                        T.C. Memo. 2007-305



                      UNITED STATES TAX COURT



            UNIVERSAL MARKETING, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8744-02.              Filed October 9, 2007.



     Daniel L. Reeves (officer), for petitioner.

     Wesley F. McNamara, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HAINES, Judge:   Respondent determined a deficiency in

petitioner’s Federal corporate income tax of $170,674 for the

fiscal year ending (FYE) May 31, 1996.

     The issues for decision are:   (1) Whether the amounts paid

to petitioner’s sole executive and shareholder constituted

reasonable compensation pursuant to section 162(a)(1); and
                                - 2 -

(2) whether petitioner is entitled to deduct $80,000 as an

expenditure for supplies pursuant to section 162(a), or if

required to capitalize the expenses, whether petitioner is

entitled to depreciate the $80,000 expenditure over a 7-year

recovery period under section 168(c).1

                          FINDINGS OF FACT

     At the time the petition was filed, petitioner maintained

its business office in Wilsonville, Oregon.2

A.   Background

     Petitioner’s predecessor, Vitamin Village, Inc. (VVI), was

incorporated by Daniel L. Reeves (Mr. Reeves) in the State of

Oregon in 1979.    VVI, an accrual basis taxpayer with an FYE June

30, was in the business of producing, distributing, and selling

skin care products, tanning lotions, diet aids, sports

performance products, nutritional supplements, health food

products, and apparel at both the retail and wholesale levels.

VVI also provided indoor tanning salon services and its own

printing, advertising, and marketing services.    VVI used the

business name of Vitamin Village for the production and sales of

nutritional supplements, health food, skin care products, and


     1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code), as amended. All Rule
references are to the Tax Court Rules of Practice and Procedure,
unless otherwise indicated. Amounts are rounded to the nearest
dollar.
     2
         The parties did not file a stipulation of facts.
                                - 3 -

tanning lotions; Club Tan for its tanning salon services; and

Universal Graphics for its advertising, marketing, and printing

activities.

B.   Incorporation of Petitioner

     On June 1, 1995, VVI incorporated petitioner and elected an

FYE May 31.   On June 1, 1995, VVI also transferred $487 in cash

along with the printing equipment used by Universal Graphics, an

automobile, and fixtures with a total fair market value of

$53,555 in exchange for all issued shares of petitioner’s stock.

The shares of stock were transferred to Mr. Reeves in a section

355 reorganization resulting in VVI and petitioner becoming

brother-sister corporations.3

     Mr. Reeves was petitioner’s president, secretary, treasurer,

sole shareholder, and sole manager.

C.   Petitioner’s Services

     In June 1995, at the beginning of petitioner’s FYE May 31,

1996, VVI entered into an agreement with petitioner, in which

petitioner agreed to brand, market, and advertise skin care and

tanning products sold by VVI for $1 million.   Petitioner’s only

other customer was its sister corporation Club Tan Centers of

Oregon, Inc., of which Mr. Reeves was the sole owner and


     3
       Additionally, in December 1994 VVI incorporated Club Tan
Centers of Oregon, Inc. (CTC), transferred the assets used by
Club Tan to CTC in exchange for all issued shares of CTC’s
stock, and the shares of stock were transferred to Mr. Reeves in
a sec. 355 reorganization.
                                - 4 -

shareholder.    Petitioner provided minimal services for CTC in FYE

May 31, 1996.

     During FYE May 31, 1996, petitioner provided the following

marketing and advertising services for VVI:     Photographed models

and VVI products, sponsored pro and semipro athletes, sponsored

various sporting events,4 negotiated with retail stores and

distributors to sell VVI’s products, including developing and

distributing advertising displays and posters to these stores,

and promoted VVI’s traveling trade shows.

D.   Petitioner’s Financial Condition and Employee Compensation

     On its Form 1120, U.S. Corporation Income Tax Return, for

FYE May 31, 1996, petitioner reported gross receipts of

$1,055,433, with total income of $1,143,468.5    After petitioner

deducted a $500,000 bonus and a $9,000 salary as executive

compensation to Mr. Reeves, $31,757 as salary and wages to its

employees, $113,369 for a supplies business expense, and $426,963

in various other deductions, petitioner’s taxable income was

$62,379 with a total tax of $21,2096 and a net income book value




     4
       Sporting events included volleyball and waterskiing
competitions.
     5
       Total income included gross rents of $67,347 and gross
royalties of $20,688.
     6
       The total tax due included an estimated tax penalty of
$1,029.
                                   - 5 -

of $38,886.7      One component of the $113,369 expense for supplies

was evidenced by a check for $80,000 that was made payable to

VVI.       The $80,000 check was signed by Mr. Reeves and bore the

notation “asset purchase UG”.8

       Petitioner’s rate of return on equity was 42 percent for FYE

May 31, 1996.9      Petitioner did not pay any dividends in FYE May

31, 1996.

       Petitioner did not maintain a compensation policy for Mr.

Reeves or its employees.       The bonus Mr. Reeves received was not

based upon a formula or previously set forth in writing.       Each

bonus was determined and paid at the end of the fiscal year when

petitioner could ascertain its cash available.




       7
       Respondent disallowed all but $100,000 of the $509,000
deduction petitioner claimed for officer’s compensation paid to
Mr. Reeves.

     Net income book value was reported on petitioner’s Form 1120
Schedule M-1. Net income book value was computed by subtracting
from taxable income of $62,379, $21,209 of Federal income tax and
$2,284 comprising Federal and State underpayment penalties,
accrued related party compensation, and a travel and
entertainment expense recorded on the books but not deducted on
the return.
       8
       Respondent disallowed the $80,000 expense deduction but
allowed petitioner to depreciate the $80,000 over a 39-year
recovery period under the modified accelerated cost recovery
system. The allowed depreciation deduction was $2,051.
       9
       Rate of return on equity is computed by dividing
petitioner’s net income book value of $38,886 by its equity value
of $92,928.
                                - 6 -

     Respondent issued the notice of deficiency on March 8, 2002.

Petitioner timely filed its petition on May 13, 2002, and filed

an amended petition on August 19, 2002.

                               OPINION

I.   Reasonable Compensation

     Petitioner contends the $509,000 paid to Mr. Reeves

constituted reasonable compensation under section 162(a)(1)

during its FYE May 31, 1996.

     Respondent contends petitioner is entitled to deduct only

$100,000 as compensation under section 162(a)(1) with the

remaining $409,000 constituting a nondeductible dividend.

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

allowance for salaries or other compensation for personal

services actually rendered”.   A taxpayer is entitled to a

deduction for compensation only if the payments were reasonable

in amount and in fact paid purely for services.   Sec. 1.162-7(a),

Income Tax Regs.10   Although framed as a two-prong test, the

inquiry under section 162(a)(1) generally turns on whether the

amounts of the purported compensation payments were reasonable.

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245 (9th Cir.

1983), revg. T.C. Memo. 1980-282.




     10
       Respondent argues only that the amount of compensation
was unreasonable.
                                   - 7 -

     Because petitioner’s place of business is in the State of

Oregon, absent stipulation otherwise, an appeal of this case

would go to the Court of Appeals for the Ninth Circuit.        See sec.

7482(b)(1)(B).     The Court of Appeals uses five factors to

determine the reasonableness of compensation, with no single

factor being determinative.       Elliotts, Inc. v. Commissioner,

supra.    The factors are:    (1) The employee’s role in the company;

(2) comparison of the compensation with that of similar

companies, (3) the character and condition of the company, (4)

potential conflicts of interest, and (5) internal consistency in

compensation.    Id. at 1245-1248.    Where shareholder-officers who

control the corporation set their own compensation, careful

scrutiny is necessary to determine whether the alleged

compensation is in fact a distribution of profits and a

constructive dividend.       Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1156 (1980).      Petitioner bears the

burden of proving the payments to Mr. Reeves were reasonable.11

See Rule 142(a).




     11
       Petitioner does not argue that sec. 7491(a) operates to
shift the burden of proof to respondent. Even if petitioner had
so argued, the burden of proof would not shift under sec. 7491(a)
because petitioner has not shown it maintained all required
records, nor has it shown it cooperated with the reasonable
requests of respondent for witnesses, documents, or meetings.
                                  - 8 -

II.   The Elliott Factors Applied to Petitioner’s Compensation of
      Mr. Reeves

      A.    Role in the Company

      This factor focuses on the employee’s importance to the

success of the business.    Pertinent considerations include the

employee’s position, hours worked, and duties performed.

Elliotts, Inc. v. Commissioner, supra at 1245.

      Mr. Reeves served as petitioner’s president, secretary, and

treasurer and handled all petitioner’s managerial duties.

However, the record does not establish the specific amount of

time Mr. Reeves spent operating petitioner after it was

incorporated.   Instead, the record indicates that Mr. Reeves

spent a considerable amount of his time operating petitioner’s

sister corporation, VVI.

      B.    External Comparison

      This factor compares the employee’s compensation with that

paid by similar companies for similar services.     Elliotts, Inc.

v. Commissioner, supra at 1246; see sec. 1.162-7(b)(3), Income

Tax Regs.

      Petitioner failed to provide any data comparing the

compensation paid to Mr. Reeves with that paid by similar

companies providing similar services.     Only respondent offered

expert testimony.    However, respondent’s expert, Scott D. Hakala,

provided a reasonable compensation analysis focusing only on
                                 - 9 -

companies dealing with the development and sales of nutritional

products and not on companies that provided branding, marketing,

and advertising services.12

     C.   Character and Condition of the Company

     This factor requires the Court to focus on petitioner’s

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

complexities of the business; and general economic conditions.

Elliotts, Inc. v. Commissioner, supra at 1246.

     Petitioner was incorporated in FYE May 31, 1996, with only

$487 in cash, and used equipment, including an automobile, with a

total fair market value of $53,555.      Although petitioner

generated total gross receipts of $1,055,433, petitioner’s net

income was only $38,886 in its initial year of operation.      All

but $55,433 of its gross receipts were generated from one

customer, its sister corporation VVI.      Petitioner had a small

staff and paid wages of $31,757 to its employees.      Therefore,

petitioner was a relatively small company whose operations were

not particularly extensive or complex.

     D.   Conflict of Interest

     This factor examines whether a relationship exists between

the company and the employee which may permit the company to

disguise nondeductible corporate distributions as section



     12
       See Vitamin Vill., Inc. v. Commissioner, T.C. Memo. 2007-
272, for an analysis of Mr. Hakala’s report.
                               - 10 -

162(a)(1) compensation payments.    Close scrutiny may be used when

the paying corporation is controlled by the compensated employee,

as in the instant case.    Elliotts, Inc. v. Commissioner, 716 F.2d

at 1246-1247.   However, the mere fact that the individual whose

compensation is under scrutiny is the sole shareholder of the

company, even when coupled with an absence of dividend payments,

does not necessarily lead to the conclusion that the amount of

compensation is unreasonably high.      Id.

     The Court of Appeals for the Ninth Circuit determined that

the reasonableness of compensation should be evaluated from the

perspective of a hypothetical independent investor.    The prime

indicator is the return on the investor’s equity.     Id. at 1247.

If the company’s earnings on equity after payment of the

questioned compensation remain at a level that would satisfy a

hypothetical independent investor, there is a strong indication

that the employee is providing compensable services and that

profits are not being siphoned out of the company disguised as

salary.   Id.   The Court of Appeals in Elliotts calculated the

return on equity using the yearend shareholders equity.    Id.

This Court follows that approach.    See Golsen v. Commissioner, 54

T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971); Lumber City

Corp. v. Commissioner, T.C. Memo. 1996-171.

     Petitioner had a 42-percent return on equity after dividing

the net income book value by the yearend shareholders equity.      In
                                  - 11 -

Elliotts, the Court of Appeals found that a 20-percent average

rate of return on equity would satisfy a hypothetical independent

investor.    Elliotts, Inc. v. Commissioner, supra at 1247.

However, because petitioner was thinly capitalized with $487 in

cash, and used equipment with a total fair market value of

$53,555, this factor is given little weight.

     E.     Internal Consistency in Compensation

     This factor focuses on whether the compensation in question

was paid pursuant to a structured, formal, and consistently

applied program.    Id.   Bonuses not paid pursuant to such a

program are suspect.      Id.   Bonuses paid to employees are

deductible ”when * * * made in good faith and as additional

compensation for the services actually rendered by the employees,

provided such payments, when added to the stipulated salaries, do

not exceed a reasonable compensation for the services rendered.”

Sec. 1.162-9, Income Tax Regs.

     Petitioner did not maintain a compensation policy for its

officers and employees, and Mr. Reeves’s bonus of $500,000 was

not awarded under a structured, formal, or consistently applied

program.    Rather, the bonus was determined and paid at the end of

the fiscal year when petitioner could ascertain its cash

available.
                                - 12 -

     F.      Conclusion

     Petitioner has failed to meet its burden of proving that the

$509,000 payment to Mr. Reeves constituted reasonable

compensation.     Therefore, the Court finds that the payment of

$100,000 in petitioner’s FYE May 31, 1996, as allowed by

respondent, is deductible under section 162(a)(1).13

III. Petitioner’s $80,000 Expense Deduction

     Under section 162(a), a taxpayer may deduct ordinary and

necessary business expenses incurred or paid during the taxable

year.     Generally, a taxpayer carrying materials and supplies on

hand is allowed to deduct expenditures for them only in the

amount that they are actually consumed and used in operation

during the taxable year.14    Sec. 1.162-3, Income Tax Regs.

However, the cost of acquiring property having a useful life

beyond a taxable year is a nondeductible capital expenditure,

except as otherwise provided in chapter 1 of the Code.15

Prudential Overall Supply v. Commissioner, T.C. Memo. 2002-103;


     13
       Conversely, the Court finds $409,000 of the $509,000
claimed as a deduction for FYE May 31, 1996, to be
nondeductible.
     14
       Sec. 1.162-3, Income Tax Regs., also allows costs of
incidental materials and supplies to be deducted when purchased
if inventories and records of consumption are not kept and
taxable income is clearly reflected.
     15
       For instance, sec. 167(a) provides that there shall be
allowed as a depreciation deduction a reasonable allowance for
the exhaustion, wear, and tear of property used in a trade or
business.
                                - 13 -

secs. 1.263(a)-1 and 1.263(a)-2(a), Income Tax Regs.      The

taxpayer is required to maintain records sufficient to enable the

Commissioner to determine his correct tax liability.      See sec.

6001; sec. 1.6001-1(a), Income Tax Regs.   The taxpayer has the

burden to prove the Commissioner’s determination was in error.16

Rule 142(a).

     At trial, petitioner produced a check payable to VVI for

$80,000, dated October 3 or 5, 1995, bearing the notation “asset

purchase UG”.17   Mr. Reeves testified that the $80,000

expenditure was initially recorded in petitioner’s books as an

“equipment purchase” and was most likely paid to purchase

darkroom equipment, plates, small hand tools, paper, and ink.        On

brief, petitioner indicated that the expenditure was most likely

for “miscellaneous equipment that would have gone hand-in-hand

with the printing equipment”.

     Although small hand tools, paper, and ink could fit the

description of incidental materials and supplies the costs of

which may be deducted currently under section 162, petitioner


     16
       Petitioner does not argue that sec. 7491(a) operates to
shift the burden of proof to respondent. Even if petitioner had
so argued, the burden of proof would not shift under sec. 7491(a)
because petitioner has not shown it maintained all required
records, nor has it shown it cooperated with the reasonable
requests of respondent for witnesses, documents, or meetings.
     17
       UG was the acronym for Universal Graphics. Universal
Graphics was the business name for VVI’s printing, advertising,
and marketing services before petitioner’s sec. 355
reorganization.
                              - 14 -

failed to produce evidence allocating any portion of the $80,000

to such incidental items so as to allow them to be deducted.    See

sec. 1.162-3, Income Tax Regs.18   Therefore, the Court finds

petitioner is not entitled to deduct any of the $80,000 as an

ordinary and necessary business expense under section 162(a).

     In the alternative, petitioner contends the $80,000 was used

to purchase property which is depreciable over a 7-year recovery

period under the modified accelerated cost recovery system

(MACRS).   Respondent does not dispute that the property is

depreciable under section 167(a) but contends that the $80,000

was used to purchase property with a 39-year recovery period

under the MACRS.19

     Section 167(a) generally allows as a depreciation deduction

a reasonable allowance for the exhaustion, wear, tear, and

obsolescence of property used in a trade or business.   MACRS

provides that the depreciation deduction provided by section

167(a) for any tangible property must be determined by using the

applicable depreciation method, the applicable recovery period,


     18
       “Taxpayers carrying materials and supplies on hand should
include in expenses the charges for materials and supplies only
in the amount that they are actually consumed and used in
operation during the taxable year.” Sec. 1.162-3, Income Tax
Regs. In contrast, the cost of acquiring “equipment * * * and
similar property having a useful life substantially beyond a
taxable year” is a capital expenditure. Sec. 1.263(a)-2(a),
Income Tax Regs.
     19
       Respondent did not delineate what type of property
petitioner may have purchased with the $80,000.
                                  - 15 -

and the applicable convention.       Sec. 168(a); Hospital Corp. of

Am. v. Commissioner, 109 T.C. 21, 45 (1997).       Only the applicable

recovery period is at issue.

     Property with 39-year recovery period is nonresidential real

property.20    Sec. 168(c).    Nonresidential real property is

defined as “section 1250 property which is not-- (i) residential

rental property, or (ii) property with a class life of less than

27.5 years.”    Sec. 168(e)(2)(B).     Section 1250 property is any

real property (other than section 1245 property, as defined in

section 1245(a)(3)) which is or has been subject to the

depreciation allowance under section 167.       Sec. 1250(c).    Real

property, as used in section 1250(c), includes land, improvements

thereto, including a building or its structural components, and

other real property except that which is defined in section

1245(a)(3)(B)-(F).    Sec. 1.1250-1(e)(3)(i), Income Tax Regs.

     Respondent concedes petitioner used the $80,000 to purchase

an asset and “petitioner’s records included documentation, at

least at one time, indicating that the check was, in fact, paid

to purchase equipment”.       Mr. Reeves credibly testified that the


     20
       MACRS generally classifies eligible personal property and
certain real property as 3-year property, 5-year property, 7-year
property, 10-year property, 15-year property, or 20-year property
and assigns that property to a corresponding recovery period on
the basis of the property’s class life. Sec. 168(c), (e)(1),
(3). MACRS generally classifies real property as residential
rental property or nonresidential real property, assigning
recovery periods of 27.5 years and 39 years, respectively. Sec.
168(c), (e)(2).
                              - 16 -

$80,000 expenditure was initially recorded in petitioner’s books

as an equipment purchase and was likely used to purchase

equipment associated with printing.

     The record indicates that the property purchased with the

$80,000 did not consist of nonresidential real property, i.e.

section 1250 property which is not residential rental property,

or property with a class life of less than 27.5 years.

Therefore, this Court finds petitioner is not required to

depreciate the $80,000 over a 39-year recovery period pursuant to

section 168(c).

      Petitioner did not produce evidence indicating the

equipment had a class life of less than 10 years, which would

allow petitioner to recover the $80,000 over a 5-year period.21

See sec. 168(e)(3)(B); Rev. Proc. 87-56, 1987-2 C.B. 674, as

clarified and modified by Rev. Proc. 88-22, 1988-1 C.B. 785.

Moreover, none of the property petitioner asserted it had

purchased with the $80,000 had a class life of 16 years or more

with an applicable recovery period greater than 10 years.      See

sec. 168(c), (e)(1), (3)(D); Rev. Proc. 87-56, supra.

     However, petitioner did produce evidence indicating the

$80,000 was used to purchase printing equipment which has a class

life of 11 years.   See Rev. Proc. 87-56, 1987-2 C.B. at 679


     21
       Property with a class life of greater than 4 but less
than 10 years is treated as 5-year property, which has a 5-year
recovery period. Sec. 168(c), (e)(1), (3)(B).
                              - 17 -

(asset class 27.0).   Therefore, the Court finds that the

equipment petitioner purchased with the $80,000 was 7-year

property with a 7-year recovery period.    See sec. 168(c), (e)(1);

Thomson v. Commissioner, T.C. Memo. 1999-371.

     The Court, in reaching its holding, has considered all

arguments made and concludes that any arguments not mentioned

above are moot, irrelevant, or without merit.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.
