had entered petitioner's market, Mr. Ruf de-

cided that petitioner needed to provide better customer service

and make its stores more convenient to the customers.     He at-

tempted to make petitioner's stores attractive and clean places

in which to shop.    He changed petitioner's tradename to Lumber

City, The City of Home Improvement.     Along with the change in


11
   The precise portion of the UBM note owned by each of the
former shareholders and Mr. Ruf is unclear, although Mr. Ruf
purchased only a "small piece" of it.
                                - 15 -


petitioner's tradename, Mr. Ruf designed, inter alia, the inter-

iors of its stores to replicate stores within a city.    For exam-

ple, all of the different departments in its stores were given

personalized names such as Joe's Hardware and Sally's Seasonal,

and all the aisles in the stores were given street names, rather

than numbers.    Rather than lowering prices, Mr. Ruf increased

petitioner's profit margins by, inter alia, increasing petition-

er's inventory turnover rate, sales per store, and sales per

employee.

     Mr. Ruf also changed petitioner's method of advertising.

Prior to Mr. Ruf's becoming petitioner's CEO, petitioner used

electronic media advertising.    That type of advertising was

expensive and was sent to areas outside of the areas in which

petitioner's customers primarily resided.    Under Mr. Ruf's direc-

tion, petitioner started utilizing print advertising such as

weekly newspaper advertisements.

     In addition to the extensive changes Mr. Ruf instituted with

respect to petitioner's home centers, Mr. Ruf changed the focus

of petitioner's wholesale lumber business from supplying peti-

tioner's internal needs to supplying outside customers.    As a

result, petitioner became the largest supplier of lumber to the

movie studios in southern California, the largest supplier of all

vertical-grain Douglas fir to sash and door manufacturers, and

the largest industrial wholesaler of upper-grade pine in the

United States.
                               - 16 -


     Ed Langley (Mr. Langley) was the manager of the wholesale

lumber business from the time Mr. Ruf became petitioner's CEO in

March 1986 and throughout the years at issue; however, he was

never an officer of petitioner during that period.    During the

years at issue, Mr. Langley talked with Mr. Ruf on the telephone

daily and met with him approximately once a week.    They dis-

cussed, inter alia, recruiting high caliber employees, raising

petitioner's credit standards for sales to outside customers, and

training petitioner's sales personnel to solicit customers.

Compensation

     Petitioner paid Mr. Ruf the following amounts of compen-

sation during, and deducted those amounts in its Federal income

tax returns for, the years indicated:12

            Year Ended         Total Compensation Paid

           Feb.   28,   1987              $80,000
           Feb.   29,   1988              132,629
           Feb.   28,   1989            1,454,746
           Feb.   28,   1990            2,600,000
           Feb.   28,   1991              750,000

In its financial statements, petitioner expensed the following

amounts of compensation that it had accrued with respect to Mr.




12
   In the first supplemental stipulation of facts, the parties
rounded the amounts of compensation petitioner deducted in its
Federal income tax returns and expensed in its financial state-
ments for the relevant years. However, the record establishes
the exact amounts of such compensation, and we shall use herein
those exact amounts.
                                 - 17 -


Ruf for the years indicated:13

          Year Ended            Total Compensation Accrued

         Feb.   28,   1987                 $395,603
         Feb.   29,   1988                1,003,629
         Feb.   28,   1989                  132,693
         Feb.   28,   1990                2,600,000
         Feb.   28,   1991                  750,000

     The $80,000 in cash compensation petitioner paid to Mr. Ruf

during its fiscal year ended February 28, 1987, represented

(1) $60,000 in compensation that was earned pursuant to the man-

agement agreement between MFC and petitioner and (2) $20,000 in

compensation that was earned by Mr. Ruf in his individual capac-

ity after that management agreement was terminated in December

1986 when Stanislaus purchased petitioner.

     The $132,629 in cash compensation petitioner paid to Mr. Ruf

during its fiscal year ended February 29, 1988, represented his

base salary for that year.

     The $1,454,746 in cash compensation petitioner paid to Mr.

Ruf during its fiscal year ended February 28, 1989, represented

four components:      (1) His base salary for that year of $132,693,


13
   Petitioner's financial statements for its fiscal years ended
Feb. 29, 1984, and Feb. 28, 1985, were audited by Peat, Marwick,
Mitchell & Co. Its financial statements for its fiscal year
ended Feb. 28, 1986, for the period Dec. 29, 1986 (the date of
the acquisition of petitioner by Stanislaus) through Feb. 28,
1987, and its fiscal year ended Feb. 29, 1988, were audited by
Touche Ross & Co. No financial statement was prepared for the
period Mar. 1, 1986, through Dec. 28, 1986. Petitioner's fi-
nancial statements for its fiscal years ended Feb. 28, 1989, Feb.
28, 1990, and Feb. 28, 1991, were not audited by an independent
certified public accountant.
                             - 18 -


(2) $315,603 that was awarded pursuant to the management agree-

ment for the period April 1, 1986, through December 1986,

(3) $933,333 that was awarded pursuant to a deferred compensation

arrangement adopted on March 20, 1987, by Mr. Ruf as the sole

director of petitioner's board of directors (1987 deferred

compensation arrangement), and (4) $73,117 of interest on the

$315,603 awarded pursuant to the management agreement.

     The 1987 deferred compensation arrangement provided in per-

tinent part:

          WHEREAS, Jesse Ruf, as this Corporations's presi-
     dent and chief operating officer,[14] has been required
     and continues to be required to render services sub-
     stantially in excess of those which would ordinarily be
     required in connection with his office due to the con-
     dition of the Corporation's business at the time of his
     employment and the need to render extraordinary efforts
     to prevent the Corproation [sic] from failing; and

          WHEREAS, Jesse Ruf has, in his capacity as presi-
     dent and chief operating officer, provided extraordi-
     nary leadership and ability as evidenced by the Cor-
     poration's current operating profits and steadily
     improving financial position;

          NOW, THEREFORE, BE IT RESOLVED, that a special
     deferred compensation arrangement is hereby awarded to
     Jesse Ruf in the amount of One Million Five Hundred
     Thousand Dollars ($1,500,000.) to be accrued in three
     (3) equal installments of Five Hundred Thousand Dollars
     ($500,000.) each during this Corporation's fiscal years
     1988, 1989 and 1990, the amount so accrued shall [sic]
     be payable by the Corporation in all events provided
     only that Jesse Ruf shall complete twelve (12) calendar
     months of employment during each such corporate year. *
     * *


14
   Although the 1987 deferred compensation arrangement provided
that Mr. Ruf was serving as petitioner's president and COO, he
was also serving as petitioner's CEO at that time. As CEO, he
assumed responsibility for all of petitioner's operations, in-
cluding acting as COO.
                               - 19 -



The 1987 deferred compensation arrangement was terminated as of

January 31, 1989.   In its audited financial statement for its

fiscal year ended February 29, 1988, petitioner expensed $871,000

in deferred compensation with respect to the 1987 deferred com-

pensation arrangement.   That expense was the only expense

reflected in its financial statements for the years at issue with

respect to that arrangement.   During petitioner's fiscal year

ended February 28, 1989, petitioner paid $933,333 to Mr. Ruf

pursuant to the 1987 deferred compensation arrangement.15

     Petitioner did not pay Mr. Ruf a base salary in either of

its fiscal years ended February 28, 1990, or February 28, 1991.

The $2,600,000 of compensation petitioner deducted in its Federal

income tax return for its taxable year ended February 28, 1990,

was not paid to Mr. Ruf pursuant to a plan.

Petitioner's Financial Results

     According to its financial statements, petitioner had the

following sales, net income after taxes (but before utilization

of net operating loss carryforwards/carrybacks), and sharehold-

er's equity for the years indicated:


15
   The record does not explain how petitioner calculated the
$871,000 it expensed in its financial statement for its fiscal
year ended Feb. 29, 1988, with respect to the 1987 deferred
compensation arrangement or the $933,333 it paid to Mr. Ruf
during its fiscal year ended Feb. 28, 1989, with respect to that
arrangement.
                                      - 20 -


                                               Net Income     Shareholder's
       Year Ended             Sales            After Taxes       Equity16

     Feb.   28,   1986     $61,499,000         ($3,599,000)   ($1,514,000)
     Feb.   28,   198717        --                   --         2,641,000
     Feb.   29,   1988      55,510,000             413,000        512,000
     Feb.   28,   1989      57,672,000             390,000      1,129,000
     Feb.   28,   1990      60,960,000             325,000      1,454,000
     Feb.   28,   1991      56,884,000             275,000      1,729,000

       According to its Federal income tax returns, petitioner had

the following sales, net income after taxes (but before utiliza-

tion of net operating loss carryforwards/carrybacks), and share-

holder's equity for the years indicated:


16
   The shareholder's equity in petitioner as shown in its par-
tial-year financial statement for the period Dec. 29, 1986,
through Feb. 28, 1987, and in its Federal income tax return for
its taxable year ended Feb. 28, 1987, reflected the purchase of
petitioner by Stanislaus. That purchase was reflected at
$2,500,000 and caused an increase in petitioner's shareholder's
equity by that amount. When Stanislaus was merged into petition-
er at the end of February 1988, the transaction was reversed, and
petitioner's shareholder's equity was reduced by a corresponding
amount. That reversal is reflected in petitioner's financial
statement for its fiscal year ended Feb. 29, 1988, and in its tax
return for its taxable year ended Feb. 28, 1989.
17
   Because only a partial-year financial statement was prepared
for petitioner's fiscal year ended Feb. 28, 1987, petitioner's
sales and net income data for that year are unavailable. How-
ever, the parties stipulated to the use of the sales and net
income amounts reported in petitioner's Federal income tax return
for its taxable year ended Feb. 28, 1987, as the sales and net
income amounts for petitioner's financial statement for its
fiscal year ended Feb. 28, 1987. Accordingly, when referring
herein to petitioner's financial statement for its fiscal year
ended Feb. 28, 1987, we shall use petitioner's sales of
$58,515,000 and net income of $823,000 as reported in its Federal
income tax return for that year in lieu of the actual financial
statement sales and net income data for that year.
                                 - 21 -


                                          Net Income     Shareholder's
  Year Ended             Sales            After Taxes       Equity

  Feb.   28,   1986   $61,499,000         ($3,591,000)   ($1,489,000)
  Feb.   28,   1987    58,515,000             823,000      2,848,000
  Feb.   29,   1988    53,854,000           1,561,000      4,082,000
  Feb.   28,   1989    57,672,000            (504,000)     1,037,000
  Feb.   28,   1990    60,960,000             (71,000)     1,212,000
  Feb.   28,   1991    56,883,000             362,000      1,508,000

Mr. Ruf's Loans to Petitioner

     At approximately the same time that petitioner paid

$1,454,746 to Mr. Ruf during its fiscal year ended February 28,

1989, Mr. Ruf lent petitioner approximately $925,000.       At ap-

proximately the same time that petitioner paid $2,600,000 to Mr.

Ruf during its fiscal year ended February 28, 1990, Mr. Ruf lent

petitioner approximately $2 million.

Mr. Neiman

     Throughout the years at issue, Mr. Neiman owned interests in

the original notes and the replacement notes issued in connection

with the sale of petitioner's stock to Mr. Ruf and the UBM note

that the former shareholders and Mr. Ruf purchased.       Until

January 1988, Mr. Neiman remained on petitioner's payroll and

retained an office next to Mr. Ruf's office.        After January 1988,

Mr. Neiman decided that he no longer wanted to be on petitioner's

payroll; nonetheless, throughout the remaining years at issue,

Mr. Ruf allowed Mr. Neiman to use one of petitioner's offices.

Prior to, during, and after the years at issue, Mr. Neiman re-
                             - 22 -


ceived and reviewed petitioner's financial statements and had

regular discussions with Mr. Ruf concerning petitioner.   At no

time during those years did Mr. Neiman disapprove the compensa-

tion petitioner paid to Mr. Ruf.   Although the original notes

initially restricted the amount of cash that Mr. Ruf was allowed

to withdraw from petitioner due to its poor cash position, Mr.

Neiman expected that Mr. Ruf would be justly compensated as soon

as the cash was available to do so.

Notice of Deficiency

     In the notice of deficiency (notice), respondent allowed the

entire amount of $132,629 that petitioner deducted as compen-

sation paid to Mr. Ruf in its Federal income tax return for its

taxable year ended February 29, 1988, and disallowed $1,322,053,

$2,600,000, and $750,000 of the amounts that petitioner deducted

as compensation paid to Mr. Ruf in its Federal income tax returns

for its taxable years ended February 28, 1989, February 28, 1990,

and February 28, 1991, respectively.   Respondent thus determined

that petitioner was entitled to deduct as compensation paid to

Mr. Ruf $132,629 for its taxable year ended February 29, 1988,

$132,693 for its taxable year ended February 28, 1989, and $0 for

its taxable years ended February 28, 1990, and February 28, 1991.
                                - 23 -


                               OPINION18

     Section 162(a)(1) allows a corporation to deduct as a

business expense "a reasonable allowance for salaries or other

compensation for personal services actually rendered".   A corpor-

ation may be entitled to deduct compensation for the year during

which such compensation is paid to an employee, even though the

employee performed the services for which he or she is being

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

U.S. 115, 119 (1930).   To be deductible, however, the corporation

must show:   (1) That the corporation intended to compensate the

employee for past undercompensation and (2) the amount of the

past undercompensation.   Pacific Grains, Inc. v. Commissioner,

399 F.2d 603, 606 (9th Cir. 1968), affg. T.C. Memo. 1967-7;

Estate of Wallace v. Commissioner, 95 T.C. 525, 553-554 (1990),

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

     Section 1.162-7(a), Income Tax Regs., establishes "a two-

prong test for deductibility under section 162(a)(1):    (1) the

amount of the compensation must be reasonable and (2) the pay-

ments must in fact be purely for services."    Elliotts, Inc. v.

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



18
   We have considered all of the arguments made by the parties
and, to the extent not discussed herein, have found them to be
without merit.
                              - 24 -


remanding T.C. Memo. 1980-282.   Since proof of the second prong

(viz., compensatory purpose) can be difficult to establish and a

compensatory purpose can often be inferred if the amount of the

compensation is determined to be reasonable under the first

prong, "courts generally concentrate on the first prong--whether

the amount of the purported compensation is reasonable."      Id.

What constitutes reasonable compensation is a question of fact

that must be determined in light of all of the evidence.      Pacific

Grains, Inc. v. Commissioner, supra at 605.

     Many factors are relevant in determining the reasonableness

of compensation, and no single factor is decisive.    Elliotts,

Inc. v. Commissioner, supra at 1245; Pacific Grains, Inc. v.

Commissioner, supra at 606.   The U.S. Court of Appeals for the

Ninth Circuit (Court of Appeals) to which an appeal in this case

would normally lie has divided those factors into five broad

categories:   (1) The employee's role in the company, (2) a

comparison of the compensation paid to the employee with the

compensation paid to similarly situated employees in similar

companies, (3) the character and condition of the company,

(4) whether a conflict of interest exists that might allow the

company to disguise dividend payments as deductible compensation,

and (5) whether the compensation was paid pursuant to a struc-

tured, formal, and consistently applied program.     Elliotts, Inc.

v. Commissioner, supra at 1245-1248.
                                - 25 -


     Petitioner bears the burden of proving that respondent's

determinations are erroneous.    Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).   If petitioner shows error in respon-

dent's determinations, the Court must decide the amount of

compensation that was reasonable based on the entire record

before us.   Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. 564,

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

     In the notice, respondent allowed the entire amount of

$132,629 that petitioner deducted as compensation paid to Mr. Ruf

in its Federal income tax return for its taxable year ended

February 29, 1988, and disallowed all but $132,693 of the amount

petitioner deducted as compensation paid to Mr. Ruf for its

taxable year ended February 28, 1989, and all of the amounts

petitioner deducted as compensation paid to Mr. Ruf for its

taxable years ended February 28, 1990, and February 28, 1991.   At

trial and on brief, respondent concedes that petitioner is

entitled to deduct all of the amounts it claimed as compensation

paid to Mr. Ruf for the last three years at issue except for

$2,100,000 of the $2,600,000 claimed for its taxable year ended

February 28, 1990.   Accordingly, we must decide on the basis of

the record before us whether petitioner is entitled to deduct for

that year an amount of compensation to Mr. Ruf in excess of that

conceded by respondent.
                                   - 26 -


     Petitioner argues that the entire amount of compensation

(viz., $2,600,000) it paid to Mr. Ruf during, and deducted for,

its taxable year ended February 28, 1990, was reasonable.    Of

that total amount, petitioner contends that $800,000 represented

compensation to Mr. Ruf for services he provided during its

fiscal year ended February 29, 1988, $800,000 represented compen-

sation to Mr. Ruf for services he provided during its fiscal year

ended February 28, 1989, and $1 million represented compensation

to Mr. Ruf for services he provided during its fiscal year ended

February 28, 1990.

     As part of its argument that the compensation paid Mr. Ruf

during its fiscal year ended February 28, 1990, was attributable

in part to services he provided during its fiscal years ended

February 29, 1988, and February 28, 1989, petitioner contends

that the $933,333 in compensation paid to Mr. Ruf during its

fiscal year ended February 28, 1989, pursuant to the 1987 de-

ferred compensation arrangement was awarded as compensation to

Mr. Ruf for services rendered during its fiscal year ended

February 28, 1987.    Thus, according to petitioner, it awarded the

following amounts of compensation to Mr. Ruf for the years

indicated, and those amounts are reasonable:

                      Year Ended            Compensation

                     Feb. 28, 1987          $1,328,936
                     Feb. 29, 1988             933,000
                                 - 27 -


                  Feb. 28, 1989              933,000
                  Feb. 28, 1990            1,000,000
                  Feb. 28, 1991              750,000

     Respondent counters that Mr. Ruf earned the $933,333 in

compensation petitioner paid him pursuant to the 1987 deferred

compensation arrangement during the years for which it was to

accrue under that arrangement,19 that Mr. Ruf was not undercom-

pensated for any years prior to petitioner's fiscal year ended

February 28, 1990, and that petitioner is entitled to deduct only

$500,000 as reasonable compensation to Mr. Ruf for its taxable

year ended February 28, 1990.     Thus, according to respondent,

petitioner awarded the following amounts of compensation to Mr.

Ruf for the indicated years, and only those amounts are reason-

able:

                   Year Ended             Compensation

                  Feb.   28,   1987         $395,603
                  Feb.   29,   1988          565,629
                  Feb.   28,   1989          632,693
                  Feb.   28,   1990          500,000
                  Feb.   28,   1991          750,000



19
   Respondent contends that, of the $933,000 that petitioner
paid Mr. Ruf pursuant to the 1987 deferred compensation arrange-
ment, $433,000 was to accrue for petitioner's fiscal year ended
Feb. 29, 1988, and $500,000 was to accrue for its fiscal year
ended Feb. 28, 1989. It appears to us that the respective
amounts that respondent contends were to accrue for those years
pursuant to the 1987 deferred compensation arrangement should be
reversed (i.e., it appears that $500,000 was to accrue for peti-
tioner's fiscal year ended Feb. 29, 1988, and $433,000 was to
accrue for its fiscal year ended Feb. 28, 1989).
                             - 28 -


     We disagree with the various contentions of both parties.

However, we believe that petitioner's positions regarding the

fiscal years for which it paid the compensation accrued under the

1987 deferred compensation arrangement and for which it paid the

compensation during its fiscal year ended February 28, 1990, are

more consistent with the record herein than are respondent's

positions concerning those matters.

     Specifically, based on our examination of the entire record

before us, we find that petitioner awarded most of the $933,333

it paid to Mr. Ruf pursuant to the 1987 deferred compensation

arrangement as compensation for services he performed during its

fiscal year ended February 28, 1987, and the balance of that

amount as compensation for services he provided during its fiscal

years ended February 29, 1988, and February 28, 1989.   The 1987

deferred compensation arrangement provided in pertinent part that

Mr. Ruf "has been required and continues to be required to render

services substantially in excess of those which would ordinarily

be required" and "has, in his capacity as president and chief

operating officer, provided extraordinary leadership and ability

as evidenced by the Corporation's [petitioner's] current operat-

ing profits and steadily improving financial position".   That

petitioner awarded substantial additional compensation to Mr. Ruf

for services he provided during its fiscal year ended February
                             - 29 -


28, 1987, is entirely reasonable given the magnitude of the turn-

around he thereby achieved for petitioner during that year.20    It

also is entirely reasonable that petitioner desired to sustain

its turnaround and attempted to maximize its chances of doing so

by requiring Mr. Ruf to continue to provide services to it during

the three fiscal years following its fiscal year ended February

28, 1987.21

     We further find, based on our examination of the entire

record before us (including the testimony of Mr. Lyons and Mr.

Ruf, both of whom we found credible on this issue), that peti-


20
   On the present record, we reject respondent's contention that
Mr. Ruf was not undercompensated during petitioner's fiscal year
ended Feb. 28, 1987, because he received an option to purchase
petitioner's stock. Respondent did not determine that the
receipt of that option resulted in taxable compensation to Mr.
Ruf. Nor did she present any evidence to show that the purchase
price paid for all of petitioner's stock was less than the fair
market value of that stock. Although the stock option was
offered to Mr. Ruf in an effort to cause him to decide to join
petitioner, it does not necessarily follow that the amount of
reasonable compensation that petitioner may deduct for Mr. Ruf's
services during its taxable year ended Feb. 28, 1987, is affected
by Mr. Ruf's receipt of that option.

21
   On the instant record, we reject respondent's contention
that, because the $1,500,000 of compensation that petitioner was
to accrue under the 1987 deferred compensation arrangement in
equal installments of $500,000 for each of its fiscal years ended
Feb. 29, 1988, Feb. 28, 1989, and Feb. 28, 1990, was payable
"provided only that Jesse Ruf shall complete twelve (12) calendar
months of employment during each" of such fiscal years, petition-
er awarded the $933,333 of compensation it paid under that
arrangement exclusively for services Mr. Ruf provided during its
fiscal years ended Feb. 29, 1988, and Feb. 28, 1989.
                              - 30 -


tioner intended to compensate Mr. Ruf for services he performed

for it during its fiscal years ended February 29, 1988, February

28, 1989, and February 28, 1990, when it paid him $2,600,000 in

compensation during its fiscal year ended February 28, 1990.

     We shall now analyze and apply herein the relevant factors

identified by the Court of Appeals to determine reasonable

compensation within the meaning of section 162(a)(1).

Role in Company

     The first category of factors identified by the Court of

Appeals is the role in the company of the employee whose compen-

sation is at issue.   Relevant considerations include the employ-

ee's qualifications, position, hours worked, duties performed,

and general importance to the company's success.   Elliotts, Inc.

v. Commissioner, 716 F.2d at 1245-1246.

     There is little doubt that Mr. Ruf played a significant role

in returning petitioner to profitability.   At the time Mr. Ruf

became petitioner's CEO in March 1986, petitioner was on the

verge of bankruptcy and was not paying its suppliers and other

creditors because it did not have enough cash.   As of February

28, 1986, petitioner's net worth was negative $1,514,000.

According to its audited financial statement for its fiscal year

ended February 28, 1986, petitioner's net income after taxes (but

before utilization of net operating loss carryforwards/carry-
                                - 31 -


backs) for that year was negative $3,599,000.    In addition, at

the time that Mr. Ruf became petitioner's CEO, petitioner was

facing increased competition from the entry of large discount

home centers into its market.    Despite that competition, under

Mr. Ruf's direction, petitioner achieved, according to its

financial statements, a positive net income after taxes (but

before utilization of net operating loss carryforwards/carry-

backs) for each of its fiscal years ended February 28, 1987,

through February 28, 1991.

     After Mr. Ruf became petitioner's CEO in March 1986, he

undertook a number of initiatives in order to return petitioner

to profitability.   Shortly after becoming petitioner's CEO, he

negotiated with petitioner's suppliers to extend petitioner's

credit even though petitioner had not been paying its bills.

Petitioner's suppliers extended petitioner's credit in part

because of Mr. Ruf's reputation in the industry for turning

around troubled home centers.

     To improve employee morale, Mr. Ruf started having 7 a.m.

"donuts with Jess" meetings with petitioner's store employees.

As a result of his efforts, employee morale improved as evidenced

by fewer workmen's compensation claims and reduced inventory

shrinkage.

     Within approximately three to six months after becoming

petitioner's CEO, Mr. Ruf reduced petitioner's office staff by
                               - 32 -


approximately 50 percent and fired virtually all of petitioner's

top management personnel.    Instead of replacing those management

employees, Mr. Ruf himself assumed their responsibilities and

performed their functions.   As petitioner's CEO and president, he

was responsible for its management and operations, including its

day-to-day operations, marketing, human resources, merchandising,

advertising, check writing, accounts receivables, relations with

suppliers and noteholders, and real estate negotiations.      During

at least the first two or three years after he became peti-

tioner's CEO, Mr. Ruf worked 12 to 15 hours a day, six to seven

days a week.   With the exception of one employee who was made an

officer for the sole purpose of acting on petitioner's behalf in

small claims court and Mr. Lyons who became petitioner's CFO in

either March 1989 or March 1990, Mr. Ruf was petitioner's only

officer during the years at issue.

     After he became petitioner's CEO, Mr. Ruf was responsible

for changing petitioner's retail marketing strategy so that it

could compete effectively with the large discount home centers

that had entered its market.   Rather than trying to compete with

those companies on price, Mr. Ruf decided that petitioner needed

to provide better customer service.     In that respect, he

(1) changed petitioner's tradename to Lumber City, The City of

Home Improvement, (2) changed the interior design of petitioner's

stores to resemble stores within a city, and (3) made peti-
                                - 33 -


tioner's stores attractive and clean places in which to shop.

Rather than lowering prices, he increased petitioner's profit

margins by, inter alia, increasing petitioner's inventory turn-

over rate, sales per stores, and sales per employee.

     Not only did Mr. Ruf refocus petitioner's retail stores, he

also refocused its wholesale lumber business.    Prior to his

becoming petitioner's CEO, petitioner's wholesale lumber business

was primarily dependent on internal sales to its retail home

center stores.   Under Mr. Ruf's direction, the wholesale lumber

business focused on selling lumber to third parties.    As a result

of those efforts, petitioner became the largest supplier of

lumber to the movie studios in southern California, the largest

supplier of all vertical-grain Douglas fir to sash and door

manufacturers, and the largest industrial wholesaler of upper-

grade pine in the United States.

External Comparison

     The second category of relevant factors identified by the

Court of Appeals is a comparison of the employee's compensation

with that paid by similar companies in similar industries for

similar services.     Elliotts, Inc. v. Commissioner, supra at 1246;

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

     For purposes of making external comparisons, both parties

rely on the opinions of experts.    We evaluate the opinions of an

expert in light of such expert's qualifications and all other
                              - 34 -


evidence in the record.   See Estate of Christ v. Commissioner,

480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C. 493 (1970); IT&S

of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508 (1991); Parker v.

Commissioner, 86 T.C. 547, 561 (1986).    We have broad discretion

to evaluate the overall cogency of an expert's analysis.       Sammons

v. Commissioner, 838 F.2d 330, 334 (9th Cir. 1988) (quoting Ebben

v. Commissioner, 783 F.2d 906, 909 (9th Cir. 1986)), affg. in

part and revg. in part on another issue T.C. Memo. 1986-318.      We

are not bound by the formulae and opinions proffered by an

expert, especially when they are contrary to our own judgment.

Orth v. Commissioner, 813 F.2d 837, 842 (7th Cir. 1987), affg.

Lio v. Commissioner, 85 T.C. 56 (1985); Silverman v. Commis-

sioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-

285; Estate of Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir.

1955), affg. T.C. Memo. 1954-139.    Instead, we may reach a

decision based on our own analysis of all the evidence in the

record.   Silverman v. Commissioner, supra at 933.    The persua-

siveness of an expert's opinion depends largely upon the dis-

closed facts on which it is based.     See Tripp v. Commissioner,

337 F.2d 432, 434 (7th Cir. 1964), affg. T.C. Memo. 1963-244.

While we may accept the opinion of an expert in its entirety,

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.

441, 452 (1980), we may be selective in the use of any portion of

such an opinion.   Parker v. Commissioner, supra at 562.    We may
                                  - 35 -


also reject the opinion of an expert witness in its entirety.

Palmer v. Commissioner, 523 F.2d 1308, 1310 (8th Cir. 1975),

affg. 62 T.C. 684 (1974); Parker v. Commissioner, supra at 562-

565.

       Respondent relies on the opinions of E. James Brennan III

(Mr. Brennan), the president of a personnel and pay practice

consulting firm.    Using statistical analyses that compared the

ratios of CEO compensation to total sales based on survey data

collected by the Wyatt Executive Compensation Service (ECS), Mr.

Brennan concluded that the following is the highest maximum

compensation to which Mr. Ruf was entitled for each of the years

indicated:

                   Year Ended              Maximum Compensation

                 Feb. 28, 1989                    $389,760
                 Feb. 28, 1990                     368,190
                 Feb. 28, 1991                     914,490

       We are unwilling to rely on Mr. Brennan's analyses or his

opinions.    One of the principal problems we have with his anal-

yses is that we are not persuaded that the ECS survey data on

which they were based are data obtained from companies that are

comparable to petitioner.       For example, Mr. Brennan used data he

obtained from the broad category of retail trade, rather than a

narrower category of retail home centers.      In fact, there is no

evidence that a single home center was included in the survey

data on which Mr. Brennan relied.      Moreover, although petitioner
                              - 36 -


had annual sales of only approximately $60 million during the

relevant years, it does not appear that any company included in

the ECS survey data had annual sales of less than $150 million.22

     Petitioner relies on the opinions of Bruce W. Barren, Ph.D.

(Dr. Barren), the chairman of an international merchant banking

firm, and Joseph D. Vinso, Ph.D. (Dr. Vinso), the president of a

business valuation and consulting firm.   We are unwilling to rely

on the analyses or opinions of either of petitioner's experts.

     In his expert report, Dr. Barren analyzed the various

factors outlined by the Court of Appeals in Elliotts, Inc. v.

Commissioner, 716 F.2d 1241 (9th Cir. 1983), and concluded that

the compensation paid to Mr. Ruf was reasonable.   Dr. Vinso also

applied the factors identified by the Court of Appeals in the

Elliotts case and expressed his opinion as to whether the weight

of those factors shows that the compensation paid by petitioner

to Mr. Ruf was reasonable.   That is not the role of an expert,

see Marx & Co. v. Diners' Club Inc., 550 F.2d 505, 508-511 (2d


22
   Although Mr. Brennan conducted a telephone survey to deter-
mine the accuracy of his results, we did not find the telephone
survey to be reliable or probative of comparable compensation.
In conducting his telephone survey, Mr. Brennan simply inquired
whether any of the companies he called paid their respective CEOs
compensation in excess of $500,000. However, there was no dis-
cussion during those telephone discussions of what constituted
compensation or whether the work performed by the CEO of each of
those companies was comparable to the work performed by Mr. Ruf.
Nor does the record establish that the companies Mr. Brennan
surveyed by telephone were totally candid and forthcoming about
information relating to their respective CEOs' compensation.
                              - 37 -


Cir. 1977); Garnac Grain Co. v. Commissioner, 95 T.C. 7, 26-27

(1990), and we do not rely on the respective opinions of Dr.

Barren and Dr. Vinso concerning such matters.

     With respect to Dr. Barren, we found him to be evasive at

times when questioned on cross-examination.    For example, he was

unwilling to give his opinion on cross-examination of the maximum

amount of Mr. Ruf's compensation for the years at issue that he

considered reasonable.   In addition, we found Dr. Barren's analy-

ses to be flawed in a number of respects.    By way of illustra-

tion, when Dr. Barren analyzed the compensation paid by each

company that he found to be comparable to petitioner, he con-

cluded that Mr. Ruf was entitled to compensation that was equal

to the total officer compensation, rather than just the CEO

compensation, paid by each such allegedly comparable company.

However, he failed to compare the roles undertaken by all the of-

ficers at each of those allegedly comparable companies with the

roles undertaken by Mr. Ruf at petitioner.    Thus, we are not

persuaded that Mr. Ruf is entitled to the compensation of all the

officers of any of those allegedly comparable companies.

     With respect to Dr. Vinso, we found his testimony to be at

times contradictory and evasive.   For example, when asked on

cross-examination, Dr. Vinso was unwilling to say whether or not

there was a statistical correlation between a company's asset

size and the ratio of its officer compensation to its sales.     In
                              - 38 -


addition, we found his analyses to be flawed in certain respects.

By way of illustration, like Mr. Brennan, Dr. Vinso used statis-

tical analyses of the ratios of officer compensation to sales

based on survey data to compute the amount of compensation to

which Mr. Ruf was entitled.   Rather than utilizing the ECS survey

data on which Mr. Brennan relied, Dr. Vinso relied on survey data

collected by Robert Morris Associates (RMA).     As was true of the

ECS survey data Mr. Brennan used, the RMA survey data Dr. Vinso

used appears to have been obtained from companies that were not

comparable to petitioner.   At trial, Dr. Vinso admitted that,

because no information was provided in the RMA survey data for

the asset range that included petitioner (i.e., $10 million to

$50 million), he used the ratios that were derived from companies

with assets ranging from $1 million to $10 million.23

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

opinions expressed by any of the experts upon whom the parties

rely to be persuasive or reliable.     We are unwilling to accept

their respective opinions regarding Mr. Ruf's compensation during

the years at issue.

Character and Condition of the Company

     The third category of factors identified by the Court of


23
   We also note that some of the criticisms that Dr. Barren
expressed during his testimony concerning Mr. Brennan's use of
survey data to calculate reasonable compensation apply equally to
Dr. Vinso's use of survey data for that purpose.
                               - 39 -


Appeals concerns the character and condition of the company.    The

relevant factors include the company's size as shown by its

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

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

Commissioner, supra at 1246.

     Petitioner has demonstrated that prior to and during the

years at issue it was engaged in a very competitive and complex

business.   Prior to Mr. Ruf's arrival, petitioner was on the

verge of bankruptcy and was facing increased competition from the

entry of large discount home centers into its market.   Although

petitioner was on the verge of bankruptcy prior to Mr. Ruf's

becoming its CEO and, according to its financial statement, had

net income after taxes (but before utilization of net operating

loss carryforwards/carrybacks) for its fiscal year ended February

28, 1986, of negative $3,599,000, its financial statements show

that it had a net profit after taxes (but before utilization of

net operating loss carryforwards/carrybacks) for its fiscal years

ended February 28, 1987, February 29, 1988, February 28, 1989,

February 28, 1990, and February 28, 1991, of $823,000, $413,000,

$390,000, $325,000, and $275,000, respectively.   Under Mr. Ruf's

direction, petitioner made a significant turnaround and returned

to profitability.

     Although petitioner's financial statements show that it had

a positive net profit after taxes (but before utilization of net
                              - 40 -


operating loss carryforwards/carrybacks) for each of its five

fiscal years that commenced with its fiscal year ended February

28, 1987, at the beginning of which Mr. Ruf became its CEO,

respondent notes that those net profits declined for each such

successive year.   She argues that such a pattern of declining net

profits is a factor that should significantly reduce the amount

of Mr. Ruf's compensation that is considered reasonable for each

such year.   Respondent's argument fails to take into account that

the decline in petitioner's net profits as reflected in its

financial statements for the five-year period that began with its

fiscal year ended February 28, 1987, and ended with its fiscal

year ended February 28, 1991, was attributable in part to peti-

tioner's expensing in its financial statements for certain of

those years (i.e., its fiscal years ended February 29, 1988, and

February 28, 1990) substantial amounts of compensation that were

partially attributable to services Mr. Ruf provided during fiscal

years other than those for which such amounts were expensed.

     In its financial statement for its fiscal year ended

February 29, 1988, petitioner expensed $871,000 pursuant to the

1987 deferred compensation arrangement.   That was the only

expense petitioner reflected in its financial statements for the

years at issue with respect to that arrangement.   Although that

amount was expensed in its entirety in petitioner's financial

statement for its fiscal year ended February 29, 1988, we have
                              - 41 -


found on the record before us that petitioner intended most of

the amount it paid Mr. Ruf pursuant to the 1987 deferred compen-

sation arrangement to be compensation for services he provided to

petitioner during its fiscal year ended February 28, 1987, and

the balance to be compensation for services he provided during

its fiscal years ended February 29, 1988, and February 28, 1989.

If petitioner had reflected the amount it expensed pursuant to

that arrangement for the years during which he provided the

services for which petitioner intended to compensate him, rather

than entirely for its fiscal year ended February 29, 1988, its

net profit for each of its fiscal years ended February 28, 1987,

and February 28, 1989, would have decreased, and its net profit

for its fiscal year ended February 29, 1988, would have increased

by an amount correlating to the total amount of the decreases in

net profit for those other two years, thereby changing the

pattern of declining profits on which respondent relies.

     Similarly, although petitioner expensed in its financial

statement for its fiscal year ended February 28, 1990, $2,600,000

of compensation it paid Mr. Ruf during that year, we have found

on the record before us that petitioner intended that amount to

be compensation to Mr. Ruf for services he provided to it during

its fiscal years ended February 29, 1988, February 28, 1989, and

February 28, 1990.   If petitioner had expensed the $2,600,000 of

compensation for its fiscal years during which he provided the
                              - 42 -


services for which petitioner intended to compensate him, rather

than entirely for its fiscal year ended February 28, 1990, its

net profit for each of its fiscal years ended February 29, 1988,

and February 28, 1989, would have decreased, and its net profit

for its fiscal year ended February 28, 1990, would have increased

by an amount correlating to the total amount of the decreases in

net profit for those other two years, thereby also changing the

pattern of declining profits on which respondent relies.24

Conflict of Interest

     The fourth category of factors identified by the Court of

Appeals concerns whether some relationship exists between the

company and the employee whose compensation is at issue that

might permit the company to disguise nondeductible corporate

distributions of income as compensation deductible under section

162(a)(1).   Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

Such a relationship exists in the instant case.    Mr. Ruf was

petitioner's sole shareholder during the relevant period.

Situations in which an employee is the sole or controlling

shareholder warrant close scrutiny.    See id.   "The mere existence

of such a relationship, however, when coupled with an absence of

dividend payments, does not necessarily lead to the conclusion

24
   We also note that if we were to determine that any of the
$2,600,000 of compensation petitioner expensed in its financial
statement for its fiscal year ended Feb. 28, 1990, did not con-
stitute reasonable compensation for that year or any other year,
petitioner's net profit for that year would have increased.
                                 - 43 -


that the amount of compensation is unreasonably high."       Id.   In

situations in which a potentially exploitable relationship

exists, such as the present case, the Court of Appeals indicated

that the Court should make an inquiry from the perspective of an

independent investor to determine whether the investor would be

satisfied with the company's return on equity after the compensa-

tion at issue was paid.    Id. at 1247.

     Return on equity is calculated by dividing the net profit

(after payment of compensation and taxes) by the shareholder's

equity.   Id.   Respondent argues that we should use the beginning

shareholder's equity to calculate return on equity.       Petitioner

argues that we should use the average of the beginning and

yearend shareholder's equity to calculate that return.       The Court

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

equity using the yearend shareholder's equity.       Following that

approach, see Golsen v. Commissioner, 54 T.C. 742 (1970), affd.

on another issue 445 F.2d 985 (10th Cir. 1971), if we were to

divide petitioner's net profit after taxes (but before utiliza-

tion of net operating loss carryforwards/carrybacks) by its

yearend shareholder's equity, as reflected in its financial

statements for each of the years indicated, petitioner would have

the following percentage return on equity:

                                             Percentage
                   Year Ended             Return on Equity

                 Feb. 28, 1987                  31
                                    - 44 -


                Feb.   29,   1988              81
                Feb.   28,   1989              35
                Feb.   28,   1990              22
                Feb.   28,   1991              16

     Unlike the situation presented in Elliotts, Inc. v. Commis-

sioner, 716 F.2d 1241 (1983), we find on the instant record that

petitioner's return on equity for the relevant years, regardless

how it is calculated, is not a reliable indicator of the reason-

ableness of Mr. Ruf's compensation for the years at issue.       The

shareholder-employee in the Elliotts, Inc. case had been the sole

shareholder of the taxpayer-corporation for 21 years prior to the

years at issue therein.      Elliotts, Inc. v. Commissioner, supra at

1242.   In contrast, assuming arguendo that Mr. Ruf were an

independent investor, petitioner's shareholder's equity does not

appear to reflect accurately his investment in petitioner during

the relevant years.    Although the final purchase price that Mr.

Ruf negotiated for petitioner's stock in November 1988 was

$2,045,520, its yearend shareholder's equity as reflected in its

financial statement for its fiscal year ended February 28, 1989,

was only $1,129,000.    We believe that an independent investor

would be concerned with the return on his or her investment of

$2,045,520, not the return on the shareholder's equity that

reflected some prior shareholder's investment.       In addition,

petitioner's shareholder's equity was subject to large fluctu-

ations during the relevant period due to Stanislaus' purchase of

petitioner and its subsequent merger into it.       In sum, on the
                               - 45 -


instant record, neither party has persuaded us that, assuming

arguendo that Mr. Ruf were an independent investor, petitioner's

shareholder's equity accurately reflected his investment in

petitioner during the relevant years.

     Moreover, even if the shareholder's equity accurately

reflected Mr. Ruf's investment in petitioner for the relevant

years, assuming arguendo that he were an independent investor

during those years, the record does not contain any credible

evidence of what an independent investor would have required as a

reasonable return on equity for investing in petitioner.    This is

especially true given the fact that petitioner was on the verge

of bankruptcy at the time Mr. Ruf became petitioner's CEO.25

     Although under the facts and circumstances presented here we

do not find petitioner's return on equity to be a reliable

indicator of the reasonableness of Mr. Ruf's compensation for the

years at issue, we find it significant that the compensation paid

by petitioner to Mr. Ruf was approved by Mr. Neiman.   From the

time Stanislaus purchased petitioner in December 1986 and

throughout the years at issue, Mr. Neiman retained an interest in

petitioner both as a founder of a corporation who wished to see

that corporation succeed and as a creditor who held notes for

which petitioner was liable.   In addition, from the time Stanis-

25
   We did not find the opinions expressed by either of petition-
er's experts (viz., Dr. Barren and Dr. Vinso) on this issue to be
helpful to the Court.
                              - 46 -


laus purchased petitioner in December 1986 until Mr. Ruf and the

former shareholders agreed on a final purchase price for peti-

tioner in November 1988, Mr. Neiman retained an interest in

petitioner's profits and net worth in that the final purchase

price for petitioner was to be calculated based on a formula

using those amounts.   Prior to, during, and after the years at

issue, Mr. Neiman received and reviewed petitioner's financial

statements, retained an office next to that of Mr. Ruf, and dis-

cussed petitioner's financial condition with Mr. Ruf.

     During his testimony, Mr. Neiman indicated that he never

objected to Mr. Ruf's compensation and believed that "it was

right and proper."   He also testified that although the original

notes initially restricted the amount of cash that Mr. Ruf was

able to withdraw from petitioner due to its poor cash position,

Mr. Neiman intended for Mr. Ruf to be "justly compensated" as

soon as the cash was available to do so.   Thus, Mr. Neiman

specifically approved the concept of retroactive compensation for

Mr. Ruf as petitioner's financial situation improved.

Internal Consistency

     The last category of factors identified by the Court of

Appeals relates to whether the compensation at issue was paid

pursuant to a structured, formal, and consistently applied

program.   Bonuses not paid pursuant to such plans are suspect.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1247.
                              - 47 -


     After becoming petitioner's CEO, Mr. Ruf was subject to

certain arrangements concerning compensation.   For example, the

$933,333 that petitioner paid to Mr. Ruf during its fiscal year

ended February 28, 1989, was awarded pursuant to the 1987 de-

ferred compensation arrangement.   All of the arrangements con-

cerning Mr. Ruf's compensation were terminated prior to peti-

tioner's fiscal year ended February 28, 1990, and Mr. Ruf's

compensation for that year was not determined pursuant to a plan.

Amounts of Reasonable Compensation

     Based on our review of the entire record in this case, we

find that, of the $933,333 that petitioner paid Mr. Ruf during

its fiscal year ended February 28, 1989, pursuant to the 1987 de-

ferred compensation arrangement, the following amounts are

reasonable amounts of compensation paid for services Mr. Ruf

provided to petitioner during the indicated years:

             Year Ended              Amount of Compensation

            Feb. 28, 1987                 $733,333
            Feb. 29, 1988                  100,000
            Feb. 28, 1989                  100,000

     We further find that, of the $2,600,000 that petitioner paid

Mr. Ruf during its fiscal year ended February 28, 1990, the

following amounts totaling $1 million are reasonable amounts of

compensation paid for services Mr. Ruf provided to petitioner

during the years indicated:
                               - 48 -


             Year Ended          Amount of Compensation

            Feb. 29, 1988               $600,000
            Feb. 28, 1989                400,000

We further find that the remaining $1,600,000 of the $2,600,000

that petitioner paid Mr. Ruf during its fiscal year ended

February 28, 1990, was for services he provided during that year

and that only $800,000 of that amount was a reasonable amount of

compensation for those services.26   Accordingly, we find that a

total of $1,800,000 constitutes reasonable compensation within

the meaning of section 162(a)(1) for which petitioner is entitled



26
   To summarize, based on our review of the entire record in
this case, we find that the following are reasonable amounts of
compensation to Mr. Ruf for the indicated years:

            Year Ended           Reasonable Compensation

           Feb.   28,   1987            $1,128,936
           Feb.   29,   1988               832,629
           Feb.   28,   1989               632,693
           Feb.   28,   1990               800,000
           Feb.   28,   1991               750,000

We note that in the notice, at trial, and/or on brief, respondent
allowed the total amounts of compensation that petitioner deduct-
ed in its returns for its taxable years ended Feb. 29, 1988, Feb.
28, 1989, and Feb. 28, 1991. Respondent also conceded on brief
the $73,117 of interest petitioner deducted in its Federal income
tax return for its taxable year ended Feb. 28, 1989, that was
related to the $315,603 of compensation awarded pursuant to the
management agreement. Consequently, our findings herein affect
petitioner's Federal income tax liability only for its taxable
year ended Feb. 28, 1990, and not for its taxable years ended
Feb. 29, 1988, Feb. 28, 1989, and Feb. 28, 1991.
                             - 49 -


to a deduction for its taxable year ended February 28, 1990.

     To reflect the foregoing and the concessions of the parties,

                                        Decision will be entered

                                   under Rule 155.
